China’s spectacular week of trading is an illustration of how far authorities have yet to go in understanding what’s involved in running markets. The long-term answer is better technology with more diverse participants that know how to use it, say experts.
To briefly recap: yesterday the currency fixing was cut by half a percent, the largest change since the yuan was devalued in August. That led to tumbling equities, which breached the 7% stop gap. Less than a week into 2016, that’s happened twice.
The global repercussions are still being tallied, but in its latest update, systematic trading fund r-squared macro reported US, European and UK equities dropping 2.6%, 1.7% and 2.0% respectively. After a grim start to the year, oil prices extended their declines another 3%. In response, the euro, yen, and Swedish krona strengthened significantly as investors sought safer assets, the fund wrote.
The stopgap measure was meant to prevent large swings in equity markets, instead it may have made things worse, experts have warned. It seems China’s central bank may agree with that sentiment, as it ultimately suspended the shiny new circuit breakers, installed earlier this year.
Afterwards, China’s markets stabilized, which begs the question: why were the circuit breakers not fit for purpose? One answer is that the mentality underpinning their use is about price manipulation not risk mitigation.
By contrast, circuit breakers in developed markets tend to be about checking the problems associated with technical malfunctions. Think: May 6 Flash Crash in the US, when free falling markets recovered in 15 minutes.
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“Most of the reason for (circuit breakers) in Western markets is to give everyone a chance to draw their breath, and ask is there a real reason for this happening? Or do we suspect that someone’s technology has run amuck?” said Steve Grob, Director at Fidessa, a technology provider.
Moreover, if market participants wanting to sell know they will get shut out of the market when certain levels are triggered, it will just exacerbate the decline as everyone rushes for the exit.
“The minute you have this sort of black-and-white, blunt instrument, it was bound to probably create the problem it did,” Grob said. “It’s also exacerbated by the fact that China doesn’t have electronic market makers.”
Electronic market makers generally thrive on periods of high volatility. Firms like Virtu Financial, one of the largest HFT players in the world, have made inroads to China but in commodities trading via a partner, according to media reports. At the moment, China’s playing field is filled with large institutions and “a whole mass of relatively unsophisticated retail players”, Grob added.
Fidessa’s own clients include Guotai Junan Securities, China Merchants Securities, China Construction Bank International Securities, Haitong Securities and Yuanta Securities.
Brokers in China number in the hundreds, many of which are encouraged by the Chinese government to internationalize. “The kind of technology they need to service institutional, international clients is completely different from what they need to run a retail brokerage in mainland China,” he added. “They are all tooling up with much better trading technology.”
The other challenge, he pointed out, is that of transparency and trust: “For stock markets to work, you have got to believe that it’s a level playing field and that it’s not going to dramatically change tomorrow.”