Wither price limits?

Price limits on the stock market have been prominent in public policy debates in recent weeks. What are the pros and cons of price limits? Should they even exist in the first place? If they should be reformed, what changes be made?

Price limits were first introduced on futures markets abroad. They are viewed as being a part of the market surveillance machinery on these markets. They supplement a sophisticated market surveillance machinery, which includes monitoring of positions at the member level, position limits on a per-contract basis, etc. Price limits on futures markets are typically quite wide compared to price volatility; for products with a daily standard deviation of 1%, the price limit would be around 10%. Traditionally, spot markets have been free of limits.

In India, the idea of price limits first came about at NSE in 1995. At the time, the market surveillance procedures were primitive, and price limits were seen as a tool which could reduce the profit rate in market manipulation. In the following years, though, they have become ossified as SEBI policy.

Price limits do help reduce the profit rate in market manipulation. However, the improvement is not enough to greatly deter manipulation. Without price limits, a manipulator in India might earn a 1000% annualised rate of return. With price limits, the manipulator's rate of return probably drops to 100% annualised, which is still very attractive.

At the same time, price limits have served to generate excruciating liquidity risk. When the price of Reliance moves by 8%, the liquidity in Reliance dries up. This is as bad as a market not existing. This has catastrophic consequences for everyone who uses the market. Now, each agent on the market has to plan for events where (in all effect) the market ceases to exist.

From a risk containment perspective, it seems nice to think that the price can only move by 8% in a day. However, for a futures clearing corporation, the impact of price limits on market liquidity is important and deleterious. Price limits convert price risk into liquidity risk. But price risk is easier to measure and manage than liquidity risk. Hence, a clearing corporation would prefer to face price risk than to face liquidity risk.

The price limits in India present real problems for fund managers, index funds and index arbitrageurs. Fund managers face the risk that when prices rise/drop sharply, they would face inflows/redemptions seeking to arbitrage on the fact that true prices are somewhat above/below the observed prices. In this situation, the investors who walk away from the fund would benefit at the expense of those who stay in (or vice versa), and the fund would find it very difficult to buy/sell shares in response to the fund flows. Similarly, in recent months, index funds have faced severe problems in doing Nifty program trades owing to the price limits. When the index futures start trading, index arbitrageurs will face impelementations problems owing to price limits; these problems will in turn generate reduced market efficiency on the index futures market.

Why do price limits exist? The academic literature analysing the impact of price limits does not clearly suggest that they help make the market more efficient. There have been conjectures that "price limits act as magnets": that when a price is in the proximity of a limit, it is likely to go to the limit. The academic evidence on this conjecture is mixed. In India, Gangadhar Darbha, Susan Thomas and I have a working paper analysing natural experiments in the past where stocks moved across price limit regimes. We find that changes in the limit regime had a fairly small impact on bid-offer spreads.

My sense is the price limits are a response of market regulators and market administrators who dislike market volatility. For example, after the 1987 crash in the US, the regulators and NYSE administrators came up with a system of "circuit breakers" which halt the entire market when the index moves sharply. The academic evidence on the usefulness of this system is unimpressive.

From an Indian perspective, what can we do in reforming the price limit regime?

The first issue is to focus on market manipulation. Market manipulation is an important problem. We, in India, have yet to come to grips with it in a serious sense. Unfortunately, there is no simple thing which can be done in improving market manipulation. It is something that can be done effectively by an exchange, and it requires political independence, freedom from corruption, institutional richness, etc.

I can visualise NSE sharply improving the functioning of its market surveillance department. But it is hard to create a set of rules at a SEBI, Finance Ministry or RBI level to mandate sound market surveillance. Most exchanges in India have poor institutions, the conflicts of interests that derive from brokers performing managerial functions in the exchange, and poor technology. They will not develop sound market surveillance. The only thing that can be done from a public policy standpoint is for SEBI, RBI and the Finance Ministry to come up with strong responses in the aftermath of a crisis (e.g. the BPL/Sterlite/Videocon crisis in summer 1998); perhaps the threat of punishment will induce these exchanges to improve their attitude towards surveillance. In addition, investors will vote with their feet, avoiding exchanges which tolerate market manipulation in favour of exchanges which do well in enforcing against it.

In an ideal world, where market surveillance functioned well, I would advocate the elimination of all price limits. Since that is not the world that we live in, we have to find a second-best solution. We may sketch one such solution as follows.

We could use a price limit regime where the limit is set to three standard deviations of the normal price volatility. For example, if Infosys has a daily sigma of 4%, then the price limit would be set to 12%. Once the stock reaches this limit, it would have to switch out of the normal (continuous market) and spend fifteen minutes in a uniform price double auction. News of this would be flashed on all realtime information systems. This would attract a lot of buyers and sellers to participate in this auction, which would deter the efforts of market manipulators. Once this auction is completed, the continuous market would continue as before.

Such a regime does not come with any predefined price limits. It only requires that when a stock moves by more than three standard deviations, the "normal market" should give way to a uniform price double auction for fifteen minutes, in an attempt to attract as many buyers and sellers as possible into the price formation and thus make it difficult to manipulate the price of the stock.

In summary, I think SEBI's recent move to relax price limits for the 200 largest stocks is in the right direction. But there is much more that can be done in getting the price limit regime right.

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