On circuit breakers, price limits, volatility curbing: truth or myth?
During turbulent times and excess volatility in capital markets, the issue of circuit breakers and price limits re-emerges – and Egypt is no exception.
Since the reactivation of The Egyptian Exchange (formerly Cairo & Alexandria Stock Exchanges - CASE) in 1992 there has been a price limit of ±5%. It was not until 2001/2002 that the exchange started to differentiate between actively and thinly traded stocks, whereby actively traded stocks would have a circuit breaker of ±10% and a price limit of ±20% based on the intra-day closing prices calculated based on the volume-weighted average price (VWAP) of stocks.
Should the VWAP change exceed the ±10%, EGX used to suspend trading for 30 minutes, and suspend trading until the end of the trading session should the change exceed ±20%. The stock’s last trade price could change by more than the stipulated percentages as long as the VWAP did not reflect the most recent trading prices during the trading session. In addition, there were no circuit breakers or price limits on the index level.
With the eruption of the financial crisis in 2008, circuit breakers’ and price limits’ reference calculations changed to be based on the order price and not the VWAP, which eliminated the chance of seeing stock prices moving outside the stipulated ranges.
Due to the January 2011 revolution and its aftermath, the circuit-breaker percentage was further reduced to ±5% and the price limits to ±10% based on the order price, and circuit breakers on the index level (EGX100 index) were introduced for the first time with suspension of trading on the entire market for 30 minutes should the index level change by ±5% and suspend trading for the entire day should the change reach ±10%.
In 2017, the EGX board took a decision, approved by the regulator, to reduce the suspension time from 30 minutes to 15 minutes for individual stocks, which was then further reduced to 10 minutes. This had a direct and vivid impact on trading activity on the market. The suspension time for the EGX100 index was maintained at 30 minutes.
During the COVID-19 pandemic with its associated volatility, the EGX board in March 2020 adopted a non-symmetrical approach on the index level and the market-wide circuit breaker is only applied when prices declines rather than increase. The decision referred to the WFE study on circuit breakers that showed several markets adopting market-wide circuit breakers in a non-symmetrical approach.
Proponents of circuit breakers and price limits from regulators and exchanges argue that circuit breakers: 1) improve information flow; 2) reduce volatility and protect investors from excess volatility; 3) provide time to restore equilibrium in the market, and last but not least; 4) provide a cooling-off period enabling investors to calm down and digest information in an orderly fashion, especially in periods of excess volatility.
Another argument that is more pertinent to emerging and frontier markets is that circuit breakers and price limits reduce market manipulation; however, we are not aware of any theoretical model that expands on this idea.
Critics on the other hand argue that circuit breakers: 1) hinder investors’ ability to trade freely based on their assessment of economic changes; 2) accelerate price changes towards predetermined limits in anticipation of trade suspensions and therefore increase volatility rather than decreasing it as intended by regulators; 3) put volatility traders in an disadvantaged position and; 4) can lead to a domino of defaults should investors be deprived of selling their positions [1].
Academic literature is beyond the scope of this article; however, the briefly reviewed results are inconclusive when it comes to the effect of circuit breakers on volatility. Furthermore, volatility and circuit breakers should be assessed at times of tranquility and turbulence as their impact varies significantly according to prevailing market and economic conditions. Even if circuit breakers reduce volatility in the short run, they lower market efficiency in the long run.
In conclusion, circuit breakers and price limits are widely implemented in advanced, emerging and frontier markets. They are a popular policy measure implemented by regulators and exchanges to appease investors during periods of erratic volatility and they are always easier to defend by their presence rather than their absence. More statistical research is needed in this area for any policy changes by regulators and exchanges.
Only time will tell what changes will be made in the long run. Rather than recent volatility during the COVID-19 pandemic making it harder for regulators and exchanges to widen circuit breakers, it gives scholars and researchers an opportunity to assess if the impact of circuit breakers and price limits is a myth or truth.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of The Egyptian Exchange or the Egyptian capital markets regulator.
[1] SFC Quarterly Bulletin Autumn 2011