loss of that magnitude is certainly not goodnews, but it is quite negligible in front of capital gains commonly inexcess of 20 percent over the past few years. Therefore, it is only legitimate to ask if we really care about dividend taxation at all. The answerto this question is most de®nitely yes, and the reason is related to thedifference we detailed earlier between traders and fund managers.We said essentially that fund managers were benchmarked andthat their performance was directly evaluated with regard to a broadmarket base. In that context, dividends, and their taxation even more,are relatively unimportant because by de®nition they are always consistent with the market.33 From a trading perspective, dividends arepurely market parameters. Every decision is made with a set ofexpected values, and any realization different from this set will generate a pro®t or a loss.34 This is all the more true with derivativeproducts, which are extremely dependent on distributed income likedividends and coupons. For example, an unexpected slide of the S&P500 yield from 1.2 percent to 1.1 percent would result in a loss of $5
31
We will detail the fair value calculation in the chapter dedicated to index arbitrage.Broadly speaking, the fair value is equal to ®nancing minus dividends. A higher taxrebate means more dividends, which translates into a lower fair value.32In practice, the activity of index arbitrageurs depends on many other parameters,making the impact of the rebate rather dif®cult to isolate. Borrowing and lending ofsecurities is a much easier way to extract this information.33Again this is intentionally a very broad statement. Managers of income funds arenaturally accountable for their decisions with respect to the overall yield of theirportfolio.34Note again here the coexistence of theoreticalÐexpectedÐand mark-to-marketÐactualÐparameters.
82
THEORY AND TOOLS
million on a $5 billion long position. Positions of that size are fairlycommon, and their expected pro®tability is not suf®cient to allow forthat high a loss.
FUNDAMENTALSWe consider a fundamental piece of information to be any data related tothe operating and ®nancial results of a company: earningsÐrealized orestimatedÐcash ¯ows, balance sheet aggregates, and so on. Under thatde®nition, dividends for example, or corporate eventsÐsplits, mergersÐare not fundamentals because they are the results of a distribution or industrial policy, not of the operating performance of theorganization.Fundamentals have a paradoxical importance in the world of arbitrage. In some cases, ®nancial analysis is the most critical aspect of atrading decisionÐfor example, in the case of some market-neutralhedge funds.35 At the same time in other situationsÐindex arbitragenotablyÐthey are almost irrelevant if only because arbitrageurs cannotpossibly follow several hundred stocks at the same time.We will take here the relatively extreme position that fundamentalshave generally only a minor impact on an arbitrage trading decision.36An absolute convergence, for example, does not depend in any way oneconomic performance. Even an explicit convergence is relativelyimmune to these considerations because of the short- to mediumterm horizon of the underlying position. Only in the case of a speculative position, concentrated on a small number of securities, is there astrong necessity to focus on microeconomicÐor macroeconomicÐfundamentals.37That said, the economic environment should not be totallyignored. It may not be necessary to follow a particular corporationin detail to trade it, but it is certainly useful to have a fair ideaabout its operating environment and performance. In addition, com35
In a market neutral strategy, funds invest in shorts and longs at the same time inorder to keep a relatively low net market exposure.36Trading decision refers to the decision process leading to the initial transaction for areasonable size. It can be argued that fundamentals have much more impact on riskmanagementÐthat is, the process of adapting the overall size of the position tomarket opportunities.37This is typically the case of market-neutral hedge funds that tend to carry only fewsecurities in their portfolio. Another example of a strategy highly dependent onfundamental analysis is naturally macro arbitrage.
CHAPTER 2 STOCKS
83
mon sense usually holds that better information leads to better decisions, and this is most certainly true in times of crisis. If onlybecause of that, a basic understanding of micro- and macroeconomics can be very helpful. In practice, many long-time tradersacquire such knowledge over time. This sense of judgment is particularly valuable, and it undoubtedly differentiates an average froman outstanding trader.
