By Quintus Fernando
Sri Lanka is indeed a land like no other. Where else in the world, are capital markets governed by bureaucrats who at their whims and fancies impose archaic regulations? A sound example of indifference and pure arrogance was witnessed on Thursday August 5 as SEC imposed a price band to the Colombo Stock Exchange (CSE) in a purported bid to limit “market manipulation”.
The CSE is undoubtedly Sri Lanka’s focal indicator of economic robustness. Over the last 15 months since the end of the conflict, the CSE’s remarkable performance has pitted it against the world’s best and earned it the title of “Asia’s best performing market”. On the back of this Bull Run, Sri Lanka has gleaned international acceptance as an economy poised for precipitated growth and has been hailed as an emerging market with great potential for international investment. Over the last year, scores of international fund managers – who in the past were wary of Sri Lanka and CSE - have visited and assessed it for stability as well as risk and reward potential.
Critical to the health of an economy and capital markets is maturity in governance and regulation. It is this maturity that international investors seek when considering a country for direct investment and for market investment. On August 5, Sri Lanka proved beyond doubt, that indeed its capital market governance was in the hands of petty-minded individuals who lacked any semblance of knowledge or understanding of the long term viability and sustenance of the capital market. On August 5, the God Almighty regulators of the Securities and Exchange Commission (SEC) led by an ill-experienced Chairperson imposed short-sighted and ill-suited price limits to the CSE, precipitating a continuous and consistent market crash over the past 7 days except for a brief upward trend precipitated by rumours of a reversal of the ruling on August 10. Ad-hoc regulation has effectively killed the country’s most evident and recognised economic indicator in the eyes of the global community - the Colombo Stock Exchange.
Surprisingly and sadly this fiasco is the outcome of SEC’s reaction to a skewed article in a financial daily on August 3 outlining speculative trading on four “fundamentally weak stocks”. Terming the market a mirage, this newspaper cited speculative trading of these four stocks as market manipulation. On August 4, the SEC which - if the case for manipulation was strong, should have acted on their assessments a lot sooner – woke up from a slumber to impose a ‘temporary criterion’ to halt trading of the cited four stocks. The following day, without any attempt towards a consultative process with stakeholders, the SEC flexed its muscles and swished its cane to punish not only the so called market manipulators but all of the investors through the introduction of a 10% low or high price band across the board. The suspension of the aforesaid four stocks was lifted without any investigation the same day. The market plummeted as retail investors sought to exist and cut losses. The impact of the price band is pervasive and will continue to dog the CSE as well as financially ruin the investor especially the retail investor who lacks holding power. In imposing a price band the SEC has effectively bound each and every stock including the so called “fundamentally sound” stocks to unrealistic constraints. It is safe to assume that the repercussions of the imposition of this price band will set in motion a series of financial losses to small and middle tier retail investors that will outdo the aggregate loss of the Golden Key and Sakvithi sagas.
Whilst various parties with personal agendas and interests try valiantly in the media and in public forums to paint a rosy picture of the effect of the price bands, this is far from the truth. Investors believe that this move by the SEC was motivated by personal interests of certain corporate and bureaucratic bigwigs in a bid to halt the rise of a rejuvenated yet leading stock at the CSE which has shown enormous growth over the past few months. There have been claims that the price band is a “circuit breaker” and a “market cooler”. In reality it is neither. The loose use of this terminology and the chaotic confusion that reins in the market has added to the acceleration of the market crash. Certain media and persons with vested interest term this a “colossal correction” of the market. It is not. And if the SEC believes that its approach to market manipulation is correct it is sadly mistaken. It only goes to prove that Sri Lanka’s Capital Market regulator is behind the times and not professionally competent. If the SEC had earnestly desired to put into practice fool-proof, up to date and proven governance practices it would have not jumped out of its seat as a result of a newspaper article but judiciously carried out the required research to find a technique employed in more complex and sophisticated markets. A little research would have opened the SEC’s eyes to the fact that price bands have been globally denounced and proven as ineffective and counter-productive including in the market that it claims it emulated – the Bombay Stock Exchange – where price bands are on their way out. It must be noted that the CSE does need regulation to avoid manipulation and fraud but these regulations should be effective to issues at large and not restrictive to the overall health of the market, as is the case with price bands.
Whilst the price band system has been apparently “hailed” by the investor community as per certain dubious reports, many remain ignorant to the overall effect of price bands. Below we make an attempt to provide a clear and technical assessment of the outcomes of price bands with practice examples of their down fall for the benefit of those investors who have been caught unguarded by the SEC’s incompetency.
1. Defining a Price Band
Price bands are automated mechanisms that pre-specify the maximum daily percentage range - upwards and downwards- in which security prices are allowed to move within a single day. In this case the limit is set at 10% change on the previous days’ price.
