The Chinese Stock Exchanges shut down trading and cancelled its stock trading program last week. Did the circuit breaker not work or did it not have its intended effect?
Logan Best: The circuit breaker worked but it didn’t have its intended effect. The second time it was put into effect it was the shortest trading day that China has ever seen. That’s a neat little fact.
One of the problems with the Chinese circuit breaker was that it was too tight. The second time it went into effect that week they suspended trading. At the [open, the drop in trading hit the] five percent level [and] stock trading was halted for 15 minutes. The idea was to give market makers and traders some time to gather orders and stabilize the market and orderly trading should resume.
It’s a brief pause. “Hey everybody, get your heads together. Why are we seeing a significant devaluation? Maybe you want to step in and be a buyer instead of having panic sell orders flood the market.” So, it gives people a chance to evaluate the market and the idea is that it will create more order in the marketplace.
What happened next?
Best: The dilemma with the China circuit breaker is the next level was two percent down. When you hit the seven percent down versus the previous day’s close, you are halted for the rest of the day.
Market participants took that 15-minute break period, analyzed their books, tried to figure out how long they were and basically tried to cover as much exposure as possible. This created panic selling because market participants didn’t want to carry that risk over the night into the next day.
How does this compare to circuit breakers in the U.S. exchanges?
Best: By contrast, the U.S. has circuit breakers. We thought about putting circuit breakers in place after the crash of 1987 and I believe they went into effect in 1989 so it took roughly two years to implement them. Since then they have evolved over the years to where they stand now. So, at 7, 13 and 20 percent [drops] we take breaks and at 20 percent we are done trading for the day.
Those are much different because those are much different levels.
What else was noteworthy about the China trading break?
Best: What was interesting was when you saw China close down its exchange, you could see continued selling in Hong Kong. That makes sense because with China down there is a fear that they are going to open lower the next day. People continued selling in Hong Kong where the markets were still open.
Why did this happen in the first place? Is this because China is new to a having a recession and fairly new to having a stock market?
Best: Their markets have been around since before the 1980s but they were starting to be established in the 80s. There definitely are some nuances. They are trying to move their economy from a manufacturing economy to a consumer and financial economy.
We have had more than a hundred years of working out the kinks in our system and they are trying to do so in a much more accelerated pace.
Are there any lessons that the U.S. markets can learn?
Best: One of the interesting things is that it showed how interconnected the global markets are becoming. Not that this is a new thing. We are not becoming interconnected, we are becoming more interconnected.
As the ripple effect of China halting its trading and having increased volatility due to market structure problems is spreading across the globe — this shows how interconnected global markets have become. Risk off trade in China is causing risk off trade globally.
Is this the last trading stoppage we’ll see from the Chinese markets or will this happen that next time there is a bad economic report?
Best: China has temporarily suspended their circuit breakers which I think was a smart move. They recognized very quickly that this was not working and they needed to do something different. I think they were wise to suspend those circuit breakers.
But there is clearly continued economic duress in China and the markets are trying to work through that. The government is also trying to prop up the market by buying stocks in state-owned funds. There are capital flight problems in China where people are trying to take their money [out of the country].
Going forward, we may see significant volatility as the Chinese markets try to grow and mature in some ways. There is also going to be a continued attempt by the Chinese government to manage this and there is going to be this processing of this fundamental, underlying economic issue that still remains in Mainland China. For the near term, we will see a continuation of this volatility.
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Logan Best isvice president of Securities Trading, International Market Making at the broker-dealer division of INTL FCStone Financial Inc.
