CHAPTER 2 Literature Review
2.2 The research of the circuit breaker mechanism
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2.2 The research of the circuit breaker mechanism
The circuit breaker mechanism has been widely adopted internationally, but scholars have continued to focus on the controversy. After the stock market crash in 1987, the Securities Committee (SEC) in the United States launched a "Brady Commission Report," where the concept of the circuit breaker mechanism was first introduced. Since 1988, the academic community has continued to debate whether the circuit breaker mechanism can positively affect the stock market. The report mainly considers the information transmission and market mechanism, and supporters believe that the circuit breaker mechanism can enhance the effectiveness of the market. When the stock market fluctuates greatly, the calm period can effectively prevent investors from behaving irrationally and can enhance the effectiveness of the stock market while reducing market volatility.
However, some scholars believe that the circuit breaker mechanism will not only have a stabilizing effect on the stock market but will also lead to the “magnet effect.” After the launch of the “Brady Commission Report,” Ugene Fama, the 2013 Nobel Laureate in economics, predicted that " investors will rush to complete the transaction before the trigger, resulting in the acceleration of the mechanism trigger." Similarly, Chicago scholar Lester Telser also believes that the circuit breaker mechanism will have an imbalance in the purchase order because " potential investors will tend to postpone trading for a better price when it is expected that some investors who are unable to maintain patience will sell or buy before triggering a fuse or a price limit." It is mainly based on price, but volatility and volume also support the delayed price discovery hypothesis, volatility spillover hypothesis, and trading interference hypothesis. Telser also supposes that the circuit breaker mechanism will hinder the market's normal price
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point, increase market volatility, and hinder normal market transactions.
2.2.1 The literature from Europe and America
The different scholars' research on the circuit breaker mechanism can be divided into two major directions: active and non-functional. The foreign research mainly focuses on the relationship between the circuit breaker mechanism and price fluctuation. French and Roll (1986) studied short-term price reversal and concluded that trading time will be more unstable than non-trading time, and they had supported the theory that implementing the circuit breaker mechanism would reduce stock market volatility. Yet, this conclusion is based on three assumptions: (1) there was more information on a trading day than a non-trading day to generate stock price fluctuations; (2) the insider information provided by informed traders causes most of the price fluctuations; (3) the irrational behavior of the trader will cause negative news to be reflected in the stock price. The third hypothesis above has a direct relationship with the circuit breaker mechanism and the price fluctuations. The first and second hypotheses only reflect the relationship between price fluctuations and message disclosure; they are not directly related to the circuit breaker mechanism. The empirical research of French and Roll explains why stock prices have greater volatility during the transaction, and it also supports the above hypotheses.
In addition, Gerety and Mulherin (1992) also proposed that fluctuations in the stock market under the circuit breaker mechanism are not only ineffective but may even exacerbate market instability. Through observing the changes in trading volume, they found that a large number of transactions occurred in the opening and closing stages because traders hoped to eliminate the overnight risk of holding stocks. Implementing
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the circuit breaker mechanism will increase the uncertainty of the reverse transaction before suspending trading, prompting the trader to overreact to the market fluctuations and even leave the market. Therefore, the conclusion is that the circuit breaker mechanism will not only reduce the fluctuation of the stock market but also increase market volatility. Lee, Ready, Seguin (1994), Kavajecz and Goldstein (2000), and other scholars have published similar opinions.
2.2.2 The literature from China
The research results of the circuit breaker mechanism in China's academia are scarce.
Most of the literature pays more attention to the theory and experience of the circuit breaker mechanism in foreign markets. Song Zhenzhen (2017) used the extreme value theory to study the circuit breaker mechanism of the trigger level in the Chinese stock market index and found that the number that triggers the breaking in the falling direction is almost double that of the rising direction. It shows that the stock yield in CSI300 is asymmetrical between a crash and burn, and it is easier to touch the breakpoint in the down direction. Also, Hu Yuyue (2007) and other scholars have listed the relevant rules of the stock market in four countries and compared their implementation of the circuit breaker mechanism. Shi Xiaobo (2014) also reached a similar conclusion, agreeing that the circuit breaker mechanism can reduce market volatility and the risk of trading. There are also authoritative journals that have performed a regression analysis on international circuit breaker mechanisms. For example, the Financial Archives (2009, 2015) introduced the rules and circuit breaker mechanisms in some major developed countries and briefly discussed the debate in the academic circles.
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However, the circuit breaker mechanism proceeded for only four days in China. There are two main defects in the circuit breaker mechanism design. First, the design of the two-pole threshold is too close, resulting in the magnet effect. For example, Hu Yuyue (2016) believes that implementing the circuit breaker mechanism will cause a trader to have the expectation of losing liquidity. The retail investors will assess the situation logically, but the collective irrationality strengthens the magnet effect and ultimately leads to the loss of liquidity in the market. On the other hand, the price limit mechanism of individual stocks and the index circuit breaker mechanism have led to a decline in liquidity. After implementing the circuit breaker mechanism, the range of intraday price was narrowed to seven percent in CSI300. Once the seven percent threshold was triggered, the market would stop trading on the day, causing the liquidity to decline.
According to the above conclusions, we determine that every country will always debate the effectiveness of the circuit breaker mechanism. It is rare to find empirical evidence about the circuit breaker mechanism in China's academic circles. Based on this, the paper analyzes the sample data during the price fluctuation to explore the impact of the circuit breaker mechanism in the Chinese market.
2.2.3 Review of research methods
The test of the circuit breaker mechanism in the market is mainly divided into two different methods, which include empirical and experimental research. However, the circuit breaker mechanism has been rarely implemented. Therefore, in the case of less real data, the empirical analysis will be difficult and the results obtained will be very limited. The earliest research data was from 1987 when Lauterbrach and Ben-Zion (1993) conducted a similar study to conclude that the circuit breaker mechanism only reduced the imbalance of trading in the short term, but not in the long run. G.J. Santoni
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and Tung Liu (1993) used daily data and intraday data to analyze the impact of the circuit breaker mechanism on price fluctuations. The final conclusions differed, and the daily data confirmed that the mechanism could not reduce price volatility. According to the past literature, there is still considerable discussion about the effectiveness of the circuit breaker mechanism among academics. One of the reasons is due to the different environments in which the circuit breaker mechanism was implemented. For example, different countries have different market maturities, and thus the mechanism will have different physiological effects and cause different conclusions. In addition, the limits due to the small scale, little data, short deadlines, and external validity of experimental conclusions make analysis difficult.
Studies in past literature have mentioned that price restrictions have had a major impact on companies with large market capitalization and have had less of an impact on companies with smaller market capitalization. Therefore, we also want to use statistical methods to determine whether the circuit breaker mechanism will have different effects on the different market values. The next section will detail the circuit breaker mechanism policy and CSI300.