Consider temporary capital controls as 
circuit breakers for forex market

Circuit breakers were introduced in US equity markets following the Black Monday crash of 1987. Since then, their use has expanded into other asset markets and across countries

By DR OBIYATHULLA ISMATH BACHA / Pic By TMR

Despite many academic arguments about the financial markets being efficient, there is no denying their idiosyncrasies and propensity for extremes. The majority of investors may be rational but being humans, they are prone to greed and fear. Two human failings that cause the extreme volatility are seen in the markets.

In view of this, regulators and the financial markets use a series of instruments to manage the volatility. For example, in derivative, commodity and equity market tools like margins, tick size rules, trading position limits, price limits and a series of other requirements are used to ensure stable and fair trading.

The raison d’être for markets is price discovery but without proper ground rules, markets can be rigged to stoke fear or greed, and the resulting prices may not reflect the fundamentals. Thus, the trading rules are designed to reduce the impact of fear and greed on price formation.

Of these rules, the ultimate is a circuit breaker or trading halt. Circuit breakers were introduced in the US equity markets following the Black Monday crash of 1987. Since then, their use has expanded into other asset markets and across countries.

Today, most developed equity markets have some form of circuit breakers in place. Their objective is to minimise huge swings in prices within short periods. When the price of a stock swings beyond a given threshold, trading in that stock is halted temporarily.

Trading resumes after an interval and if the price continues to move wildly to hit another (broader) threshold level, trading is halted again for a longer interval or until the next trading day. In addition to individual-listed stocks, trading halts also apply to the overall index.

Triggering Circuit Breakers

Since their introduction in 1987, there have been many occasions where circuit breakers were triggered in the US markets and in other countries. While some critics have argued that their use has caused prices to converge towards the threshold levels during times of volatility, few have questioned the efficacy of circuit breakers in taming excessive price moves.

A UK government-commissioned study concluded that despite the abrupt interruption to trading, the need for circuit breakers remains. In the US, since 2012, a further refined, limit up, limit down mechanism has been in place.

The key point to note is that while circuit breakers impose trading halts that can temporarily delay price movements in a given direction, they cannot prevent the inevitable. For example, if an oil exploration firm announces the discovery of huge reserves, its stock price is likely to hit limit highs even following initial trading halts. In due course, the stock price will rise to settle at a price that reflects its fundamentals.

So, circuit breakers are meaningful in preventing price dislocations caused by rumours or manipulative trading. A trading halt enables investors to evaluate whether the price deviation is warranted. So, on balance, even if disruptive, stock exchanges and their regulators can see the value of circuit breakers in proper price formation. Thus, the spreading popularity of its adoption.

In the context of foreign-exchange (forex) markets, temporary capital controls could be the equivalent of equity market circuit breakers. Capital controls — by restricting capital flows effectively — eliminate pressures on a currency. Controls on capital inflows would tamper home currency appreciation while controls on outflows, home currency depreciation.

As opposed to long-term capital controls which are highly distortionary and give rise to perverse incentives and perpetuate misaligned exchange rates, short-term capital controls (two weeks or thereabouts) can have the beneficial effects of circuit breakers.

So, why are capital controls such anathema? Because of moral hazard and the cover it provides for bad policymaking.

Capital controls, particularly on outflows, can be a means by which governments and central banks try to avoid the pain of market discipline. When bad exchange-rate policies lead to overvalued exchange rates and eroding reserves, the home currency becomes vulnerable to speculative attack.

The resulting depreciation corrects the overvaluation, albeit in a painful way. There really is little economic logic to long-term capital controls, particularly a broad-based one.

Currency Market

Even so, the currency markets like other asset markets are prone to fear and greed. Thus, some means to tamper excess volatility is surely needed. There are two reasons why this may be more important for currency markets.

First, unlike other asset markets that are centrally organised with participants who have been registered and trades that are traceable, the forex market is clouded in anonymity. Anonymity and a nebulous market structure with opaque trading rules make it easy for hit-and-run speculative attacks.

Furthermore, manipulative moves to stoke the fear that can lead to capital outflows and self-fulfilling crises are a lot easier under the cover of anonymity. While there is little justification or morality in protecting bad policymaking, there is even less morality in enabling a small group of speculators enriching themselves at the expense of ordinary citizens, particularly of poor and emerging nations.

Second, exchange rates have far more determinants at play than most asset prices. To complicate matters, many of these determinants may have nothing to do with host country policies. The current US interest-rate hike is a case in point. Emerging markets are experiencing outflows not due to changes in their fundamentals but to a switch in the US interest-rate regime.

While the outflows, if orderly, will lead to adjustment and a new equilibrium, opaque markets can be rigged by those with access to speculative capital to hold governments to ransom with the potential to cause a self-fulfilling crisis.

Circuit breakers are designed precisely to avoid fear- or greed-based tangential price movements arising from distorted information.

As is the case with circuit breakers in equity markets, temporary capital controls cannot prevent the inevitable. Weak currencies will fall, even if the depreciation is temporarily disrupted. Given their efficacy
in the equity and commodity markets, policymakers ought to seriously consider their use in forex markets.

  • Dr Obiyathulla Ismath Bacha is professor of finance at the Malaysia-based International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.