How Good Is NSE's Trading Limit Rule?

Online, April 25, 2014 (Newswire.com) - National Stock Exchange Ltd (NSE) has decided to adopt the "limit up-limit down" mechanism introduced by the US exchanges some time ago; but with some modifications. The mechanism prevents trades from occurring outside of a specified price band, and can be an effective tool for protecting the market from sharp movements caused by erroneous orders. NSE said in a circular to its members that the new mechanism will apply to mid-month and far-month futures and options contracts; for now, the new rules won't apply to the exchange's most liquid contracts (with near-month expiry).

As pointed out earlier in this column (http://goo.gl/2RB0aZ ), the "limit up-limit down" mechanism is superior to the current dynamic price bands system, because instead of putting restrictions on order entry, they put limits on order execution. However, NSE's deviations from the US model may result in some complications. Another criticism is that it may be unfair for the exchange to decide unilaterally on such market structure issues.

Some experts in market microstructure believe that there should be no price restrictions either on order entry or trade execution. One justification for this is a belief in free markets and that there should be no curbs on market participants who engage in the important task of price discovery. The other reason given is that such restrictions can be used by some market participants to game the system. The simpler the mechanism, the easier it becomes for all market participants to navigate the markets. There is certainly some merit to this argument—certain special order types used by US equity exchanges have been used by high frequency trading firms to gain an advantage over other participants.

While NSE may be within its rights to make these changes in its risk management, it will do well to fine-tune the system sooner than later, so that Indian markets can benefit from this mechanism to protect against freak trades.

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