“I commend the SEC for price band”

By Professor Lalith Samarakoon

On August 4, 2010, on the directive of the SEC, the CSE instituted a 10% upward and downward price band on all listed securities within any trading day based on the previous day’s closing price. This was in response to the unusual price volatility of some stocks. Over the subsequent three days, the market declined by 6.7%. But it rebounded 4.7% on August 10, and closed marginally lower on August 11.

Price limits are pre-specified upper and lower limits within which stock prices are allowed to fluctuate in a single day. The main purpose of price limits is to moderate excessive volatility that may result from market manipulation and excessive speculation. Price limits have the effect of reducing daily volatility, and spreading volatility over long periods of time. This is particularly important in Sri Lanka because of illiquidity and the highly concentrated share ownership.

Price limits have been used in many markets, both developed and emerging. The developed markets include Austria, Belgium, Finland, France, Italy, Japan, Portugal, Spain, and Turkey while emerging markets include Ecuador, Egypt, India, Jordon, Kenya, Korea, Mexico, Pakistan, Peru, Philippines, Taiwan, Thailand and Venezuela. Some countries use narrower limits such as 5% while others use wider limits such as 50%. Some countries specify different limits for different stocks, mostly based on the price of the stock.

I think this move by the SEC and CSE is long overdue, and I commend them for implementing price limits. I think that the CSE already had the provision for imposing security halts under automated trading rules, although the specific limits had not been formulated. While there are various advantages and disadvantages, both theoretically and empirically, associated with price limits, this is an important tool that the stock exchange should have in order to deal with unusual price volatility of stocks, and to maintain a fair and orderly market. The list of 10% is fairly in line with the limits that other markets impose. They vary mostly in the 5% to 20% range. Two main objects of the SEC are to create and maintain an orderly and fair market and to protect the interest of the investors. Price limits, along with market-wide circuit breakers and security trading halts, can be effectively used to reduce excessive price fluctuations.

While there is no universal agreement, some of the known pros and cons of using price limits include the following:
 
Pros:

• Provide a time-out for the market to cool-off, disseminate new information and thereby reduce volatility.
• Discourage market manipulation, reduce speculation activity, and reduce short-term overreaction by market participants. We do not want the market to be driven by excessive speculative activity. Such as market erodes the integrity of the capital market. The market must reasonably reflect economic, industry and company fundamentals. Such a market increases investor confidence. Particularly foreign institutional investors perceive speculative markets as very risky and hence reduce their exposure to such markets.
• Protects investors, particularly those uninformed and small investors, from exposure to wide price fluctuations.
• Provides time for traders and investors to digest any new information, analyze the stock, consult clients or portfolio managers, and re-evaluate their investment decisions and strategies.

Cons:

• Could reduce liquidity, particularly when the price limit is hit.
• Could delay price discovery. Price limits may not necessarily lead to increased dissemination of relevant information. The SEC and CSE have to ensure that any relevant information is quickly disseminated to the market by companies. Price limits should be used along with trading halts, when necessary, to ensure dissemination of firm-specific information.
  It is important that the SEC and the CSE examine certain important areas and take appropriate initiative to prevent market manipulation and to develop a fair and efficient capital market. Some of these key areas include the following:
• Strengthen their market surveillance and monitoring capacity. If they do not have one now, they should create a joint dedicated task force on market surveillance, which is responsible for continuous monitoring of the market activity, alert the management on suspicious activity, and create necessary policy framework for a fair and orderly market.
• Have proper databases, well-trained analysts, and continuous surveillance technology to detect potential market manipulation. Market manipulation can take the form of transactions-based manipulation in which transactions are made with the intent to artificially distort prices and volume or securing a larger stake or position in a security to manipulate the price. It could also take the form of information-based manipulation, which involves things such as spreading false rumours or issuing false positive or negative information to induce trading by others. Market manipulation damages investor confidence, and the SEC and the CSE have a responsibility for taking credible actions to preserve investor confidence and the integrity of the Sri Lankan capital market.
• Ensure prompt, accurate and full disclosure of material information by listed companies to all market participants simultaneously. It is important to evaluate the exiting methods of information dissemination and to make actions to ensure that stock market information is communicated to the investing public quickly in clear and understandable formats and languages.
• This is the first time price limits are imposed. It is important for the SEC and Exchange to study its impact on liquidity and volatility. Single price limit is appropriate at this stage of market development. But as the market develops, the CSE might consider changing the price limits and perhaps creating a regime with multiple bands.
• Must examine how stock brokers, analysts, senior management and corporate finance managers of listed companies, investment banks, and fund management firms that deal with material, non-public information. The SEC and CSE must make sure that appropriate fire walls exist in these institutions to prevent communication of material non-public information. It is important to review regulations regarding how listed companies share important non-public information with its employees, analysts and the investing public.
• Strengthen the enforcement mechanisms relating to insider trading and market manipulation.
• Must examine existing regulations relating to ownership limits. The ownership of listed companies is highly concentrated, and there are many large holdings and cross holdings. These can naturally lead to various types of market manipulation. Safeguards must be in place to prevent potential market manipulation by large shareholders. In the medium to long run, the ownership structure needs to be more broad-based by developing a proper and viable investment industry.
• It is also important to educate the investing public on investments so that they are able to better understand the behaviour and determinants of stock prices as well as to avoid market and investment conditions that do not fit their ability and willingness to bear risk.

(Lalith Samarakoon (BSc, Business Administration, MBA, PhD, Finance, FCA and CFA) is presently the Associate Professor of Finance, University of St. Thomas, USA. He is Sri Lanka’s first Professor of Finance. He is also a Financial Economist, a Chartered Accountant, and a Certified Financial Analyst. As a consultant and an International Finance Sector Advisor, he has worked with JICA, USAID, World Bank, ADB, Central Bank, Ministry of Finance, SEC, CSE and other key banks and financial sector institutions. Professor Samarakoon is widely respected in the Sri Lankan finance sector as an authority on the Sri Lanka’s financial markets. He is an accomplished researcher in the areas of capital markets, has received Sri Lanka’s highest research recognition, and written five books on securities markets. He pioneered the finance education in Sri Lanka and masterminded the transformation of the Faculty of Management Studies and Commerce of the University of Sri Jayewardenepura)

source - http://www.thebottomline.lk