Critique on conditional trading suspension of derivative linked shares proposal in India

By Dr Trilochan Tripathy

Extreme price movement of stocks are often considered undesirable by exchanges, policy makers and regulators. Various measures are put in place to suspend trading of specific securities or instruments in response to significant market events or irregularities considered too volatile, ranging from market wide circuit breakers to stock level price limits. The rationale and effectiveness of trading suspension during extreme price movements are widely debated in academic and policy circles.   Recently India’s market regulator SEBI proposed measures to curb extreme price movement in shares with derivative trades including tighter circuit limits, longer trading suspensions and restricting price movements. The trading suspensions on shares in the futures and options segment, especially when there is a 10% daily fall or rise, can have both advantages and disadvantages. Let’s critically examine the advantages pertaining to market stability and preventing market manipulation. Suspending trading when there is a sharp 10% fall or rise in share prices helps maintain market stability. Extreme price movements can create panic among investors and result in a cascade of selling or buying, exacerbating market volatility. By suspending trading, regulators can provide a cooling-off period, allowing market participants to reassess their positions and prevent further rapid price movements. SEBI is of the opinion that discretionary trading suspensions can also help prevent market manipulation. In volatile situations, some traders may exploit the rapid price changes to manipulate the market for their benefit. Suspending trading allows regulators to investigate potential market abuses and take appropriate actions to safeguard market integrity.

Trading suspension might be beneficial for constrained market participants, who might otherwise be ‘forced’ to trade. The forced selling could either be driven by hard constraints like margin calls and fund outflows, which are often more severe when the market stays open, and prices fall drastically. The forced selling could also be due to (perceived) information disadvantage when investors are not well-informed of their current trading strategy during drastic market movements. Trading suspension may give investors the much-needed time to process new information, without which investors may choose to stay out of the market altogether. Finally, drastic price movements may cause panic and overselling which may lead to inefficient portfolio decisions. Independent of the reasons behind the “forced” selling, the possibility that additional selling demands can exacerbate the crisis is the main rationale behind most government interventions and trading restrictions during crisis times.

Trading restrictions is generally imposed and implemented by the exchange based on certain predetermined mechanical rules about price movements or order imbalances. Market participants or firms do not have discretion or influence over the decision to suspend trading on their stocks. As a result, it is hard to assess how these measures are perceived by market participants ex ante and whether they meet the regulatory goals ex post. Further such restrictions may also lead to loss of liquidity, uncertainty and information asymmetry, impact on hedging strategies and market efficiency. Trading suspensions can lead to a loss of liquidity in the affected shares. Investors who want to buy or sell these shares during the suspension period are unable to do so, resulting in a temporary halt in market activity. This lack of liquidity can be frustrating for investors who need to adjust their positions or exit their investments urgently. Trading suspensions can create uncertainty and information asymmetry among market participants. Investors may be unsure about the reasons behind the suspension or the duration of the halt, which can lead to speculation and further market volatility once trading resumes. Additionally, if the suspension is due to undisclosed material information, some market participants may have an unfair advantage over others, leading to inequitable trading conditions.

Apriori, it is not clear whether investors can benefit from trading suspension on their stocks. Opponents of trading suspension often question the rationality of stopping investors from trading during a market crash. Investors can always choose not to trade when the market is open. Therefore, having the option to trade and rebalance their portfolio is always beneficial for rational and unconstrained investors. Tradability might be particularly important during extreme market movements as more information is revealed during turmoil times, either about fundamentals or about investors’ risk preferences.

Trading suspensions can disrupt hedging strategies in the futures and options segment. Hedgers use derivatives to manage their risks by taking offsetting positions in the underlying shares. If trading is suspended, hedgers may not be able to adjust their position, accordingly, thus get exposed to additional risks until normal trading resumes. This can impact market participants who rely on derivatives for risk management purposes.  Frequent trading suspensions based on a fixed threshold like a 10% daily fall or rise may raise concerns about market efficiency. While the intention is to stabilize the market, such suspensions can impede price discovery and hinder the ability of markets to react quickly to new information. Over time, this may affect market participants’ confidence in the fairness and efficiency of the trading system.

Trading suspensions have exhibited a history of fallouts, with both positive and negative implications. On May 6, 2010, Dow Jones Industrial Average of US plunged nearly 1,000 points within a few minutes. To tackle such a severe flash crash and extreme volatility, several trading suspensions were triggered. However, these suspensions led to confusion and uncertainty among market participants, as trading in individual stocks was halted at different times and for varied durations. The fallout from these suspensions highlighted the need for better coordination and clarity in trading suspension policies during extraordinary market events.