BORROWING AND LENDING OF SECURITIES38Securities- and Cash-Driven Transactions
The borrowing and lending of securities can be separated in two broadcategories, based on the ultimate purpose of the transaction: securitiesdriven and cash-driven.39 Securities-driven transactions consist of loansof speci®ed securities for a period of time. The fact that the securitiesborrowed are clearly identi®ed is important because the purpose of thewhole operation is usually to sell them. Borrowing in that case isindeed the only way to acquire the possibility to sell without owninga particular security. The alternative to that would be a sale withoutany associated delivery, something largely forbidden. In other words,the need to sell is driving the requirement to borrow, which in turncreates an opportunity to lend. There is a small variation in this schematic description in countries where ®scal authorities recognize theexistence of tax rebates. There, securities-driven transactions mayalso be effected to bene®t from a cash distributionÐtypically dividendsÐthrough ®scal arbitrage. In that case the securities need to beclearly identi®ed as well. By contrast, a cash-driven transaction consistsof an exchange of securities against cash, which is essentially a collateralized loan. The particular set of securities included in the collateral isrelatively irrelevant, provided that they meet certain requirements, interms of liquidity, for example.4038
For a very comprehensive description of the market for borrowing and lending ofsecurities throughout the world, see: ``Securities Lending Transactions: MarketDevelopment and Implications,'' International Organization of SecuritiesCommissions (IOSCO), July 1999, available online at www.iosco.org. This documentconsiders a range of issues like taxation, accounting, regulation, credit, and counterpart risk management.39This terminology is borrowed from the IOSCO report.40Note that it is perfectly reasonable to conceive a security versus security transaction.Therefore, the distinction between securities-driven and cash-driven is certainlyhelpful, but other structures do exist.
84
THEORY AND TOOLS
Security loans are essentially transactions negotiated over thecounter. Functionally, one party borrows a security from another,with the legal commitment to return it at a later date. Practically,they may take distinct forms. In a repurchase agreement, the lenderagrees to sell some securities and buy them back at a speci®ed priceat a later date. The fact that the operation goes through an actual sellensures that the borrower acquires the legal ownership of the securities. In a security loan, the contract recognizes a loan between theparties, but it is structured in such a way that the borrower acquiresownership anyway; otherwise the transaction is of no interest to himor her. In a sell-buyback, the lender sells and buys its shares backsimultaneously, but the settlement of the purchase is deferred.41Regardless of the speci®cs, the lender is entitled to all the economicbene®tsÐmonetary and otherwiseÐattached to the securities that heor she would otherwise enjoy if he or she held them.42 This situation isparticularly important in the context of arbitrage where corporateevents may have disastrous consequences for the borrower, as wewill see.Our examination of the borrowing and lending market here will besomewhat schematic. Even though it is virtually possible to borrowany type of security, we will consider exclusively equities as we havedone consistently before. Also, despite the relative variations in actualstructures, we want to concentrate on core issues and build a stylizedview of the process as opposed to getting deeply involved in the intricacies of speci®c markets. Indeed, the subtleties behind a security loanversus a repurchase agreement are not of a particular relevance from atrading perspective.4341
The difference between a repurchase and a sell-buyback lies in the operation date ofthe purchase. In a repurchase, the lender agrees to buy back but has not done so yet.In a sell-buyback, the purchase has occurred, only its settlement is postponed.42This precision is important: The lender is legitimately in a position to claim something similar to a replacement value. For example, if a foreign lender is taxed ondividends at 20 percent, but the borrower enjoys tax-free payments, the lender hasno automatic claim on the 20 percent saved taxes. This is the essence of ®scalarbitrage.43The reasoning behind this statement is the following: Most trading organizationshave pro®t centers dedicated to the activities of borrowing and lending securities.These desks naturally have a comprehensive understanding of the types oftransactions they effect, and they manage their risks accordingly. From his or herperspective, the arbitrageur is concerned primarily with the cost of borrowing aparticular security or the potential revenue generated by lending it. Beyond thisquantitative aspect, it is conveniently simple for us to assume that the actual formof the transaction is irrelevant.
