| On this day - 08 January 2016 |
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| Apurva Sheth |
Chinese Regulators Need to Get out of the Way.
The Chinese Regulators Are Only Making the Situation Worse.
What a pleasant surprise it was, when after reaching school, you found out the administration or government has declared an unexpected holiday. An innocent child would hardly bother to understand why and would immediately start to plan the rest of the day having fun with friends.
An unplanned holiday comes as a pleasant surprise when you are a child, but it may not be so pleasant as an adult, especially if you are invested in the Chinese markets.
Chinese markets had to be shut for trading on Wednesday after the Shanghai Composite Index hit the circuit breaker limit of -7%. This was the shortest trading day ever recorded in the history of Chinese markets. Trading lasted for a total of 29 minutes including the 15-minute temporary suspension after the index hit the first circuit breaker of -5%.
The China Securities Regulatory Commission (CSRC) overlooks the Chinese stock markets. The CSRC introduced a two-part mechanism to tame the drastic volatility on 4 January 2016. As per this mechanism, the circuit breaker halts exchanges for 15 minutes after a 5% drop in the index and then halts them for the rest of the day after a 7% fall.
The CSRC may have implemented this mechanism with good intentions of protecting investors from volatility, but this rule is doing more harm than good. This was the second time in a week that the Chinese markets had to be shut. Markets were shut on Monday as well after the 7% circuit breaker was triggered.
The problem here is that the circuit limits set by the regulator are too narrow. Chinese market are generally considered to be high beta in nature. A 5% move either way isn't abnormal for Chinese markets, especially during a crisis such as the one China is going through now.
With such a tight range for the first circuit filter, the regulator is narrowing the scope of movement for the index in a day. A trading halt after a 'small' 5% drop in the index gives traders enough time to flood the system with sell orders. Thus, when trading starts after the 15-minute halt, the index quickly moves lower and hits the 7% circuit breaker.
The worst part of all this is that the Chinese regulator has got it all wrong at a much deeper and a fundamental level.
They implemented this rule in anticipation of a short-selling ban, which was supposed to be lifted on 8 January 2016. The regulator expected that lifting this ban would invite short sellers, so it was necessary to limit the extent of a fall.
By banning on short selling and implementing a narrow circuit breaker, the regulator is blocking the natural flow of markets. With these policies in place, the regulator is not facilitating its primary objective of efficient price discovery.
They are missing some fundamental rules of how markets operate.
Markets exists only because there is a difference of opinion. For every buyer there is a seller and for every seller there is a buyer. Markets cannot operate without both parties. A ban on either of these activities (buying/selling) is silly.
Markets go through cycles. Everything that goes up must come down. Stocks cannot rise forever. The Shanghai Composite rallied more than 150% from June 2014 to June 2015. The fall that followed after topping out in June 2015 should be seen as a 'healthy' correction rather than a problem.
The CSRC's actions have the opposite impact of what it should have had. Instead of calming investors' nerves, they have exacerbated their panic.
Just as I sit down to finalize this letter, the CSRC has scrapped the circuit breaker limits for the index. Thankfully, better sense prevailed.
Do you think China should have wider circuit limits? Share your views in theClub or share your comments here. |
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