Circuit Breakers And Closing Auctions: Reforming Hong Kong’s Marketplace

Andy Maynard, Global Head of Trading and Execution Services, CLSA, looks at the two major market structure changes facing Hong Kong
At the end of the day, the overriding premise of an exchange has to be the integrity of the market. Instilling confidence in the exchange is key, for market participants to trade on and invest in, and also to protect investors’ confidence and their assets when they go into the market outside the normal market dynamics of profit and loss. On the other hand, I do feel somewhat sympathetic to the view that stocks should rise and fall on their own merit as well.
Circuit breakers are, in some ways, a mechanism used to delay where a stock is going to end up eventually anyway; it just makes the change occur in a more orderly process. So, if you look across Asia, do the markets that have circuit breakers benefit from the fact that they have this extra protection? I would argue no. The reality of those markets is that everybody trades on the understanding that there are circuit breakers in place. I cannot say for sure that from an institutional point of view any of our clients look at those markets with extra confidence. As long as circuit breakers are done in a way that allows investors to also sell stock when they find there is adverse news on the name that is fine. If it is down 10% and they want to sell it down 10%, I feel that they should be able to do so, rather than being blocked from trading, only to watch it move down another 10%.
There is a very fine line between a free market and one that is constrained by circuit breakers. It’s going to be very difficult for any regulator to appear to have a foot in both camps. Do you profess that you’ve got a free and open market where stocks can do whatever they want to do based on the fundamentals of the stock, the geo-political scenario, the overall economic global scenario, and the local scenario, or do you say, no, stocks only move in the 5% range every day, and that’s it? I feel that Hong Kong will have to try to come to a common understanding about what’s right for the market; what’s right to attract investors into the market so people don’t feel that it’s a controlled environment, and at the same time, protect investor confidence. This seems to me to be a reaction as part of a wider trend of extra regulation for the market, which is really being driven from the US. Are we going to get to a point where Asian markets are over-regulating based not on what’s happening in their own markets, or even in their regions?
The Hong Kong stock exchange is a very different market to a venue like NASDAQ or NYSE. As long as circuit breakers are implemented in a way that protects investor confidence, no matter whether it is institutional or retail, I would have no problem working with them. Obviously I feel investors should also be able to sell stock that’s down 20% if the stock is moving down. There are plenty of examples of that across Hong Kong; where stocks have been in a free fall and never come back. Would circuit breakers stop that?
There are also many questions around the implementation of the breakers: is a 5% movement OK? What happens if it’s 5.1%? Does that mean that you can’t sell the stock? The high percentage of retail activity is also a key consideration.
In the 22 years I’ve been in Hong Kong, the exchange has worked almost perfectly. The Hong Kong stock exchange will suspend a stock very quickly if there’s enough adverse movement. To me, they already have some sort of delayed circuit breaker mechanism in place. Stocks get suspended a lot here. With the recent events around the Mainland exchange, the market had time to pause and time to analyse what was going on in the market and what was going on in the fundamentals of the relevant stocks. In that scenario, would a circuit breaker have stopped that event? No. Would it have exacerbated it? Potentially. I think stocks should be able to find their own level.
It is also good for the brokerage community to regulate their own parameters in terms of trading mechanism risk, and I think that should be done totally separately from a circuit breaker mechanism. You should have parameters and risk profiles set up, and you should have internal circuit breakers to stop the wrong button being pushed on your system. Similarly, when a DMA client flows in, you should have parameters set up. The counter argument is that this is fine for the bigger brokers because they have the technology spend to implement such controls, and I agree that as a result, it is difficult to appease everybody. However, we’ve potentially walked down a road of protecting the integrity of the market based on a reaction to something that hasn’t actually happened in Hong Kong.
Closing auction
The closing auction is something I feel Hong Kong desperately needs, and has needed from the outset. They have an opening auction, but no closing auction. You look at so many markets across Asia where a very significant amount of the overall trading volume is done on the close, without much price volatility, and we can’t find a mechanism that’s able to do that in Hong Kong.
Asset managers have a guaranteed benchmark set by a client, and they have to achieve it. There is more risk in Hong Kong because we don’t have an auction. This means we need to be more aggressive in the close, which means we are adding to volatility just so we don’t lose money. The closing mechanism as it is right now makes it more volatile because you can’t afford to be passive; you could be 20 basis points on one side and 30 basis points off the other side. You add that up across 100 stocks with the dollar size of these trades and you could end up with a very good day or a very bad day. Hence, I feel that the closing auction is necessary for a developed market.
Institutional clients base their whole performance and fund NAV on the closing price. Most countries have a mechanism to allow for the incorporation of that function. In order to promote investor confidence in the equity market, we need a closing auction. Rather than regulating HFT, everybody wants to know the closing price of stock. That helps everybody evaluate their investment.