National Stock Exchange Ltd (NSE) has decided to adopt
the “limit up-limit down” mechanism introduced by the US exchanges some
time ago; but with some modifications. The mechanism prevents trades
from occurring outside of a specified price band, and can be an
effective tool for protecting the market from sharp movements caused by
erroneous orders. NSE said in a circular to its members that the new
mechanism will apply to mid-month and far-month futures and options
contracts; for now, the new rules won’t apply to the exchange’s most
liquid contracts (with near-month expiry).
As pointed out earlier in this column (http://goo.gl/2RB0aZ
), the “limit up-limit down” mechanism is superior to the current
dynamic price bands system, because instead of putting restrictions on
order entry, they put limits on order execution. However, NSE’s
deviations from the US model may result in some complications. Another
criticism is that it may be unfair for the exchange to decide
unilaterally on such market structure issues.
Some experts in market microstructure believe that there
should be no price restrictions either on order entry or trade
execution. One justification for this is a belief in free markets and
that there should be no curbs on market participants who engage in the
important task of price discovery. The other reason given is that such
restrictions can be used by some market participants to game the system.
The simpler the mechanism, the easier it becomes for all market
participants to navigate the markets. There is certainly some merit to
this argument—certain special order types used by US equity exchanges
have been used by high frequency trading firms to gain an advantage over
other participants.
Having said all this, not doing anything to prevent flash
crash type episodes is not wise either and the new mechanism has some
useful features. The current system of putting limits on order entry
(within a pre-defined price range) results in a deterioration of the
depth of an order book and is avoidable.
Here’s how the system with limits on order execution
looks in the US—there is a 5% price band on execution. This band will be
dynamic and will change depending on the average traded price in the
past five minutes. If a stock suddenly rises/falls 5%, it will enter a
“limit state” for a 15 second period. During this period, trades can
still happen, but only within the +/- 5% limit. If the rise/fall was
caused by an erroneous order, it will give the trader adequate time to
cancel the order and avoid a situation where the order drags down the
market beyond the 5% limit. If, however, the order which caused the
rise/fall is neither cancelled nor executed against other fresh orders
within the price limit, then a five-minute trading pause will be
declared, before normal price discovery can begin again. The second
scenario will typically play out when there is a big news development,
which causes a big shift in the market’s view of the stock’s price, and
that price falls outside the trading range defined by exchanges. Of
course, it must be said here that while all of this looks good on paper,
there isn’t adequate empirical evidence to suggest the new mechanism
has helped the US cash equities market.
PRASHANT SHARMA
PGDM-IIsem
source-MINT
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