Volatility and regulatory responsibility

A Daily FT article published on 23 August 2010

The thoughts of last week relating to the captioned subject attracted several calls, emails and text messages.

I was happy that the basis for the thoughts, the examples of similar actions of established jurisdictions not only in 1929, 1987 or later and indeed even today, as well as the spirit in which the article was written, was well understood by most. That was encouraging.

To others, I must say that in the very first paragraph of last Monday’s article I said, “The response of the regulator may not be the ideal but no response at all would have been irresponsible.” I maintain that position.

Exemptions from capital gains and wealth tax

Referring to the Strategy for Industrialisation of 1989/1990, I conveyed how we brought in exemptions of tax on capital gains transactions and exemptions on wealth tax on the value of shares at 31 March – a key incentive of two decades which is at the very core of market volatility in peace time.

I pose the questions: “What if there was a capital gains tax, would the volatility and the day trades and the margin trading exposures have been less?” “What if there was wealth tax – would not the volatility towards end March and early April (generated by locals in particular) be driven by a desire to lower values at 31 March, regardless of fundamentals?”

It is useful not to provoke the authorities, whether it is the regulator of stocks and shares or the authority which conceptualises, designs and imposes taxes.

Circuit breakers in the United States

In the US there are three thresholds, which represent different levels of decline in the Dow Jones Industrial Average. In the event the first threshold is breached, the first halt is triggered. If that occurs before 2 p.m., the market is shut down for an hour.

If the first threshold is breached between 2 p.m. and 2.30 p.m., the halt remains in place for 30 minutes. Trading is not halted if the first threshold is breached after 2.30 p.m.

In the event the second threshold is breached before 1 p.m., the market is shut down for two hours. If the decline took place between 1 p.m. and 2 p.m., a one-hour pause is implemented. The market is closed for the day if stocks dip to that level after 2 p.m.

When the third threshold is breached, the market closes for the day, regardless of the time. These thresholds are computed at the beginning of a quarter. The chart shown on this page is a visual which explains the circuit breaker mechanism, adopted in the US.

France

France adopts a system of daily price limits. These limits apply to the cash and derivatives markets. Securities are of three categories depending on the number and volume of daily transactions. Price limits vary depending on the category to which the security belongs.

When the price movement of a security in a more liquid category, exceeds 10% from the quoted price at the close of the previous market day, quotation is suspended for 15 minutes.

If the price then goes up or down by more than 5%, transactions are again suspended for 15 minutes. The 5% threshold can apply once more before transactions are halted for the rest of the day.

When transactions are suspended in the cash market on a given security, due to undue price movements, transactions on the option based on the underlying security are also suspended.

Additionally, when over 35% of the capitalisation of the CAC  40 Index is unable to be quoted, the calculation of the CAC 40 Index is suspended and a trend indicator replaces the index.

When less than 25% of the capitalisation of the CAC  40 Index can be quoted, quotations on the derivatives markets are suspended for half an hour or one hour when additional margin deposits are requested.

The CAC 40, which takes its name from the Paris Bourse's early automation system Cotation Assistee en Continu (Continuous Assisted Quotation), is a benchmark index of the French Stock market.

The index represents a capitalisation-weighted measure of the 40 most significant values among the 100 highest market caps on the Paris Bourse. An independent Index Steering Committee reviews the CAC 40 index composition quarterly.

Single stock trading pauses in the US

It is useful for us to be aware also, that the NYSE as recently as May 2010, filed with their SEC to add Rule 80C, which would provide for a trading pause for individual securities for which the Exchange is the primary listing market, if the price of a security in the proposed pilot moves 10% or more from a sale reported to the Consolidated Tape in a preceding five-minute period.

The Exchange is proposing that this rule be implemented on a pilot basis, set to end on 10 December 2010. During this pilot period, the rule would be in effect only with respect to securities included in the S&P 500 Index.

During this period, the Exchange will continue to assess whether additional securities need to be added and whether the parameters of the rule would need to be modified to accommodate trading characteristics of different securities.

The dialogue must continue

I said last week that “the Regulator has a statutory obligation to risk minimise and mitigate the implications to the economy, the local and global reputation of the capital market and the role it plays as a conduit for fund raising. It has also to ensure that the capital market is a forum for rational, individual investors whose pockets are less deep than those with many cash cushions to fall back on and who have been enjoying that warmth, for two decades.”

I also said that it would “be prudent for the SEC and the CSE to engage in awareness building, deeper dialogue, and progressing as rapidly as possible to a new legal and regulatory framework more acceptable to all stakeholders” and that “the time has come for a review of rules, regulations, upgrading of hardware, software, trading systems and platforms, as well as the management of perceptions.”

End game of the ‘Thought Leadership Forum’

The purpose of the ‘Thought Leadership Forum’ is to build awareness and facilitate dialogue. Hence, though time does not permit me to write at length this week, I thought I owe it to readers, regulators and market participants to invest time in a follow up article. I have no doubt of course that many – particularly in the SEC and the CSE and in the investing and broker community – would be aware of what I have said today. However, I hope that at least in a small way, my thoughts will enhance, sustain and maintain the dialogue.  This is an imperative if all stakeholders are to align their interests for the larger benefit of the nation – more so at a time when we need to make the best of this post war era. We must learn to share the spoils and the pains. That is a necessary ingredient in a mature nation.

A nation which must remember that an aware and robust regulator is a fundamental ingredient in a sustainable market economy – whether it is in the stock market or any other market within the economy.

That realisation will also take the bite out of the rhetoric of those who point at the market economy of the so called ‘West’ as the cause of all the ills of the collapse of a stock market, a bank, a corporate, a state owned corporation, a government or an opposition.

It is time we get real and responsible. But we must give the regulator space and time at the drawing board just as much as the EU and the US must give Sri Lanka time to reposition itself as an eligible recipient of GSP, whether plus or otherwise, rather than expect the ideal state overnight.

Gambling and casinos

I would like to close on a less than serious, perhaps humorous note. While living and working in the Bahamas, I used to visit casinos, just to browse, since as work permit holders we were not allowed to even play at the slot machines ordinarily frequented by old women.

A client once told me about the many controls, monitoring and surveillance systems, and how they profiled globally renowned high rollers and monitored their activity.

In my presentations on project evaluation and screening, due diligence of projects, of promoters and divestment analysis, I sometimes read out the words of the Kenny Roger’s song ‘The Gambler’: It is important to know “when to hold and when to fold up, what to keep, and what to throw away, and indeed when to walk away and when to run.”

If you do not, you cannot complain about the rules of roulette or black jack if you keep buying chips and lose what you gained. I hope this article may have a thought or two, for all, and as Kenny Rogers says, “An ace that one could keep.”