[This was my last column for Business Standard, published on 24 June 2003. I was sad when I was eased out.]
Where are all the jobbers gone?
The Wall Street Journal reported on a curious row in the New York Stock Exchange. A buyer complained that the NYSE broker made an improper profit of $15,000. The buyer had placed an order for 50,000 shares of Georgia-Pacific Corporation. The broker bought 20,000 shares at the sticker price of $16.40, and sold 30,000 of his own holdings to the client at the same price. Thirty seconds later, the sticker price was $15.90. The buyer complained to NYSE that the broker had made 50 cents on the shares he sold.
How did the broker come to have shares of Georgia-Pacific to sell? He was a “specialist” or a market maker; anyone who wanted to buy or sell Georgia-Pacific shares went to this broker. He was prepared to buy and sell shares of this company – and in order to be able to do so he held a stock of them.
This system would not be unfamiliar to those who know the London Stock Exchange, or indeed the old Bombay Stock Exchange (BSE). Both distinguished between brokers, who went on to the floor and executed their clients’ orders, and jobbers, who specialized in the shares of particular companies. Why the distinction? Because there were times when the flow of orders into the market was too thin and buyers could not find sellers and sellers buyers at the price on the board. