It’s often seen that regulations seek to achieve certain objective, but they ultimately result in a totally different, unintended and unforeseen consequence.

The recent crusade by some investors to make SEBI impose price bands and circuit filters on stocks that have futures and options attached to them, is headed in that direction. These players are of the view that the absence of price bands on these stocks has made a large hole in the investor portfolios and hence these restrictions need to be introduced.

The market regulator paid heed to these demands and released a discussion paper inviting public comments, on imposing restrictions on price movement in such stocks. The concerns of the market participants however appear misplaced and imposing such restrictions is unlikely to affect the value of their portfolio. But that said, imposing price bands and circuit filters on these stocks as well as equity futures and options contracts could be good for the trading framework from a long-term viewpoint.

The increasing proportion of algo trading on our bourses makes prices in both cash as well as derivative segment susceptible to exaggerated intra-day moves. Such checks can help avert steep declines caused by programmed trades.

Currently, 20 per cent price band is imposed, both up as well as down, on most of the actively traded liquid stocks traded on the exchanges. But stocks on which derivatives products are available or stocks that constitute the indices on which derivatives products are traded, do not have any price bands or circuit filters. There are no restrictions on price movement in the equity derivative segment as well.

SEBI’s arguments for not imposing price bands or circuit filters on these segments has been, well, a little jumbled. The regulator has not imposed restrictions on the price movement of equity futures and options because the value of these contracts is tied to the underlying stock’s spot prices and hence imposing further restraints was considered unnecessary.

Now, no price bands or trade filters are applied on stocks that are the underlying of derivative contracts because, according to the regulator, imposing price bands in the cash segment alone will lead to misalignment of prices between the cash and derivative segment. Further, since these are the most liquid stocks in the market, such trade restrictions were said to be a hindrance to price discovery. This has resulted in no price band on F&O contracts as well as the underlying stocks.

However, in order to avoid fat-finger trading errors, exchanges were allowed to impose dynamic price bands, which could be expanded provided sufficient demand was seen at lower levels.

Matters came to a head last September when a host of NBFC stocks, which were also trading in the derivative segment, fell sharply in a single session following concerns of possible default in their payment obligations in the aftermath of the IL&FS crisis. With many of these stocks losing over 30 per cent in a single session, opinions were expressed that halting a steep erosion in a single trading session could have stemmed the losses, suffered by investors.

SEBI has, therefore, proposed three options in its recent discussion paper. One, adoption of 20 per cent price band and circuit filter both ways on individual stocks on which derivatives are available. Two, continuation of dynamic price bands along with a certain threshold — maybe 30 per cent in either direction. If price reaches the threshold, either a circuit filter can be imposed or a call auction can be conducted for a fixed duration and the price discovered in the call auction can be used for further trading. The third option given by SEBI is to continue the current rules, with no alteration.

Why the worry

Before we move on to the suitable option, the concern on the risks from absence of price bands on these stocks appears overblown.

SEBI’s analysis of the price movement of stocks attached to derivatives, over a six-month period, revealed that 40 stocks moved more than 20 per cent in a single session in that period. But, of these, just 11 stocks moved more than 30 per cent and six stocks declined more than 40 per cent in one session.

We have around 200 stocks that have derivatives attached to them. Therefore, the probability of a stock that you own, declining more than 40 per cent in one session, over a six-month period, is 3 per cent, which is quite low. Also, it needs to be noted that 2018 witnessed unprecedented volatility in mid- and small-cap stocks with eight out of every 10 stocks recording losses in that year. In a typical trading year, large intra-day moves in stock prices are relatively rare.

A closer look at some the stocks that declined sharply shows that these stocks continued to slide in subsequent sessions too. For instance, this debate has been triggered due to the sharp decline in DHFL, YES Bank and other NBFC stocks including Indiabulls Housing on September 21, 2018. DHFL fell over 60 per cent in that session to close at ₹350. The stock is currently trading around ₹134. Similarly, YES Bank and Indiabulls went on to plumb new lows in the following months.

This shows that once the fundamentals of a stock change, arresting intra-day movement will not help investors as the stock will continue to fall in the subsequent sessions to discover its intrinsic value.

There are also natural checks in markets in the form of investors bottom-fishing at lower levels, that arrests undue price erosion in a single session.

The optimum solution

While steep intra-day falls are rare, it might however be a good idea to restrict intra-day movement in stocks attached to derivatives, within a certain threshold. These are the most traded stocks on exchanges and algo trading is also concentrated in these stocks.

These algos could exacerbate price moves as many of them are programmed to execute buy or sell orders once certain thresholds are breached. Dynamic price bands that expand based on demand at each incremental band might therefore become ineffective as the trading algos could create more demand as price moves lower.

Therefore, SEBI’s second option — to stay with dynamic price band that exists now with the option to expand it up to 30 per cent — appears most suitable. The circuit filter and price band, both ways, can be applied at 30 per cent. Circuit filters could be superior to call auctions as the latter can lead to disruption in trading.

SEBI also needs to seriously think about imposing price bands and circuit filters on futures and options contracts. According to World Federation of Exchanges’ survey, around 65 per cent of derivative exchanges that took part in the survey have imposed price bands on derivative contracts too. SEBI should also follow suit, especially since sharp moves in derivatives, where algo trading is higher, could influence cash price movement too.

SEBI’s second option should, therefore, be imposed on both futures and options contracts as well as the underlying stock prices in the cash market.

Related Topics