CHAPTER 2 STOCKS
85
Securities-Driven Lending
Lending a stock is equivalent to delivering it to a determined counterpart against payment, with the explicit agreement that this counterpart will deliver it back later in the future, again in exchange formonies.44 The payments at initiation and expiry need not be exactlyknown from the very beginning and indeed are usually not.Consider the situation from the lender's perspective: The loan iseffected and terminated against payment, which implicitly pricesthe securities at both ends of the transaction. If all prices wereknown at initiation of the loan, the lender would actually be hedgedagainst any market movement in the price of the securities for thewhole period of the loan. Therefore, the loan would have signi®canteconomic consequences beyond a pure temporary transfer of ownership. By contrast, in the absence of a preset price at expiry, thelender is fully exposed to market ¯uctuations. In order to establishthis exposure and restrict the whole operation to a pure loan, theprice at expiration is speci®ed with respect to a market reference,typically the closing price on the main exchange of the underlyingsecurities. This procedure also allows a simple calculation ofamounts to be settled.In general, borrowing and lending transactions can be betterunderstood by looking at the monetary ¯ows, so let's consider theposition of each party. The lender delivers shares otherwise held idleand receives a cash collateral against them. The transaction is structured in such a way that he or she is assured of all economic bene®tsattached to the shares, except one, the opportunity to sell them.Therefore, he or she would expect to be compensated for this rightthrough a fee paid periodically by the borrower. Because he or sheowes interests on the collateral, in effect he or she borrowed liquidity atan advantageous rate while getting an additional fee.45 The borrowernaturally carries an opposite position: He or she receives the shares,
44
Because we do not want to enter technical details here, the expression ``deliveryversus payment'' is actually the best way to describe all transactions alike. The payment may be a regular payment in the case of a repurchase or sell-buyback agreement, or a collateral in a loan.45The rate is advantageous because the transaction is collateralized by the stocksÐthatis, the credit risk disappears.Note that if the lender does not have any particular use for the collateral he orshe receives, he or she may invest it and receive market rates, used to pay thecounterpart. In that case the economic bene®t of the stock loan is limited to thefee.
86
THEORY AND TOOLS
sells them, and delivers the cash as collateral.46 He or she pays theborrowing fee regularly, which means that he or she does not get thefull proceeds of the sale. Essentially the borrower ends up with a shortposition for which the proceeds from the sale are delivered as collateral. Insecurities-driven loans, the whole purpose of the transaction is in theestablishment of this short, as we indicated earlier.There are several important additional mechanisms involved instock loan transactions:. Because the market prices of the securities vary continuously, the
amount of collateral needed to guarantee the loan varies as well,creating a need for margin calls. If market prices go up, the borrower needs to deposit more against the shares, and vice versa.These payments occur periodically, typically daily or weekly.. The borrowing fee is often called the repo rateÐa contraction ofrepurchase rate. Indeed, common practice is to refer to stock loansas repo transactions. The repo rate is usually a percentage of thenominal amount of the transaction and is actually paid regularly,typically weekly.47 Depending on the liquidity of the market forstock loans, the magnitude of the fee varies wildly. In the UnitedStates, the largest and most liquid market, securities under normalmarket conditions can be borrowed typically for less than 0.30percent. In Japan, the other extreme, it is not uncommon to borrowsecurities at more than 1 percent, sometimes much higher. In general, naturally the fee depends dramatically on the number of shortsellers. In a situation of risk arbitrage, the repo rate for the acquiring company can go much higher than its usual level because of theparticular situation and opportunities related to the arbitrage.. During the whole period of the loan, the lender is unable to sell thestock. To address a possible dif®culty here, most stock loans carry a
46
There is a minor sequencing problem: The shares have to be secured on the accountbefore they can be sold. Therefore, the borrower cannot deliver the proceeds from thesale immediately; he or she has to borrow the collateral for a short period of timeduring which he or she receives the shares and actually sells them.47Note that if the fee is proportional to the amount, it varies with the market. From thelender's perspective, this variability may represent a risk because the revenue streamis unsecured. From the borrower's perspective, the risk is the opposite because thestream of payments is unsecured. Both may have to hedge it, for example, with aderivative such as a futures.In certain instances, the contract is established so that the repo is settled throughdelivery of additional shares instead of cash. This may be advantageous to the borrower who does not want to pay the fee in cash.
