Price limits: Time for surgery
Price limits are a part of the regulatory regime of India's equity market. All stocks have a price limit of 8% per day, except those with prices below Rs.20 which have more permissive limits. Suppose a stock closed at Rs.100 on Monday. Then, on Tuesday, orders are only allowed between Rs.92 and Rs.108. If you try to place a order at Rs.108.05 (or at Rs.91.95), it is rejected by the trading computer.
This is not a "circuit breaker" which gets triggered and halts trading. Trading is never formally halted. If the entire market thinks that the price should be Rs.110, and if orders above Rs.108 are forbidden, then trades cease to occur. But trading is never halted. A few minutes later, if the market thinks that the true price is near 108, then trades will happen.
Why do we have price limits? Do they not violate the essence of financial markets, which is the job of continuously discovering prices for assets? If bad news gives us a price below Rs.92, we should not shoot the messenger.
I was party to the early introduction of price limits in India (in 1995), and the rationale then employed was as follows. India's equity market has a high incidence of market manipulation, for stocks with a limited "floating stock". The equity market is not a true spot market. It is a futures market, and like all futures markets, it is vulnerable to the "short squeeze". Here, manipulators adopt buy positions on the market which are larger than the total floating stock of the stock. When the sellers try to get out of the positions - which they have to, since they don't have the shares - prices skyrocket.
The most direct way to deal with market manipulation is to monitor positions, track down cartels, prosecute people who initiate short squeezes, etc. This is hard work, especially in the light of India's legal system. There is a problem of jurisdiction: the exchange (which is the front line of enforcement) has no powers to go behind brokerage firms and probe the actions of customers.
Price limits are a tool commonly used by futures markets in curbing manipulation without addressing the core issue (though the limits used by futures markets internationally are much weaker than those seen in India). A price limit of 8% limits the profits of a manipulator to "only" 8% per day (this is much lower than what has been seen in some manipulative episodes). A price limit regime of 8% limits the losses of an innocent speculator to 8% in a day. This seems to have some appeal. If a speculator shorts a stock in opposition to a manipulator, he is playing a noble role in the market, and it seems useful to have a world where his losses at the expense of the manipulator are limited to 8% in a day. I believe that from 1995 onwards, the institution of price limits has helped avoid scandals like Gujarat Cotex, Rupangi Impex, etc. which took place in preceding months.
However, price limits should not be viewed as the sole tool in the armoury of exchanges. Price limits are neither necessary nor sufficient in blocking manipulation. The high-visibility market manipulation on BPL, Sterlite and Videocon, on the Bombay Stock Exchange in June 1998, took place in a regime with 8% price limits.
The best case that can be made for price limits is that they are a stop-gap, until a more serious enforcement machinery was put into place. In addition, efforts were made in 1996 to tune the limits to individual stock characteristics. Highly liquid stocks do not need price limits: it is very hard to manipulate them and it is efficient for scamsters to attack illiquid stocks. Highly volatile stocks need wider limits since their natural movement is greater. A better price limit regime is tuned to stock characteristics in this fashion.
Instead, from 1997 onwards, the price limit regime got ossified. All stocks above Rs.20 were put into 8% limits, regardless of liquidity or volatility. SEBI uniformly imposed this price limit on all exchanges, and when price limits shifted from an exchange tool to a regulatory requirement, it stifled all R&D.
Today, the price limit regime on the equity market is clearly a problem. The greatest problems are faced at the clearing corporation. Price limits convert price risk into liquidity risk: when prices move, they generate a breakdown of liquidity (since the price limit blocks orders outside a price range). This breaks the core tool of the clearing corporation - to pre-emptively closeout positions when needed. The clearing corporation has a sophisticated mechanism to deal with price risk. This armament regularly breaks since price limits convert price risk (something that the clearing corporation knows how to handle) into liquidity risk (something that the clearing corporation can't deal with).
In 1995, when price limits first came up, they were not viewed as an answer; they were viewed as a first move in a chess game. We have become frozen at that first move.
There is a lot more to dealing with market manipulation than price limits. The path that we should adopt is as follows:
- India's equity "spot" market is actually a futures market. This is what leaves us engaging in futures-market discussions about open interest, position limits, price limits etc. However, there is no reason why we should be trapped in this debate. We should rapidly move the equity spot market into rolling settlement, and get out of these problems.
- The price limit regime should shift to having less restrictive limits, and varying limits by liquidity and volatility on a per-stock basis. The most liquid stocks in India (members of Nifty) do not need price limits.
- New tools needs to be developed for dealing with market manipulation: these include position limits at a per-broker and overall-market level, methods for detecting circular trading, etc.. If the float on a stock is judged to be Rs.10 crore, then the open interest of the market should not exceed Rs.10 crore.
- A major revamp of the enforcement machinery is called for, at the exchange level and at SEBI. We have seen the involvement of senior exchange administrators in market manipulation. This is a disgrace. To my knowledge, we have not yet seen even one imprisonment associated with a case of market manipulation.
In summary, price limits were created as a stop-gap measure to reduce the profits to market manipulation, pending the creation of serious tools for surveillance and enforcement. With a SEBI requirement that all stocks should use 8% limits on all exchanges, price limits have become ossified into government policy. BPL, Sterlite and Videocon have taught us that price limits - by themselves - do not block all manipulation. Further, price limits convert price risk into liquidity risk, and make it hard for the clearing corporation to do its job. We need surgery to get out of this situation: to move to rolling settlement, to back away from the existing limit regime, and to forge a new set of tools to fight manipulation.
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