2. Circuit breaker vs. Price Band
By definition, circuit breakers or trading halts represent a temporary interruption in the trading of an individual asset on an exchange to force information disclosure to eliminate asymmetric information, whereas price bands are boundaries set by market regulators to confine the daily movements of security prices within a predetermined range to mitigate excessive price volatility. Trading halts do not include limitations on price movements. Once trading resumes after a trading halt, the price is determined solely by the market. Unlike the price band, trading halts are not mechanically or predictably imposed but rather are subjectively imposed in certain circumstances by exchange officials or supervising authorities. In contrast, the activation of the price limit depends solely on the price movement.
3. Proven negativities of Price Bands
Through the utilisation of changes in liquidity and volatility to describe the negativities and the counter-productivity of price bands, there exists a range of sufficient and proven evidence to demonstrate that trading halts (circuit breakers) seem to perform better than price bands. Price bands have a significant impact on the stock market. Interference with market mechanisms delay the price discovery process, price band hits cause spillover volatility and liquidity risks whilst market over-reaction persists for upper price limits.
(a) Delayed price discovery
Interference in market mechanisms through price bands inevitably affect price resolution and the magnitude of such impacts depend on the level of price limits. They thus make trading impossible and therefore harm the price discovery process. Price bands only prolong the number of trading days it would take for the market to achieve equilibrium price. Trading usually stops when the price hits either the upper or lower limits until the limits are recalculated. Price boundaries prevent stocks reaching their equilibrium price during that given day. Once the limit is hit and it blocks prices and stocks have to wait for a subsequent period to continue towards their true price.
The delay in price discovery is a costly problem. If price bands are to be effective in preventing over-reaction, then there needs to be price reversals after price limits are hit.
(b) Cause spillover volatility
First, volatility increases after price band hits, but no significant change of volatility is observed after trading halts. Price Bands are thus ineffective in reducing volatility. They may in fact cause volatility to spread over a long period of time because limits prevent large one day price changes and immediate price corrections. Thus, price bands increase volatility and act like magnets in that volatility does not revert to normal and to pre-limit hit levels. Instead volatility simply “spills over” into subsequent days.
Evidence of strong price continuations and return reversals eliminates the possibility of a cooling-off effect and indicates that the upper price limit does not reduce overreaction. In that the objective of price limits is to reduce overreaction, upper price limits fail to achieve their intended goal. Thus, this disproves SEC’s claim of the price band working effectively towards the elimination of manipulation.
(c) Interference in liquidity
Second, liquidity increases following trading halts, whereas it actually decreases after price band hits. Stocks become less liquid if the price limits prevent trading, hence liquidity decreases the day following a price limit hit. Trading activity on the following day/s may increase as a result of interference.
Price Bands also tend to be self-fulfilling, as they motivate traders to rush and cover their positions through active trading especially in circumstances where fear of being locked into potentially undesirable positions is high. The fear of potential illiquidity in their positions would cause them to rush into the market, increasing volume on one side of the market, and thus accelerate the approach to a price limit.
Price Bands prevent market participants from trading beyond the limits, and information cannot be fully transmitted, which results in an increase of information asymmetry and traders’ unwillingness to provide liquidity. Volatility increases after price limit hits and unlike with trading halts where volatility remains unchanged. If the primary objective of price limits is to reduce volatility, they not only fail to achieve their intended goal, they make it worse.
4. Price Bands a boon for market manipulation by large scale investors
In the case of the CSE, the imposition of a price band across the board on ALL stocks leaves more than ample room for market manipulation by large scale investors who have the wherewithal to dump money into the market. This was evident on August 10, 2010 when so called bargain hunters dumped billions to hit maximum price limits. Price Bands enable market overreaction for upper price limits. Moreover, with thinly traded securities, price limits can be used by “big hands” as a signal to signal their manipulation to uninformed traders.
5. Price Bands create bottlenecks in settlements
Another disadvantage of price bands is that they present barriers to the clearing mechanism. Traders will be made unable to either liquidate or take up positions and, therefore, be unable to hedge and control risk on their own books effectively. Price bands cause those with long positions in a downward market to face liquidity problems because of the potential unwillingness of buyers to enter the market because of anticipated price decreases.
6. In practice how implementation differs in other markets
Circuit breakers or trading halts are implemented on individual stocks or indexes at the Toronto Stock Exchange, NASDAQ, NYSE, and Paris Bourse whilst exchange-wide circuit breakers are also implemented based on circumstances at NYSE and Tel-Aviv Stock Exchange. They are triggered by pre-defined rules (e.g. Paris Bourse) or decided upon by a “surveillance system” (e.g. Toronto).
Price Bands, on the other hand, are less popular and have been used rather unsuccessfully by the Athens Stock Exchange (ASE), India’s National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). (ASE) imposed an 8% price band in August 1992 which remained in place until February 2000. Due to the phenomenon of short-term overreaction, the ASE discontinued the use of price bands.
