Wednesday, May 12, 2010

Market Circuit Breakers Are Really Censorship

Market prices, price changes and price volatility of publicly traded shares and commodities convey important information about company valuation, relative sector valuation, the economy and geopolitical risks. Circuit breakers prevent trades, hide prices, and decrease apparent price changes and volatility.

Circuit breakers prevent prices from reflecting new information, whether based on speculation, rumor or fact. Algorithm computerized trading, while disparaged by many for the wild up and down US stock market price swings of last Thursday, use public information, such as last trade, relative prices, price changes, trade volume, etc. to determine if stocks should be sold, bought or held.

As computerized trades sold stocks on Thursday, as prices dropped to low levels, other computerized trades bought stocks. Sure, some stocks were sold at very low prices only to see the prices recover to near their old, higher levels very quickly. To the extent that the way trades are allocated among stock markets caused the price swing, that should be fixed to avoid a future occurrence. However, sharp price swings over short time periods in themselves are not a cause for reform or circuit breakers. Short term volatility captures the information uncertainty about risky political events and other risk at the time of the trades.

The European Finance Ministers, frightened by the price drop in global stock indices including the intra-day 1000-point drop on Thursday in the Dow Jones Industrial average, worked over the last weekend through Sunday night before Asian markets opened to put together an enhanced and bigger Greece bailout package to calm Monday morning financial markets.

On Monday in response to the EU's new, larger Greece bailout package, global stock markets surged.

With Greece facing default on its debt, with news coverage of Greeks rioting in the streets, and geopolitical uncertainty about the stability of Greece, other European countries, the EU and the Euro currency, it not not surprising that there was a large volume of shares traded last Thursday. It should also not be shocking that with so much geopolitical risk and uncertainty that there would be sharp price swings in share prices over very short time frames.

With geopolitical risk, there are no press releases as events unfold. Speculation and the merest hint of a rumor could cause trades and price swings. Information, speculation, rumors and political fear travels in microseconds across the globe among traders and investment managers these days. Without a press release or a defining moment, such as a declaration of war, or a military coup, market investigators will be hard pressed to discover any triggering event for the sharp price drop or price swing.

If markets had remained smooth and not reflected the markets' concerns about the first Greece bailout package through Thursday's price volatility and price drops, would the EU's finance ministers' work over the weekend to enhance the Greece bailout and finish before Asian markets opened Monday?

Circuit breakers do not change the underlying events that increase market and political risks. Circuit breakers are just makeup that hides blemishes without fixing the underlying condition. Short-term price volatility measures risks, rumors, speculation and other indicia of geopolitical and economic concerns of the market. Masking trades through circuit breakers, masks volatility and price drops and hides the riskiness of world events.

Political leaders, central banks, and finance ministers need to see markets unnerved. It motivates these government servants to action. Positive market responses, such as Monday's global market surge, visibility rewards and appreciates these government efforts.

Those that sell shares as their prices sharply drop only to see the prices quickly recover may feel they were unfairly treated by their brokers and the stock market. Market regulators and leaders can decide under what conditions these kind of trades can be voided.

Political leaders dealing with geopolitical and global economic risks need to see markets unnerved with increased short-term volatility. It motivates governments to act quickly and appropriately to the crisis. A positive market response through decreased volatility and increased prices acts as a positive indicator and a sign of an adequate response to these officials.

Market circuit breakers are really just government censorship of geopolitical risk and uncertainty expressed through price swings and drops.

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