Why China Is Suspending Market Circuit Breakers

Chinese regulators have announced that beginning on January 8th, circuit breakers used to halt its stock markets will be suspended in order to "smooth" trading operations. Chinese stock markets were halted on Wednesday, January 6th after falling more than 7% in the first 29 minutes of trading – following a previous halt two days earlier on the very first trading day of the 2016 calendar year.

Chinese officials have repeatedly engaged in economic stimulus measures over the past few months including attempts to devalue their currency, the yuan, in order to boost exports as demand weakens. Despite these efforts, the Shanghai Composite Index is down 12% since the beginning of the year. (For more, See: What happens when a circuit breaker is put into effect?)

Regulators in China are saying that such as suspension will create stability in equity markets; however, the inclusion of such circuit breakers were originally meant to maintain stability and continuity in markets. Are Chinese authorities caving in to investor pressure, or are they being prudent in suspending them? (See also: High Debt and Savings Rates Hinder China's Economy.)

Also known as a trading curb, circuit breakers have been implemented in stock markets, and other asset markets, around the world.

The intention of a circuit breaker is to halt trading in a security or market to prevent fear and panic selling from collapsing prices too quickly and without a fundamental basis and spurring more panic selling in the process. Following a modest decline, a market may be halted for a number of minutes or hours and then resume trading once investors and analysts have had some time to digest price moves and might perceive the sell off as a buying opportunity. The goal is to prevent a free fall and balance buyers and sellers during the halt period. If markets continue to fall, a second breaker may trigger a halt for the rest of the trading day. When a halt occurs, trading in associated derivative contracts such as futures and options is also suspended. (See also: Connecting Crashes, Corrections And Capitulation.)

Circuit breakers were first conceived following the stock market crash of October 19th, 1987, also known as Black Monday, when the Dow Jones lost nearly 22% of its value in a single day, or half a trillion dollars in value. They were first implemented in 1989, and were initially based on an absolute point drop, rather than a percentage drop. That was changed in updated rules put into effect in 1997. In 2008, the Securities and Exchange Commission (SEC) put into effect rule 48, which allows for securities to be halted and opened more quickly than a circuit breaker would allow under certain circumstances before the opening trade of a stock for the day.

In the U.S., for example, if the Dow falls by 10%, the New York Stock Exchange (NYSE) can halt market trading for up to one hour. The size of a drop is a measure that will determine the duration of the halt: the larger the decline, the longer the trading halt. There are other circuit breakers in place for declines of 20 percent and 30 percent in a single day:

Source: NYSE

There are similar breakers in effect for the S&P 500 and Russell indices as well, and for many exchange traded funds (ETFs). Global markets, too, have implemented curbs.

The goal of a circuit breaker is to prevent panic selling and restore stability among buyers and sellers in a market. Circuit breakers have been used a number of times since their implementation, and they were crucial in stemming an outright market free fall after both the Dotcom bubble burst and the fall of Lehman Brothers. Markets did continue to decline after those events; however, the selling was much more orderly than it otherwise could have been.

For Chinese securities, current rules state that if the benchmark index CSI 300 falls 5% in a day, trading will be halted for 15 minutes, and a 7% decline will trigger a halt in trading for the rest of the trading day. Some people have complained that the 7% threshold for a full day halt is too low and that it should be increased to at least 10%. (See also: Chinese Stocks Halted for 2nd Day in 2016.)

If curbs promote market stability, is the Chinese assertion that removing them will be positive for trading fluidity?

One argument is that the 7% trigger is too small of an event to warrant a full day stop. Some hedge fund managers and portfolio managers active in Chinese markets were forced to liquidate positions in order to get cash out prior to the halt, exacerbating the event.

According to a report by Bloomberg, due to China's emerging market status, many funds have agreements with their investors that dictate mandatory liquidation levels if their holdings drop below a specified level. This can create herding behavior as fund managers all are mandated to sell at the same time, driving prices even lower. (See also: 8 Ways To Survive A Market Downturn.)

With breakers removed entirely, however, the much-feared panic-driven free fall in prices is open to occur without hindrance. On the other hand, free market advocates, arguing that markets will take care of themselves and trading halts are artificial barriers to market efficiency, say if a market falls 20% or more in a single day, it is because it should be lower by such an amount. This puts Chinese regulators in a catch-22 situation where whichever decision they take regarding circuit breakers will face potential criticism.

With Chinese markets in turmoil, regulators have lifted trading halt rules based on circuit breakers after they've been tripped twice over the course of two days, with the January 6th market lasting only 29 minutes from the open before the circuit breaker was triggered.

Circuit breakers were put in to effect following the Black Monday market crash, and have been promoted as providing market stability by preventing panic selling from snowballing in to an all out free fall. While a trading halt may allow buyers and sellers to re-calibrate, market purists claim that halts are artificial barriers to market efficiency and should not be used.

Chinese fund managers and traders have complained that the 7 percent limit down being used right now to trigger a full day halt is too small of a margin, and that it should be increased to 10 percent or more. Since many funds engaged in Chinese stock markets have agreements with their investors to liquidate positions given a specified drop in value, herding behavior may actually increase panic selling, and the removal of circuit breakers might allow markets to drop unchecked.