Circuit filters: a neccessary evil?

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: The issue of circuit filters has once again surfaced to haunt he stock market community. Those who cheered at the removal of the first-day price band for stocks that are re-listed were caught on the wrong foot, when the shares of KGN Industries shot up to Rs 55,000 on May 21, turning its promoters to overnight billionaires. But neither the regulators nor the exchange did act. The next day, Sylph Technologies did a KGN. The company's shares, of which just around 2% are in the demat form, zoomed 99,900%.

Though the Bombay Stock Exchange (BSE) swung into action later, it was criticised for allowing the stocks to trade the next day as well. And this has brought up a question to the fore - the necessity of circuit filters on the first day of re-listing.

Earlier in 2007, Sebi had proposed a 20% circuit filter on the first day. However, Sebi in consultation with the market participants on issues of price discovery in the case of various corporate actions such as mergers, de-mergers, amalgamations, capital reduction, scheme of arrangement, revocation of suspension had come up with a circular on March 12, 2008, directing the stock exchanges to do away with the existing circuit filters for better price discovery of the stocks.

However, post the KGN and Sylph fiasco, Sebi had reportedly come down hard on the exchanges saying, "The practice of keeping the price band open for trading of scrips after evocation of the suspension is to enable the market to discover the price. However, the recent incidence of attempt to distort the price discovery of particular scrips is being viewed by the Sebi very seriously. The market regulator has asked the exchange to investigate and initiate appropriate action for such non-serious and frivolous market behaviour"

In a random survey by FE, market participants were divided over the need for a first-day circuit filter for re-listing. "There has to be a logical basis (for the stock price movement)," says Hasit Pandya, a stock broker. He feels that since around 80% of the stocks are not liquid, there needs to be some mechanism.

As of now, the logical basis can be created by only two options: either to have a circuit filter or not to have it. In the event of circuit filters to check manipulation, are there any viable tools for price discovery?

One option is to have a special session for price discovery. One instance in the past is the special session to discover the price of Reliance Industries' stock, after the company was demerged, in 2006. The price band for the next day onwards can be based on the overall indication arrived at the special session. A volume-weighted average price of the stock at this session can be worked as a basis for commencing the real trade. But when it comes to the Z category stocks, there is a lack of wherewithal to go for such a mock trade every time, since most of them are small stocks. "There can be dummy filters in the case of small-caps. Our market is still in a state of evolution. There is a huge possibility of operators manipulating the stock on the first day of re-listing. So circuit filters in general are a necessity," says Dinesh Thakkar, chairman of Angel Broking. The filters are there to protect the interests of investors, he said.

The debate on daily price limits in financial markets came up in the aftermath of the crashes of 1987 and 1989. The New York Stock Exchange and the Chicago Mercantile Exchange introduced circuit breakers that would halt trading for a certain time-period in case the indices go beyond a level in a day.

If circuit filters are indispensable, how will the stock find its real value without which the investor stands to lose? Some experts believe that circuit filter is an indispensable tool to check manipulation, but it will not prevent price discovery. A stock can discover its true price over a few trading sessions, they said. Others have a different view.

The price at which the stock was trading when it was last traded will be in most cases too low. In the case of Sylph Technologies, it commanded just 80 paise when it was delisted more than seven years ago. "A company may have been delisted for various reasons. What change it has undergone fundamentally is the basic question," said Pandya.

BSE adds, "While some companies may have improved fundamentally and financially, there may be companies, which may not have any such improvement in their business activity to support the significant price rise. The investing public is requested to note the quality of companies, especially the group in which the scrip is placed at the exchange before dealing in such scrips."