On Dec 13, 2019, the Pakistan Stock Exchange (PSX) announced the security-wise enhancement in price movement limits from existing five per cent to 7.5pc.

The new circuit-breaker regime was implemented on Jan 20 in a phased manner: the enhancement of 0.5pc after every 15 days until the circuit breakers reach the level of 7.5pc or Re1, whichever is higher.

This means that once maximum 7.5pc circuit breakers are enforced from the fourth week of March, a stock can fall or rise by Rs3.75 (or 7.5pc) if it opens on a new trading day at Rs50. It cannot cross the limits until the end of that particular day.

Similarly, a penny stock worth less than Rs13.35 can only be traded for one rupee above or below its opening value and cannot go beyond this limit.

The Securities and Exchange Commission of Pakistan (SECP) had been considering enhancing security-wise or index-based caps since 2010. However, owing to the volatile nature of Pakistan’s equity market, the fear of investors’ overreaction, potential broker defaults and a lack of trust between the SECP and the PSX, the proposed rules were not implemented.

Some say circuit breakers increase volatility on subsequent days and prevent immediate corrections in order imbalances

Stock exchanges have put in place price limits to reduce the chances of a default rise in the case of extreme price volatility. They also help curb extreme swings owing to the investors’ overreaction. Regulators see price limits as a mechanism to curb any overreaction to news as well as control non-fundamental trading based on rumours spread through social media.

Furthermore, circuit breakers mitigate the clearing-house risk, avoid large defaults and extend timeouts in an overheated market situation. Price limits minimise the default risk by enforcing a cap on daily price changes.

On the other hand, potential circuit breakers delay price discovery owing to artificial price barriers. They also prevent market participants from entering and exiting the market at their convenience. The loss of liquidity makes a market with price bands unattractive.

There is a huge debate among policymakers, market participants and academics about the effectiveness of price limits or trading halts. Broad literature suggests that price limits do not enhance market efficiency and, in fact, impose severe costs. Especially, narrower price limits exhibit a higher acceleration rate: markets document a high frequency of upper- and lower-limit hits with narrower price bands.

Prior to the change in the circuit-breaker regime, Pakistan had the narrowest price limits at 5pc. In Taiwan, Saudi Arabia and Malaysia, the scrip-wise price bands are 7.5pc, 10pc and 15pc, respectively. In many developed exchanges, security-wise price bands have been abolished and 5pc caps are imposed only on benchmark indices.

From the market volatility perspective, there is a growing debate on the enforcement of price limits. The spill-over hypothesis mentions that price limits increase volatility on subsequent trading days. Circuit breakers prevent large one-day price changes and immediate corrections in order imbalances.

The imposition of price bands does not contain volatility. It only postpones it. Thus, markets observe extreme volatility once they resume normal trading after the cool-off period or the next trading day. However, a major justification given by the regulator for the imposition of circuit breakers is to inhibit extreme price movements.

The table shows data for the KSE All-Share index in two periods: Dec 2, 2019–Jan 17, 2020 and Jan 20–March 3. It shows only two stock market variables for comparison: liquidity and volatility.

These figures show the average daily turnover following the regime change declined significantly although higher liquidity was expected. Similarly, volatility slightly increased following the enhancement of circuit breakers, which was expected.

Two things need to be put in perspective before interpreting the results: a) the post–regime change data shows only a gradual enhancement of price bands and not the full impact of maximum 7.5pc enhancement; b) after the policy shift, Pakistan’s economy encountered a few adverse events, such as inflation of 14.6pc in February, tension between the SECP and the PSX on the issue of the new brokers’ regime and the threat of novel coronavirus.

Thus, the expected result of price cap enhancements did not come owing to negative macro-economic factors.

Therefore, the policy question of raising price limits and their level of appropriateness is still unanswered in the case of the PSX.

The writer teaches finance at IBA, Karachi

Published in Dawn, The Business and Finance Weekly, March 16th, 2020