Raising Price Limits
Does enhancement of security-wise price bands bring efficiency to the Pakistan Stock Exchange? This piece is an eye-opener.
On December 13, 2019, Pakistan Stock Exchange (PSX) announced security-wise enhancement in price limit from existing 5% to a new level of 7.5%. The new circuit breaker regime was implemented from January 20, 2020 in a phased manner; i.e., enhancement undertaken by 0.5% after every 15th day till the time circuit breakers reach the level of 7.5% or Re. 1, whichever is higher. This means that once a maximum 7.5% circuit breakers are enforceable from fourth week of March 2020, if a stock opens on a new trading day at Rs50, it can fall or rise by Rs3.75 (seven and a half per cent) and 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 on that particular trading day.
The apex regulator, Securities and Exchange Commission of Pakistan (SECP) was contemplating to enhance security-wise or index-based caps since 2010, following the end of Global Financial Crisis 2007-09 and in line with global best practices. However, due to the volatile nature of Pakistan’s equity market that emanates from investor overreaction, potential brokers’ default and lack of trust between SECP and PSX, the proposed rules never came to fruition. For example, chances of default rise in case of extreme price volatility, to curb extreme swings due to over-reaction, stock exchanges have put in place price limits. Regulators see price limits as a mechanism to curb overreaction to news or sometimes to control non-fundamental trading based on rumours spread through social media. Furthermore, circuit breakers mitigate clearing-house risk, avoid large defaults and extend time-outs in an overheated market situation. Price limits facilitate minimizing of default risk by enforcing a cap on daily price changes.
On the other hand, potential circuit breakers delay price discovery (due to artificial price barriers); for example, due to company’s announcement the price of security trading at Rs. 20 may go up by 22, but the circuit breakers limit the price change to Re 1 (5% upper lock at the advent of good news, thus because of narrower circuit breaker regime, the security price does not incorporate/reflect complete information on that particular day) - and market participants, in general are constrained from entering and exiting the market at their convenience (i.e. turnover/liquidity declines). If the sophisticated investor wants to book a capital gain at Re 22, then the investor has to wait for the next trading day to fully realize the profit; therefore, the exit becomes difficult and thre is less turnover in that security. Similarly, in case of adverse information, if the price is assumed to fall from Re 20 to 18; the smart investor who wants to invest at a discounted/lower price, has to wait for the next trading day to invest for a better yield – that shows constraint to entry due to price bands as price can go down to Re 19 on that trading day at the advent of bad news. To sum up, the loss of liquidity (i.e., low turnover) makes a market with price bands unattractive.