Both the NSE and BSE (both of which have been used as the model for CSE’s price band implementation) operate in a vastly different manner to the price band at the CSE. The Securities and Exchange Board of India (SEBI) introduced “circuit filters” that are applied for different classified baskets of stocks based on their price, liquidity, volatility and market capitalisation. This means that blue chips are dealt with in a different manner to penny stocks with broader price bands applied for low value shares. This proves that the SEC has been ridiculous and immature in applying the same yardstick across all stocks at the CSE, despite their claims that they have adopted the methodology from SEBI. Moreover, recognising the constraints of price bands, the SEBI accepted the recommendation of its Group on Risk Management for Equity Markets to relax the price band to 16%, with a 30-minute “cooling period” after the scrip has hit the initial filter of 8%. SEBI’s Group on Risk Management for Equity Markets, while recommending relaxation of the price band and the margin rules, has reportedly pointed out that even the 16 per cent limit should be discarded at some point. Some of the group’s members are toying with the New York Stock Exchange model of putting bands at 900 points either way from the Dow Jones Industrial Average index at the previous day’s closing.
In addition, some exchanges (e.g. Tokyo Stock Exchange) have price variation rules that initiate a halt in trading if the price difference between successive trades is larger than a pre-specified amount.
On the backdrop of the above mentioned factors, and in the interest of all of the investors at the CSE including a large proportion of retail investors, it is essential that the SEC re-assess its stand on price bands. Whilst the intention for regulation against market manipulation is a necessity, the urgency for the aforementioned parties to further analyse and utilize appropriate regulation is the key to the safeguarding of investor interests. At present the price band system allows for large scale or “big hand” players to effectively manipulate the market whilst punishing and killing investor confidence of the medium and retail tiers.
In conclusion, the following points need to be reiterated:
1. The SEC implemented the price bands in the most ad hoc of manners without a consultative process with the related stakeholders. In other markets such as the United States, a move of this nature would be preceded by months of consultative dialogue. As a result of this high handed attitude, the stock broker community remains unwilling to publicly oppose the regulation due to fears of reprisals and targeted attacks.
2. The SEC has failed to understand that trading halts are not meant to interfere with stock pricing but to disseminate information in a manner in which the market players can make an informed decision on uniform information.
3. The price band system remains unsuitable for Sri Lanka due to the nature of the market. As a developing capital market where market capitalization remains at USD 15 billion and where sufficient liquidity continues to be an issue. The CSE does not compare with the Indian markets or the Japanese, United States or any other developed capital market where this form of regulation is in place albeit at a more evolved level. The point needs to be made that even in the few countries where price bands were implemented, no single band has been imposed across the board, as is the case at the CSE. Those countries that implement price band do so in a complex and calculated manner wherein equities and indices are categorized based on different fundamental factors such as market capitalisation, volatility, liquidity and stock pricing. Hence, penny stocks and fundamentally strong stocks are treated differently through the adoption of varied triggers and price bands.
4. Further, in markets such as India, the NSE and BSE adopt price bands in a manner where once a share hits the price band, the share continues to be allowed to trade subsequent to a predetermined cooling period. Moreover, the price bands are constantly reviewed based on the market dynamics. Even in developed markets such NYSE, NASDAQ price bands are not enforced instead the mechanism adopted are that of price halts or circuit breakers that are imposed for pre-defined periods for individual equities and indices. Markets such as London Stock Exchange (LSE) and the Singapore Bourse do not adopt even circuit breakers in a bid to maintain the market equilibrium through unhindered demand and supply.
5. The very function of a stock market is to allow for continuous trade, denial of this facility is a negation of the market function. Dispensing with price bands does not mean there is no need for checks and balances. In fact, there is a need to evolve suitable steps to moderate any runaway movement of stock prices. This Machiavellian meddling that the SEC has adopted instead has resulted in a detrimental plunge in market turnover due to declined market activity as a result of the non-prevalence of market forces. However, the undeniable truth is that the CSE will continue to demonstrate growth due to the involvement of the “big hands” in playing large quantum of stocks. This is not necessarily a healthy outcome.
6. The SEC speaks of penny stocks, day traders and speculation as if they are bad words. As regulators they should be more than aware of the fact that all three of these factors are inherent to a stock market. Speculation is part and parcel of any healthy capital market including the money market. If SEC does not desire for the prevalence of penny stocks at the CSE, then due consideration should be given for their assessment and de-listing. However, this remains contentious in that rogue companies continue to be allowed to list through IPO’s that are unimaginably oversubscribed. Day traders are being treated as rogues and frauds when in fact they constitute and play a fundamental role in trading systems across the world.
7. All in all, the SEC has proved to be a let-down to each and every investor of the CSE (apart from probably the few whose interest they are looking after through the imposition of this price band). When more effective alternatives are available, the SEC chose to implement a regulation without due reference to the issues outlined in this article. In doing so, SEC has struck out at the small and mid tier investors as well as the margin traders. By doing so it has intentionally or unintentionally created space only for the big time investor who has large scale capital accessibility.
source - http://www.thebottomline.lk
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