Price limit system needs work

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Price limit system needs work

The argument for scrapping the daily trading limit stems from the fundamental question of its effectiveness. A cap provides a degree of protection for investors, especially when a stock’s price is on a downward spiral, but it also has risks of raising volatility and undermining price discovery - or the fair value of the underlying stock. Academic studies suggest that price limits can offer a cooling-off period for investors, allowing them time to research and employ a more sensible and informed approach. As the Korean capital market matures, the system’s contribution to fending off speculators and volatility has been watered down. Instead, the daily price limit often hinders the discovery of the stock’s real value as well as the efficiency of investment moves. The system produces more harm than good.

It is generally believed that a price limit can help ease volatility in stock prices. But when a security has an “up limit” or “down limit” day, it usually approaches the upper or lower level of the daily trading limit in subsequent sessions, which in the end increases the volatility of the stock.

A stock also can gain momentum to move faster toward the intraday limit due to a magnet effect. An equity trading at a price variation of 13 percent during the day may end up at the 15 percent high or low limit. The cap, in fact, can broaden volatility and unfairly work on the underlying stock.

The limit also delays and hinders price discovery. Once a stock approaches the upper or lower limit, trading cannot be pursued and the price cannot be adjusted, thus creating an imbalance in order placements. Few sell orders are made when the price hits the upper cap and the same happens with buy orders when the price plunges to the lower limit. Price correction is deferred to the following day, which interferes with the price discovery process and increases the cost of trades by delaying settlements.

The price range system, therefore, serves ineffectively in its primary purpose of containing volatility, and instead undermines the market’s efficiency by interfering with assessment of the fundamental share value.

Most market players agree the system needs to be revised. Simply lifting the upper cap cannot be the solution. Opposition to the system without offering an alternative is equally irresponsible. The price limit range should be approached from the perspective of improving the overall market stability mechanism. The range should be gradually eased until experts and authorities come up with more lasting and effective means to stabilize the market.

The new mechanism must be able to contain frenzied volatility and movements without getting in the way of price discovery. The stabilization tool should be activated flexibly, according to market volatility. We could study applying European-style volatility interruption, offering a brief cooling-off period and adjustment in trading without stopping buying and selling. Market participations are informed of the interruption when the price goes beyond a predefined range, and they can react to it by adding, modifying or deleting orders and quotes. Because trading is not interrupted, the price discovery process and information on underlying stock is unhindered. When applied to our market, sharp price swings can temporarily be halted, but can still move beyond the 15 percent range during the day.

Just a handful of Asian countries, including Korea, maintain a daily trading price limit system. Beyond Asia, only the United States and Canada impose a halt to trading, not only for individual stocks but the market as a whole, in the form of a traditional circuit breaker.

The heavy cluster of regulations does not befit the Korean bourse in view of its scale and maturity. We must devise a different market safety system by easing or revising the blanket price limit.

Translation by the Korea JoongAng Daily staff.

*The author is the director of research division at I’M Investment & Securities.

By Hwang Sei-woon
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