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Saturday, April 06, 2013

Obtaining liquidity for illiquid stocks

The problem

While there are thousands of listed companies in India, for all practical purposes, stock market liquidity is the exclusive preserve of large companies. For small securities, the conventional continuous market presents daunting problems of liquidity. In conventional continuous trading, the price is made by the orders that come in from one second to the next. However, within a few seconds, there may not be many orders. The price may get swayed sharply by one large order.

An illiquid market suffers from two main problems: Investors suffer large transactions costs when entering and exiting, and there is a heightened danger of market abuse. Market abuse is the falsification of information about prices, spreads, turnover, etc. Innocent participants get sucked into making wrong decisions about investment when they see prices, spreads, turnover which are not the result of normal market forces, but are caused by a deceptive scheme. The possibility of market abuse, in turn, deters market participation and exacerbates illiquidity. This sets up a vicious cycle where fear causes illiquidity, illiquidity engenders market abuse, and the presence of market abuse causes fear. Detecting and blocking market abuse is the central function of infrastructure institutions and regulators.

While illiquidity is partly inherent to the listed firm, it is also influenced by the market design. There are mechanisms through which an improved market design can yield improved liquidity. As an example, when we moved from floor trading to continuous screen-based trading in India, liquidity improved.

The call auction

An alternative design -- the call auction -- helps address this problem. In a 30 minute call auction (say), orders that come in over a 30 minute period are pooled. The equilibrium price is worked out based on the supply and demand over this 30 minute period. This is likely to be a more robust price when compared with the price that is discovered moment to moment, under certain circumstances. 

In India, at present, the call auction is used in three settings:
  1. The opening price is discovered using a call auction. This allows the market to absorb overnight news.
  2. When trading halts owing to a circuit breaker (i.e. a large price movement), the news is absorbed into the market using a call auction when trading recommences. Example.
  3. At first listing (or after re-listing), the price discovery in the first 60 minutes is done using a call auction.
In general, trading through call auctions is not exciting to securities firms since turnover is more limited. However, call auctions are good for investors (zero impact cost), issuers (lowered liquidity premium) and the economy at large (reduced market abuse).

SEBI announcement on new market mechanism for illiquid stocks

On 14 February, SEBI announced that for illiquid stocks, the market design shall constitute a series of one-hour blocks in the day which are call auctions. The SEBI circular gives a precise definition of what constitutes an illiquid stock. This is a fairly big initiative: it will affect 263 stocks on NSE and 2050 stocks on BSE. The new market mechanism will be in place from Monday the 8th of April onwards.

If this works well, it will have four effects:
  1. From the viewpoint of investors, the ability to enter and exit a stock with zero impact cost should yield a reduced liquidity premium. The valuation of stocks that trade through the call auction should be better when compared with the valuation of stocks that trade in the continuous market, where the round-trip transactions cost (i.e. two payments of impact cost, at entry and exit) can be a substantial expense.
  2. When an episode of market abuse comes together, there are extreme fluctuations of prices or turnover. This should take place to a reduced extent; the problems of market abuse are smaller for illiquid stocks under the call auction.
  3. For unsophisticated investors, the call auction is more attractive as there is a reduced possibility of market abuse. Firms in this mechanism should be able to achieve a more diversified investor base. This would also yield an improved valuation.
  4. The price in the call auction, revealed each hour, should be a better estimator of true value when compared with the price seen under continuous trading. There should be fewer departures from market efficiency, such as mean reversion. This will reflect a combination of two effects: avoiding the temporary price pressure associated with illiquidity, and avoiding market abuse.

Reflections on the regulatory process at SEBI

Now that the draft Indian Financial Code is in front of us, we see regulation-making in new light. This gives us a fresh perspective upon what SEBI has done. Why does SEBI use a `Circular' as a legal instrument? The only two legal instruments that SEBI should use are Regulations and Orders. It is nice to see that this circular was discussed at an Advisory Council (the existing SEBI SMAC). However, the SEBI document does not do enough in terms of analysis. What is the problem that this regulation seeks to solve? How will this intervention solve this problem? What are the costs and benefits? Where was the notice-and-comment period?

S.59 of the draft Code requires that three years after the issue of regulations, a review should take place. It requires measuring the costs and benefits. The clarity of articulating objectives (e.g. points 1..4 above) becomes the natural frame through which this review would be done. The extent to which these four outcomes are achieved constitutes a mapping of the benefits.

When we think of how one specific regulation (e.g. period call auction trading for illiquid securities) would work out under the Code, we see that the superior regulation-making process embedded in the Code would  push regulators towards more thought, and thus improve the quality of regulation-making.

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