CHAPTER 2 STOCKS
87
recall clause, allowing the lender to recall shares after a predetermined noticeÐtypically ®ve business days. In someÐrareÐcases,the loan explicitly forbids recalls, in which case the repo is wayhigher, compensating the lender for a strict impossibility to changehis or her mind. The recall clause is clearly another major risk facedby arbitrageurs entering short positions.48. During the period of the loan, all corporate events modify theliability of the borrower. For example, after a split the outstandingposition is automatically adjusted by the split ratio.49The business in general is very much driven by client relationships. Traders on stock loan desks tend to be much more salespeople than they are traders per se. In particular, in numeroussituations shares availability is critical, and the best names can sometimes ®nd shares that others will not be able to see. Risk arbitrageis, for example, absolutely dependent upon the arbitrageur beingable to short-sell the overpriced company. The more pro®table theopportunity is, the more dif®cult it is to get those shares. In thatsituation, a respected and established loan desk is a particularlyvaluable asset.As a general rule, stable lenders tend to be institutional investorswho are not in a situation of high turnover. This typically includespension funds, insurance companies, and similar institutions. Thestability of their holdings through time and their huge portfoliosmake them ideal partners, and a sizable source of short-sellingpower, particularly in the United States. These institutions are primarily interested in improving the yield on their portfolio, whichwould remain unproductive otherwise. Borrowers tend to be traders48
The reasoning was exposed earlier with closed-end funds arbitrage. Typically a lender might want to sell his or her stock after a sharp increase in price, and to thatpurpose exercise the recall option. A short seller in that situation has to ®nd anotherlender or buy back the shares at a much higher price than when he or she sold them,realizing a loss. In the case of an arbitrageur, this loss on one leg does not necessarilytransform into an overall loss because the spread between the two legs may havemoved in the right direction. The problem is that the position may have to be closedregardless of its current pro®tability. The recall option is therefore a very interestingfeature similar to the option to recall embedded in most corporate bond issues. Ingeneral, traders on stock loan desks enter ``gentlemen's agreements'' not to recallunless unexpected circumstances make it absolutely critical. By and large these agreements are respected.49We will examine in more detail how this liability is modi®ed and the risks that areassociated with it in the chapter dedicated to corporate events.
