May 18, 2009 was the reverse of May 17, 2004. On both days, circuit breakers were triggered on NSE and BSE. However, basic questions need to be asked about the circuit breaker regime. The job of financial markets is to always be there: particularly on news-rich days like these.

The ?circuit breaker? rules that were defined by a Sebi circular in 2001 have defined three triggers of 10%, 15% and 20%. These trigger off either a trading halt, or a closure of trading for the day. The term ?circuit breaker? sounds sophisticated. However, such market rules are fraught with difficulty. They are supposed to help market participants take a pause and digest information when dramatic developments have taken place.

A functioning financial market plays two valuable roles. The first is price discovery. The process of buying and selling yields a price. As an example, on 18th, it was very important and interesting to know: How much is this news worth in terms of the overall change in Nifty? Which companies stand to lose from this change in guard? Eg one might expect companies who were close to cabinet ministers who have reduced influence to come out losing more on the stock market.

This continuous flow of information makes financial markets one of the most critical components of the statistical system. This information is used by a broad range of decision makers. When this information is snuffed out by a circuit breaker, there is a cost.

The second role of financial markets is to be a source of liquidity. In response to news, many people desire adjustments in their portfolios. In particular, people holding an options portfolio, which is hedged using futures, absolutely need a continuous supply of liquidity. If prices change while trading is infeasible, then this hedging?which is basic to the production technology of options?breaks down. Market closures directly do damage by interrupting the continuous supply of liquidity.

A critical feature of properly functioning financial markets is, thus, the feature of being there. The financial market must function continuously at all times, without interruption of service. The existing circuit breaker regime contradicts this function. When news breaks, and financial markets are needed most, circuit breakers interfere with the functioning of the market.

In 2009, there were two important differences when compared with 2004. The first was the build-up of liquidity with Nifty futures in Singapore (which, in turn, was caused by the earlier restrictions on participatory notes). So when circuit breakers shut down Nifty futures trading at NSE, some of this order flow migrated to SGX. When an onshore player suffers from interruptions of service, while an offshore competitor does not, this is a competitive disadvantage for us.

The second difference was the availability of currency futures trading at NSE. To some extent, people who could not trade in Nifty futures used currency futures as a rough Nifty proxy. NSE?s currency futures turnover went up on May 18 to an all time high of over a billion dollars. Some of this was caused by the interruption of service on trading in Nifty.

Looking forward, two positions can be taken in reforming the system. The first position is that there is nothing wrong with a continuous market; market-wide closures should not be done. This is a reasonable position and should be carefully considered.

If it is felt that in times of extreme movement, market participants really deserve a pause to ponder the world, there is a superior alternative to closure. This is the ?call auction? market. We could have a rule saying that when Nifty moves by more than 10%, we will go into a call auction for 15 minutes.

In a call auction, buyers and sellers place or modify their orders, and the system continuously shows a provisional price, at which the supply and demand curves intersect. So for 15 minutes, orders would build up for both buy and sell, and a single market-clearing price would be continuously computed and displayed. When the 15 minutes end, the market-clearing price that is discovered reflects a large number of orders and is hence more trustworthy. At the end of this period, a single price is announced and all orders that satisfy this price are matched. The remaining unmatched orders represent an ideal starting point of a liquid market for continuous trading.

If one is optimistic about the ability of financial markets to continuously discover a price when major news breaks, then one would veer towards having no closure. Even if one feels that a 15 minute pause is desirable, with a special effort at discovering a trustworthy price running through this pause, this suggests dropping out of the continuous market into a 15-minute call auction every time there is a 10% move of Nifty. Both these alternatives are better than the existing system of circuit breakers, which interfere with a core function of financial markets: that of being there.

?The author is an economist with interests in finance, pensions and macroeconomics