23 October 2016
Experts believe a "circuit breaker" mechanism will help stabilize the market by providing a respite at the onset of panic. Photo: CNSA
Experts believe a "circuit breaker" mechanism will help stabilize the market by providing a respite at the onset of panic. Photo: CNSA

What a ‘circuit breaker’ actually does in the stock market

The Shanghai and Shenzhen stock exchanges jointly released a notice on Sept. 7 proposing to introduce a new “circuit breaker” mechanism to the mainland stock market.

The “circuit breaker” will be linked with the CSI 300 Index. When CSI 300 Index falls or rises over 5 and 7 percent, the exchanges will adopt respective measures to temporarily halt trading. The mechanism will be added to the existing 10 percent daily limit rule.

Industry insiders believe the mechanism will help stabilize the market by providing a respite at the onset of panic. However, some fund managers argue that market liquidity will be under severe threat if trading were forced to stop.

Such mechanism was actually a “legacy” from the Wall Street’s experience on Oct. 19, 1987, better known as Black Monday, when the Dow Jones Industrial Average declined 22.61 percent in the single day, triggering a worldwide stock market crash.

According to the experience of the United States, there were only few times when the breaker was triggered.

One example occurred on Aug. 8, 2011, when the US stock market fell sharply after the S&P downgraded the US sovereign rating. The “circuit breaker” performed its role as a stabilizer.

A recent case was on Aug. 24. The three major US stock market indices fell by the 7 percent “break” threshold not long after a low opening. Trading was suspended for 10 minutes. The indexes then began to rise as panic in the market was relieved to a certain degree. The market closed about 4 percent lower on that day.

However, don’t forget that the US market is dominated by institutional investors while the Chinese market is crowded with individual investors.

Professional institutional investors are more rational and have higher risk tolerance than individual investors. In addition, in A-share market, the bear market usually lasts longer than the bull market, while the situation is the US is the opposite.

Many foreign investment experts find it hard to understand the volatility in the A-share market. A foreign investment banker once asked me whether the market would be even crazier if the 10 percent daily limit didn’t exist. I said “probably not” as the liquidity may improve.

Besides the ups and downs of the market, the problems A-share markets face are about liquidity and the lack of maturity among market players.

Moreover, since many A shares don’t offer dividends, their holders can only gain profit from price rises.

The government may consider requiring mature and large-cap listed companies (e.g., banks, oil firms and telcos) to pay dividends. This will allow individual investors in China, many of whom are retirees, to have stable earnings, as if they are holding bonds.

Will the “circuit breaker” work in the A-share market? If the mechanism had been in effect since June 15, it would have been trigged 19 times — 14 times by panic selling, and five by steep rises.

A halt in trading, while it looks like it can help stabilize the market, can only delay the risk to the next trading day.

This article appeared in the Hong Kong Economic Journal on Sept. 15.

Translation by Myssie You

[Chinese version中文版]

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adjunct professor in the Department of Finance at HKUST Business School

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