88
THEORY AND TOOLS
with speci®c strategies, and arbitrage strategies are a large componentof that.50
Tax-Driven Lending
Consider the situation we introduced earlier: a French corporationpaying a dividend of 15, taxed at a 331/3 percent rate at the recipient'slevel. The gross dividend of 15 is then divided in two: withheld taxesof 5 and net dividend of 10. We assume that a French shareholderwould be in a position to claim a 5 tax rebate from ®scal authorities,in effect making the dividend distribution tax free. At the same time,imagine a foreign investor holding the same security but unable toclaim any rebate. If the investor agrees to lend his or her shares tothe domestic institution, he or she might expect to receive a regularborrowing fee and part of the 5 rebate.51In order for this structure to work, the domestic investor must beable to claim a rebate from ®scal authorities. As we mentioned before,this means that the organization behind him or her must show a taxable pro®t; otherwise no deduction is possible. This amount of taxablepro®t must naturally be commensurate with the expected level of additional rebate acquired through stock loans. Overall, this type of arbitrage requires a strict and rigorous tax management, at the highestcorporate level.52In terms of nomenclature, a rebate claim acquired through a stockloan transaction is said to have been purchased. Conversely, when aclaim is being transferred away, it has been sold. These appellationsre¯ect the fact that the rebate is a marketable commodity, somethingwe mentioned earlier. Indeed, consider, for example, that a Frenchdomestic investor borrows the shares described above with a rebate50
Arbitrageurs are certainly not responsible for the totality of the short interest in themarket. Note, also, that their position must always be relatively symmetrical withrespect to short and long exposure, which is in sharp contrast to many other categories of investors.51Note that the shareholder receives a payment equal to the net amount immediatelyand a rebate at the end of the ®scal year. However, ®scally speaking, the rebateaccrues to the holder of the shares on the ex-day. Therefore, the arbitrage onlyrequires the lender to deliver shares for a few days around the ex-day.52Note that the borrower has committed to the lender for a certain amount. If eventually the rebate allowance is insuf®cient, the borrower realizes a loss when he or shepays the original lender. Conversely, if an institution with a stock loan portfolio endsits ®scal year with a rebate allowance too low compared to what it could haveclaimed based on its taxable pro®ts, it faces an opportunity loss because it couldhave been more aggressive in borrowing stocks.
CHAPTER 2 STOCKS
89
pricing of 40 percent.53 If the shares are being again lent away shortlyafter for a rebate of 60 percent, the net difference of 20 percent is a purerisk-free pro®t for the intermediary traders.54 Why would somebodypay 60 percent? Because another institution may be in a position toclaim 100 percent with little risk and be ready to pay 60 percent. Theother natural question arising from this situation is why sell at 60percent when the securities can be held through the ex-date and deliver100 percent? For one, the overall rebate allowance at the end of the yearmay be uncertain or limited. And secondly, the 20 percent pro®t materializes in cash on the ex-date of the security, whereas the rebate is onlya deduction months away.
Equity Financing
Equity ®nancing transactions are essentially stock loans arrangedexclusively for the purpose of borrowing cash.55 These are thereforelender-initiated loans as opposed to securities-driven loans. The keydifference in that context is the paramount importance of credit risk. Asin any other deal, the borrower has a direct risk on the lender's credit,offset here by the delivery of securities. In equity ®nancing, the ultimate commodity exchanged is cash, not equity; therefore the setup ofthese transactions usually implies a process more stringent with respectto credit lines. Not surprisingly, the counterparts involved in thesedeals are not necessarily identical to those engaged in securities-drivenoperations. For example, institutional investors like pension fundsrarely need cash and would have a limited interest in lending theirportfolio for this sole purpose.This situation has two practical consequences: Transactions call forthe introduction of a haircut rate designed to protect the cash lender,and the rating of the cash borrower is particularly important in settingthe repo rate. The haircut works in the following way: The stock lenderagrees to deliver a nominal higher than the cash he or she receivesÐfor example, 110 percentÐto protect the other party in case of53
As a reminder, this 40 percent indicates that 40 percent of the tax savings of 5 isbeing ``reimbursed'' to the lender.54It should be apparent here that stock loan traders have a critical role to play in manyrespects, and they do engage in trading activities at least in areas where ®scal regulations make it appropriate. Note that in contrast to our description of an arbitrageurattending to his or her business quietly and discreetly, stock loan traders have animpact on the overall tax risk of their employer.55Note that the stock borrower is the cash lender and vice versa.
90
THEORY AND TOOLS
liquidation.56 The credit ratings of both parties become also extremelyrelevant. Consider, for example, a market participant lending stocks toa counterpart rated much higher, and assume that the traded repo is0.50 percent. In essence, the cash borrower has obtained a loan at a rate0.50 percent higher than the ®nancing rate of its counterpart. If thiscounterpart as we assumed has a much better rating, a spread of 0.50percent may indeed be a very good deal. Therefore, the repo in thesecases is not so much related to the availability of shares in the marketbut rather to the creditworthiness of the cash borrower.
