Milton Friedman Society
Trading during the age of Coronavirus: can financialmarkets be left alone?
Aggiornamento: 7 apr 2020
by Giacomo Mander.
Global indices have hit a rough patch, to say the least. The S&P 500 dropped 7% (or more) against the previous days’ close on four separate occasions during the last two weeks, prompting the first (of three) level circuit breakers to halt trading on the NYSE for 15 minutes. This development has opened the door to calls for other restrictions, such as shortening trading hours, banning short-sales, and calls for indefinite trading halts in many of the world’s largest stock exchanges.
While these proposals have some merit, especially circuit breakers, closing markets would do more harm than good, potentially amplifying the spectacular selloff currently sweeping the markets, as pointed out by several experts in the industry.
Circuit breakers could put the brakes on spiraling volatility and keep high-frequency traders in check, as trading volume reached near-record highs. Panic selling triggered by bad news could be tamed, helping investors adjust their expectations and strategies, allowing for smoother trading afterward. However, they also cause countless trades to “go bust”, meaning that even if they were already executed, they get reversed, leaving many market participants in peril.
Looking at the recent immediate market reaction after the 15-minute trading halt is up, it is apparent that every time the S&P 500 loses more than 7% at closing, casting doubts over the usefulness of circuit breakers. Another excellent example of this instrument’s supposed inefficiency comes from China in 2016, when the government decided to review its circuit breakers system, after reaching the conclusion that they actually compounded the negative sentiment and hampered market recovery.
However, single stock trading circuit breakers have garnered some support, including that of Phil Mackintosh, chief economist at NASDAQ Inc, who claimed that they provided essential guardrails for share prices, giving investors a little breathing room.
Closing markets for a prolonged period of time, however, is a very different story and has occurred only twice in 21th-century America, after the 9/11 terrorist attacks and during hurricane Katrina. The most immediate effect of shutting down markets is depriving investors of important pricing information and draining the economy of vital liquidity, straining market dynamics.
In response to the Covid-19 outbreak, the Philippines decided to halt all stock, bond, and currency trading indefinitely on March 16th, becoming the first country to introduce such a drastic measure. This was done after the government was unable to prop up prices by requiring pension funds to double their average trading volumes. This measure might lead other nations to follow suit, causing significant headaches for traders and investors alike.
Such a policy aims to shield market participants from decreasing prices and severe volatility, hoping that economic conditions will stabilize and quell investors’ fears over the closing period. If this does not occur, the possibility of a significant selloff at the reopening bell will increase, threatening further the already fragile markets.
Interestingly enough, the Philippines resumed trading after two days, and what happened next should serve as a strong warning to anyone thinking about emulating their handling of the crisis: stock prices plummeted 13.3%, the largest one-day drop in history, closing at their lowest level since 2009. Manny Cruz, a strategist at Papa Securities Corp, perfectly summarized the situation, claiming that “The money that wanted to go out got accumulated and investors got scared and lost confidence whether they can go out anytime they want so they took this resumption as an opportunity to rush to safety”. This same reasoning is likely to apply to investors in every market around the globe, potentially paving the road for a disastrous selloff.
Some proponents of trading halts argue that markets cannot carry out their fundamental functions during a crisis of this magnitude, such as price discovery and having a sound public price for trading. This reasoning implies that markets are “broken”, and so closing them would be the most sensible course of action.
As pointed out by the Financial Times’ editorial board, this could leave investors without a reference price and make valuing securities even more complicated, encouraging further downward price swings. Market prices reflect investor sentiment, which in turn is influenced by news and fundamentals, so if there is great apprehension about a worldwide recession, this should be accounted for in market prices. Moreover, any progress regarding the development of a vaccine, or positive economic data, would not be priced in a timely manner should the markets be closed; additionally, the effects of government policies could not be quantified in any way in the short term, increasing uncertainty.
With regards to price transparency, the role of short sellers needs to be understood, as they could be easily perceived as vultures preying on economic hardships, instead of important players in setting prices and keeping firms’ management accountable. That being said, several countries have banned short selling for three or six months, including South Korea, Italy, Spain, among others.
Jay Clayton, chairman of the SEC, recently claimed that markets must remain open through these tough times, as banks are well-positioned to deal with this crisis and provide credit and liquidity to struggling firms (Unlike during the 2008 financial crisis). Furthermore, companies need to access capital markets to fund their operations, as noted by NASDAQ’s CEO, Adena Friedman, as price transparency becomes paramount in this predicament.
Finally, keeping markets open incentivizes countries to avoid relying solely on monetary policy and to enact swift and decisive fiscal policy to combat the economic fallout of the outbreak. This is evident in the US, as the Fed’s “extreme” measures (bringing interest rates to zero and launching a $700B quantitative easing program, among others) have so far failed to calm investors, prompting the Trump administration to propose a series of stimulus packages, including a bipartisan bill to secure funding for coronavirus testing, worth roughly $100B, and temporarily cut payroll taxes.
In conclusion, the soundness of financial markets is being put to the test, and artificially altering their behavior might result in its fundamental functions being distorted, fueling further uncertainty in an already dire situation.