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Lessons to learn

If you are at some Himalayan peak, you don't want to lose balance. What if the weather gets bad? Well, time to pack up and go home.

The weather has been turbulent for US stock investors since the Dow Jones Industrial Average crossed the 10,000 mark last year. According to Salomon Smith Barney, the price swings among the 100 largest stocks in the Russell 1000 index now average 42 per cent, which is quite close to the swings of 46.5 per cent during the stock market crash of 1987.

The problem about high volatility is that investors find it harder to trade at reasonable prices. Those who create this turbulence -- known as momentum investors -- of course gain from it. But others lose. For them trading costs become very high.

However, despite the turbulence, not many are willing to pack up on Wall Street. So the NYSE has proposed an increase in capital requirements for floor trading firms, also called specialist firms. These firms are like traffic controllers who are supposed to maintain fair and orderly markets in the securities assigned to them.

When there is a temporary shortage of buyers or sellers, NYSE specialists buy or sell for their own accounts, against the trend of the market. Increase in capital requirements will ensure that the specialist firms have enough funds to keep movements smooth and control volatility in the market.

Isn't that interesting? NYSE is trying to take steps that may hurt some of its own members, but will be healthier for other investors. This would not be the first time. NYSE often formulates rules and guidelines to ensure that there are no abuses through insider trading or other means. Indeed, it is the most active self-regulator in the securities industry.

That is one of the crucial differences between securities exchanges in developed countries and those of emerging economies. Huge volumes are traded on exchanges in developed countries every day. Hence, these exchanges have huge stakes in maintaining a high level of credibility.

Compare the NYSE with the Bombay Stock Exchange. While both the NYSE and BSE are nothing more than private country clubs with a selective small number of wealthy brokers or big companies as members, NYSE and stock exchanges in industrialised countries operate on rules. For instance, they do not close down whenever it suits their members. Often BSE stops trading for days without any explanation to investors. In fact, the NYSE web-site lists the nine days on which the market would be closed in the next two years.

Every transaction made at the NYSE is under continuous surveillance during the trading day. Stock Watch, a computer system that searches for unusual trading patterns, alerts the NYSE regulatory personnel to possible insider trading abuses or other prohibited trading practices. In fact, information on insider trading is available to investors so that they know the corporate insider's opinion on the strengths and weaknesses of their stocks. Now, of course, several Web sites provide market-moving data on insider transactions, often free.

The exchange's other regulatory activities include the supervision of member firms to enforce compliance with financial and operational requirements, periodic checks on broker's sales practices, and continuous monitoring of specialist operations.

At the beginning of every quarter, the NYSE announces circuit breaker points or the thresholds at which trading would be halted market-wide for a single-day fall in the Dow Jones Industrial Average. And the important thing is that the exchange sticks by its rules. The exchange is closed down for trading for a day only if the Dow declines by 30 per cent in a single day. If the decline is between 10 to 20 per cent, trading is closed for half hour to one hour depending on the time of the day the decline occurred.

By the present rules, if the Dow declines by 20 per cent before 1 pm, trading is halted for two hours and if that happens between 1 to 2 pm trading halts for an hour. If the Dow falls by 20 per cent or more after 2 pm, the trading is closed for the day. But the crucial thing is circuit breaking points are announced in advance; not arbitrarily imposed.

Stock exchanges have emerged as one of the key institutions of present day capitalism. Unfortunately, in most emerging economies including India their functioning is riddled with feudal practices. It is not possible to gain full benefits of free markets, unless this bastion of modern capitalism is run on free market lines.

Neeraj Kaushal, a former senior editor of The Economic Times, now lives and works in New York.

Neeraj Kaushal

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