Margin Trades
As a general rule, every market transaction is supposed to be settledshortly after its execution, through delivery of shares and payment.However, most markets allow nonstandard transactions to occur, inwhich the seller does not deliver the sharesÐat least directlyÐand thebuyer does not necessarily deliver the full amount. The general principle is that investors do not have to settle their purchases in full if theychoose to, and can borrow the missing part from their broker.57Conversely in case of a sale, investors can choose to sell shares theydon't hold, in which case the broker will deliver them instead, borrowing, for example, from another client. These trades are called margintrades, because the risk embedded in the open position creates a needfor periodic margin calls. In addition, because they usually inducecreation of credit, they are tightly regulated by central banks.In the United States, for example, margin trades have to be bookedon segregated accounts, and individuals can borrow up to 50 percent oftheir transactions.58 The exchange does not know a margin trade froma regular one because the trade itself is settled as a standard transaction. The broker manages its clients' margins and positions, and naturally charges a fee for these services.Margin trades are of little interest, in general, to professionalsbecause they have cheaper alternatives. However, the overall balanceof margin transactions, usually published by exchanges regularly for alarge number of stocks, can be highly indicative of a widespread mar56
This protection is meant to cover the possible market impact if the securities need tobe liquidated in a very short period of time.57Naturally this borrowing is not free; indeed, it is rather expensive. This type of tradeis therefore almost exclusively used by individuals who cannot, or do not want to,commit signi®cant capital to their portfolio.58Because margin trades induce creation of credit, their regulationÐthat is, requiredcoverageÐfalls under the jurisdiction of the Federal Reserve.
CHAPTER 2 STOCKS
91
ket sentiment. It is therefore important to understand the fundamentalunderlying mechanisms.
TRADINGIn this section we consider the practical side of stock transactions,speci®cally the structure of the market. Because of the wide diversityof systems and environments, this examination is meant to be a simpleand broad introduction. There is no doubt that a clearer and morethorough understanding of many practical and technical details is tremendously important in day-to-day trading.
Market Microstructure: Dealer versus Auction, Floorversus Screen
Market microstructure is the ``study of the process and outcomes of exchanging assets under explicit trading rules.''59 Although the issues related tothe design of an ef®cient market structure are not trivial, for our purpose we can schematically say that there are two main organizationalstructures: auction markets and dealer markets. Auction markets areorder drivenÐthat is, orders are executed through a set of liquidityproviders that show their interest in a limit-order book. Most of the timethese auction markets are continuous and electronic. Dealer markets,on the other hand, are quote driven: Liquidity is provided primarily bymarket makers who have no limit-order commitment but communicateinstantaneous quotes for other participants to trade. Transactions arethe result of a negotiation with the market maker and are still effectedover the phone for large sizes. Nasdaq in the United States and SEAQin the United Kingdom are two examples of dealer markets, with theparticularity of providing electronic routing systems. The stockexchanges of Paris and Frankfurt are auction markets, while NewYork and London are a combination of both.60 Tokyo became entirelyelectronic when it closed its trading ¯oor in April 1999 after 120 yearsof service.59
Maureen O'Hara, Market Microstructure Theory, Blackwell Publishers, 1995, p. 1. Thisbook contains a complete discussion of the market microstructure theory.60London implemented the Stock Exchange Electronic Trading Service (SETS), a fullyelectronic trading system, in 1997 on the largest capitalizations included in the FTSE100 index. This migration proved a success with more and more orders going throughthe electronic system, accounting for half the trading volume at the end of 1998.