Chinese stock market crash in 2015 forced the Chinese regulators to impose widespread trading suspensions on hundreds of stocks, leading to a suspension of nearly half of China’s stock market by value. The fallout from these suspensions included a loss of investor confidence, increased market volatility, and concerns about the Chinese government’s ability to effectively manage the crisis. The suspensions were seen by market experts as a stringent measure that exacerbated market panic rather than stabilize the situation.

Following the Brexit referendum held in June 2016, the UK stock market experienced significant volatility and uncertainty. To manage the market turmoil, the London Stock Exchange implemented temporary trading suspensions on mostly financial sector stocks to tackle extreme volatility and market turmoil. The fallout from these suspensions included criticism from market participants who argued that the trading halts limited their ability to adjust positions and intensified the already heightened market uncertainty. The exchange faced scrutiny for the timing and transparency of the suspensions, highlighting the importance of clear communication during such events. In response to the market turbulence caused by the COVID-19 pandemic in March 2020, several major stock exchanges around the world, including the NYSE and Nasdaq, triggered circuit breakers and implemented temporary trading suspensions. These measures were intended to provide a “time-out” period to help stabilize markets. The fallout from these suspensions was mixed. While some argued that the circuit breakers and suspensions were effective in reducing extreme volatility and preventing panic selling, others criticized the lack of coordination and the potential impact on market liquidity.

The effectiveness of trading suspensions depends on a multitude of factors, including market conditions, regulatory policies, communication, duration, impact on market participants, and international coordination. During periods of extreme volatility, trading suspensions can help mitigate panic selling or buying and prevent further price distortions. However, if suspensions are implemented in relatively stable markets without compelling reasons, they may disrupt normal market functioning and hinder price discovery. Further, the design and implementation of regulatory policies play a crucial role in the effectiveness of trading suspensions. Clear and transparent guidelines on when and how suspensions will be imposed help market participants understand the rules and reduce uncertainty. However, empirical evidence in certain cases demonstrate that trading suspensions can have unintended consequences and raise concerns about price stability, investors’ confidence, and the effectiveness of such measures during periods of extreme market turmoil. It highlights the need for regulators to carefully evaluate the potential fallouts of trading suspensions and consider the broader implications on market participants and overall market functioning.

Consistency in applying the suspension mechanism across different securities and market segments is also vital for maintaining market integrity and fairness. Effective communication regarding the reasons for trading suspensions is essential. Regulators should promptly disclose relevant information to market participants to prevent speculation and information asymmetry. Transparency in the decision-making process, including clear criteria for imposing and lifting suspensions, helps build trust and confidence among investors. The duration of trading suspensions significantly impacts their effectiveness. While short-term suspensions can provide a cooling-off period and allow market participants to reassess their positions, excessively long suspensions can disrupt market liquidity and impede efficient price discovery. Regulators must strike a balance between maintaining stability and facilitating market activity.

Trading suspensions affect various market participants differently. Investors who rely on liquidity may face challenges if trading in a particular security or segment is suspended. Market makers and liquidity providers may find it difficult to manage their positions during suspensions, thus potentially impacting market efficiency. Regulators should carefully consider the potential consequences for different stakeholders when imposing suspensions. In an interconnected global market, the effectiveness of trading suspensions can be influenced by international coordination. If suspensions are imposed in one jurisdiction but not in others, it can lead to arbitrage opportunities or market distortions. Collaborative efforts among regulatory bodies to align suspension policies and coordinate actions can enhance the overall effectiveness of such measures.

In a nutshell, trading suspension of derivative linked shares in India remains a critical task before the market regulator and implementing such a regulation SEBI must carefully evaluate its potential fallouts of trading suspensions on concerned company, market participants, and overall market functioning. Clear guidelines, transparency, and effective communication are crucial to ensure that trading suspensions are deployed judiciously and in a manner that enhances market stability without unduly impeding market efficiency. However, trading suspension for an individual or security group having derivative exposure is an empirical question, whether the benefits of trading suspension for such securities in India would outweigh the costs and whether the trade-off differs for different investor groups and under different market conditions required to be investigated by the market regulator in India.

(Dr Tripathy is a senior faculty at XLRI Jamshedpur. The views expressed are personal opinion of the author.)