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Circuit-Breakers Keep Equities From Overheating

by Tavaga Invest
Circuit Breakers

Automatic time-outs are not unwelcome in high volatile equity markets

By: Tavaga Research

It was Friday the thirteenth, and the stock markets were in for the scare of a lifetime. The indices on the National Stock Exchange (NSE)  and Bombay Stock Exchange (BSE) nosedived in a way that seemingly knew no bottom, triggering the circuit-breaker. Trading had to be halted for 45 minutes, the first time since 2008, as soon as markets opened on March 13. 

At play were the rise in Covid-19 cases in India and the gloom descending on economies the world over. Investors have the mechanism of circuit-breaker to thank for not losing out more that day. 

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What is a circuit-breaker?

As with electrical systems where a tiny circuit-breaker cuts the flow of electricity when there is an overwhelming surge of current, a stock market circuit-breaker is an automatic process of halting trading if certain levels, either upper or lower, are breached. 

If there is an unfettered fall or rise in an index during trading hours that is enough to breach the lower or the upper limit (or filter) is breached respectively, the markets shut down to stem the movement.

Circuit breaker hits the market
Source: Tavaga

Why is a circuit-breaker needed?

The circuit-breaker is a regulatory tool of ensuring the investor does not lose a devastating amount of their capital or traders don’t face margin calls for wild swings. 

It also helps to reboot the markets in a free-fall, at times infusing perspective or hope among investors and traders who may then want to keep in check the actions causing the rapid movement.

Circuit-breakers could be more needed than ever in this day and age of high-frequency and algorithm-driven trades to keep errors from getting out of hand. 

How does a circuit-breaker work?

India has market circuit-breakers and price bands for certain company stocks that act as circuit-breaker limits. 

The circuit limits, mandated by Sebi, are common to all the exchanges. If the circuit limits are crossed by either of the benchmark indices — Nifty50 and Sensex — the circuit breaker is triggered for both the markets.

Rather than an absolute value limit, the system tracks percentage change or movement in the indices. There are three predetermined percentages of change that trigger the circuit-breaker — 10 percent, 15 percent and 20 percent fall or rise. The percentages are calculated on the previous day’s closing values of the indices by the exchanges. The percentages are different for different countries and exchanges.

Once triggered, trading in all equity and equity derivative markets are stopped nationwide.

The limits set for indices that trip the circuit-breaker are called circuit filters.

Price bands are for individual company stocks and are set by the exchanges. They are 2 percent, 5 percent and 10 percent, all either ways, set daily based on the previous day’s closing value. Trading on these stocks stops if any of the limits are breached.

But not all individual stocks have this safety net. Only those that have no derivative contracts and/or are not part of an index that has a derivative contract are eligible for circuit price bands. 

For how long is trading stopped?

The amount of percentage movement and the time of the breach determine the duration of halt as seen in the table below:-

The circuit limits are calculated daily based on the previous day’s closing level of the indices, rounded off to the nearest tick size.

Circuit-breaker on March 13

The Nifty50 breached and the Sensex was close to breaching the lower limit. 

The bourses stalled for 45 minutes as the Nifty50 fell by 10.07 percent or 966 points to 8,624 and Sensex plunged by 9.43 percent or 3,090 points to 29,687 in early trade. 

The Nifty had closed at 9,590 the day before on March 12, and hence, circuit limit the next day was crossed.

Reboot after circuit-breaker

Before trading resumes, there is usually a pre-open session that sees a call auction for 15 minutes after the time-out. Trading continues till the next time a circuit-breaker is triggered.

This time the reboot worked for the day as the Sensex recovered 4,715 points on March 13, after trading resumed, showing how market sentiment may get reversed during the forced time-out.

History of circuit-breakers

The tumble of Black Monday, a day of worldwide-markets crash in 1987, starting in Hong Kong and echoing all the way in the US, is often said to have given birth to the regulatory measure of a circuit-breaker. 

When the Dow Jones Industrial Average lost 22.6 percent or 508 points in a day, the US regulators stepped in and instituted a circuit-breaker. 

The regulatory guideline has since then been adopted by other countries too. 

Origin of circuit-breaker in India

Sebi issued a circular in June, 2001 to ask exchanges to implement index-based, market-wide circuit-breakers from July, 2001. The present rules were a result of modifications in 2013 by Sebi. Now it is a daily limit that gets revised based on the previous day’s closing value of the indices, earlier it used to be set quarterly.

Safeguards other than circuit-breaker

Besides triggers in the indices of equity markets, stocks and derivatives markets also deploy other safety nets.

Recently, in light of the current market turmoil, Sebi reminded us of some other tools such as the Value at Risk (VaR) margin that requires a margin at the start to cover 99 percent risk of a transaction and the extreme loss margin which covers the residual risk of a transaction. 

Circuit-breakers set off in 2020

We are just three months into 2020, and already hoping it ends on happier notes. Exacerbating recessionary trends the world over, the microscopic novel coronavirus’ onslaught has brought markets to their knees.

Wall Street has already hit circuit filters more than once in March, with the Dow Jones index falling more than 7 percent and the S&P 500 falling 9.5 percent one day.

Shocks in a circuit-breaker

The novel coronavirus-led selloff has triggered circuit-breakers across markets, making some complain they add to the confusion and volatility that the tool seeks to curb. However, the jury is still out on that and we have seen benefits in such time-outs. Volatility is inescapable in these times but at least, there is hard-stop before a huge fall or rapid unfounded rise.

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