Starting next month, the Korea Exchange will expand price limits and introduce market-wide circuit breakers that should provide some relief for stock traders and retail investors.

Price limits and circuit breakers are used by many stock exchanges and regulators to counter severe price movements in financial markets, and Korea is no exception. Price limits are maximum percentages or values that a security or derivative contract can rise or fall in a trading day. Circuit breakers are trading halts triggered by sharp price movements, and can be imposed on either an individual financial instrument or the market as a whole. They were first adopted by the New York Stock Exchange and other U.S. exchanges in 1988.

Circuit breakers had been recommended by the U.S. Presidential Task Force in the aftermath of the stock market crash on Oct. 19, 1987, when the Dow Jones Industrial Average fell 508 points, or 22.7 percent. These circuit breakers were not triggered until a decade later, on Oct. 27, 1997.

Korea’s bourse operator has announced that, starting June, the price limit is set to rise to 30 percent, while the circuit breaker would halt trading for 20 minutes if the benchmark index falls 8 percent and 15 percent and shut down the daily session if the index plunges more than 20 percent.

Currently, stocks listed on the main KOSPI and tech-heavy KOSDAQ markets are allowed to move within a 15 percent price range from the previous session’s closing price. It is the first time in 17 years that the daily price cap is being revised. The existing circuit breaker allows the bourse operator to suspend trading for 20 minutes once a day if the market cap falls by 10 percent and is not triggered after 2:20 p.m.

“Although the current price limit system has contributed to stabilizing the stock market, it has hampered effective price setting by preventing the latest information from being immediately reflected in share prices,” officials of KRX were quoted as saying by the media.

It is hoped that the expanded price range will help the market better set the appropriate price in accordance with corporate values, he noted.

There is no doubt that a fair and orderly trading environment is key to maintaining a vibrant and well-functioning securities market.

Market interventions are aimed at preventing potential market disorder and restoring order in a trading environment that may be under stress. By providing a break or limit in trading, interventions are intended to provide the opportunity for information to be disseminated widely and equally, for market participants to reconsider their trading decisions rationally in light of new information and to serve as a signal of potential order imbalances in the system.

However, there is no consensus on whether price limits and circuit breakers are effective tools during crises. To date, there is still no convincing evidence of their potency.

Let us take a brief look at the two different schools of thought on the validity of these market invention systems.

As noted earlier, supporters say the systems provide investors with a cooling-off period to calm fears or provide time to digest news when there are steep declines in the markets; reduce market volatility and protect investors from excessive market volatility; provide time to restore the equilibrium between buyers and sellers; and provide the opportunity for increased information flow.

Those against market intervention, however, argue that they prevent investors from engaging in equity transactions that reflect their assessments of economic events, trapping investors in their positions. They find the tools counterproductive as they drain liquidity and diminish market depth.

The tools accelerate price movements toward the pre-announced limits as market participants alter their strategies and trade in anticipation of a market halt. In addition, they induce panic and uncertainty if the markets shut down suddenly and scare away the buying power necessary to turn a selling panic around.

The other arguments are that they are unfair to market participants with positions that benefit from volatility and deprive market participants of opportunities to raise liquidity to meet other obligations and lead to a chain of defaults.

In essence, price limits and circuit breakers deprive market participants of the opportunities to transfer risk and interrupt the price discovery process, two key market functions.

Economists have pointed out that one way to tackle this is to have the right of a discretionary halt built into the regulatory system, but use it rarely or sparingly as a deterrent. Such a deterrent would be just that ― a deterrent.

This is because, without a breaker, the price is continuously available as a barometer for investor beliefs. However, with a breaker in place, the price simply ceases to be displayed. This causes uncertainty among market participants as to what the asset is truly worth. The execution price uncertainty can also lead to misallocation of resources and the bearing of unwanted and avoidable risk.

Another alternative to such halts are “sidecars,” which have been used in the U.S. exchanges. Market orders are batched over short intervals and then matched against limit-order books, and move from a continuous auction to batch orders during extreme market moves, which would potentially slow trading down and calm markets. These procedures do not cause total cessation of trade and price discovery.

In any case, the market intervention mechanisms have been in used in many advanced countries, and one does not expect the Korean regulators to ditch the automatic system to shield the market from volatility.

It is good to know that the KRX will adopt a wider range of measures to prevent excessive market fluctuation and step up market monitoring in the first month to detect any suspicious trading activities. It is also preparing changes in the electronic trading system in cooperation with brokerage houses to introduce new functions to curb excessive stock fluctuations.

Given that, since the rules are being eased, it is absolutely necessary that the bourse operator strictly monitors trading, not just for one month, but continuously. The regulator cannot afford to let its guard down.

The stock market is an important barometer of the aggregate economy. A growing stock market signals to policymakers that sentiment is positive and investors expect economic conditions to improve. Appropriate policy action can then be taken. In a similar vein, a falling stock market signals that market participants expect bleak economic conditions. Policymakers may then take action to stimulate growth and perhaps contain inflation.

Therefore, it is very important for the stock market to function efficiently without any hiccups and the regulator should make all efforts to ensure it.

By Ram Garikipati 

Ram Garikipati is a business writer at The Korea Herald. He can be reached at ram@heraldcorp.com. ― Ed.