Hong Kong’s circuit breaker takes the risk out of the market - but without risk there is no market

PUBLISHED : Monday, 22 August, 2016, 6:33pm
UPDATED : Monday, 22 August, 2016, 11:00pm

HKEX said the system’s launch will bring Hong Kong into line with guidance issued by the G20 and the International Organisation of Securities Commissions [IOSCO] on implementing control mechanisms to deal with systemic risks arising from volatile market situations.

SCMP, August 20

And blah, blah, blah, blah. It all comes down to just another variant of the old dictum that we have to do it if Singapore does it.

We are now to have a so-called circuit breaker in the stock market. Trading in individual stocks is to be suspended for five minutes if they rise or fall by more than 10 per cent during any session, which is exactly the Singapore rule.

Out in the swank offices of our Securities and Futures Commission, chief executive Ashley Alder no doubt breathed a sigh of relief. He has only just been appointed chairman of IOSCO. Fine precedent it would be if Hong Kong then rejected IOSCO guidance. How would he ever exert his God-given authority over our own stock exchange were it to happen?

IOSCO, a regulators’ talk shop headquartered in a luxurious Spanish palace, is staffed by lawyers and bureaucrats who, like their reflections in G20, pontificate ceaselessly on financial dealings but have very little hands on experience of a dealing desk.

No need for HKEX’s new circuit breaker, as stocks remain largely flat

This matters because in some key respects the workings of law and regulatory practise are the exact opposite of the workings of financial markets. Specifically, few of these people understand a cardinal principle of the market – Push it in here, it bulges out there and there ain’t nothing you can do about it.

They are always busy writing rules to tell the market it must stay where they push it and not bulge out elsewhere. The only result has been that their rule books have bulged out to elephantine proportions.

It’s really quite simple. Financial markets are about risk. People who participate in them know that they stand a chance of losing their money. They do it because they see an equal prospect of making money. Take away the risk and you take away the financial market. The market does not exist without risk.

But some people (invariably those who dare not wet their toes in the risk pool) think that you can somehow limit the risk while not limiting the prospects of making money.

What then happens is that the risk-takers find some other way of taking on the amount of risk they are happiest to have. They gear themselves up to a higher level of debt, deal in riskier securities or put more money in high stakes derivatives games. We are then back to the same risk/reward balance with which we started

In this matter of circuit breakers, the regulator’s worry is that a sudden untoward event having nothing to do with a stock’s underlying value may suddenly drive down its share price and set off a panic that cannot be stopped. Best introduce a cooling off period to let reason prevail again.

I think it is a misunderstanding. In the first place I am not sure that unreasoned panic ever exists right across a market. In my experience as a stockbroker there were always bargain hunters ready to jump in for a steal of a deal.

Secondly, what is called unreasoned panic usually proves in hindsight to have been perfectly reasoned. Panic was just an excuse word when reality could not be denied.

Most of all, the very existence of this danger is what keeps risk in check. If a circuit breakers does actually bring about a cooling off period in which panic can subside, it only induces risk takers to take on more risk in the knowledge that the circuit breaker will protect them. The danger of a crash then remains just as great as it was before.

In fact, however, I think a cooling off period does not result in cooling anyway. It is more like a boiling up period. People who are desperate to get out don’t calm down when the exit doors are locked on them. The best way of dealing with a market panic is to keep that market open, not close it.

But this would create fewer jobs for regulators. Can’t have that. Call in IOSCO to stop it.