92
THEORY AND TOOLS
Another dimension of market structure is the distinction between¯oor and screen markets, somewhat independent of the nature of theorder matching process.61 In a traditional ¯oor market, all orders arebrought to an open-outcry pit where brokers and market makers showtheir immediate interest with a complex set of hand gestures. In ascreen-based model, orders are inputted into an electronic interface,regardless of the matching process.With the volume of transactions growing dramatically over theyears, the traditional ¯oor has evolved into a modern version inwhich the ¯oor still exists, but the open-outcry has been replacedby an electronic entry system. For example, on the NYSE, specialistshave their dedicated booth, but there is no pit serving as a marketplace anymore. Indeed, most modern markets have now adopted ascreen-based trading, in the sense that prices are available in real timeon a screen and small orders can be routed electronically.62 However,the degree of reliability of these prices depends highly on the natureof the underlying market. For example, Nasdaq is screen based, butarguably it is still dif®cult to rely on quoted prices. Therefore, for allpractical purposes we can consider all the largest markets as screenbased, at least for the stock side. The only exception of interest to usis Chicago for the S&P 500 futures, still traded in an open-outcrypit.63In the interest of time and briefness, we will not go into much detailbeyond this introductory description, which allows us to have apanoramic view, suf®cient to serve our purpose. It is necessary toemphasize, however, that many issues related to market structureend up having a signi®cant impact on arbitrageurs' ability to conducttheir business pro®tably.
Circuit Breakers and Trading Halts
Circuit breakers and trading halts are mechanisms designed to moderateexcessive volatility by interrupting the normal stock trading process for61
See, for example, Alexander Kempf, ``Trading System and Market Integration,''Journal of Financial Intermediation, 7, 1998, pp. 220±239, for an empirical discussionof ¯oor- and screen-based trading systems.62In the case of dealer markets, this is not true for sizable orders, and the phone callremains the only viable choice.63The FTSE 100 Future in London was until May 1999 traded in an open-outcry pit aswell. It is now traded on LIFFE-Connect, the electronic trading platform developedby the London International Financial Futures Exchange (LIFFE).
CHAPTER 2 STOCKS
93
a period of time.64 Circuit breakers are used throughout the market andwere originally proposed by the U.S. Securities and ExchangeCommission in 1987 on the grounds that had such measures been inplace earlier, they would have signi®cantly reduced the magnitude ofthe October crash. Trading halts are market suspensions on individualsecurities, to allow, for example, fair dissemination of new information.Both types of suspensions can be information based or rule based.Information-based interruptions are activated under the exchange discretionary power to re¯ect the fact that important new information hasthe potential to change prices signi®cantly and should therefore bedisseminated fairly to all market participants. Rule-based interruptionsare systematic interruptions based on a set of rules ®xed in advanceand communicated to all participants. Table 2-3 gives an overview ofall categories.Intentional market interruptions implemented by exchanges arehighly controversial and the subject of much debate because of theunderlying practical and philosophical justi®cations advanced inboth camps. On one side, regulators and exchanges overwhelminglycite protection of investors' interests as the ultimate goal of circuitbreakers and trading halts, and many people truly believe they appropriately serve this very goal. On the other side, academic research hasattempted, and failed in most instances, to prove that these mechanisms have been bene®cial to the stated purpose. Indeed, some studiesTABLE 2-3
Trading halt
Information Based
Rule Based
For individual securities:dissemination of information,clari®cation of rumor, violationof exchange rules
For individual securities: trading outsideof a predetermined percentage or pointvariation based on the previous day'sclose, current day's open, or a movingaverage of trading bandFor the entire market: trading outside ofa predetermined percentage or pointvariation based on previous day's closefor an index, current day's open, ormoving average of trading band
Circuit breaker For the entire market:national emergency
(Source: Joshua Galper, Managing Market Volatility: A Report to the FIBV WorkingCommittee for the Focus Group Study, FIBV Working Paper, 1999.)64
For a review of stock exchange practices throughout the world, see Joshua Galper,Managing Market Volatility: A Report to the FIBV Working Committee for the Focus GroupStudy, FIBV Working Paper, 1999.
9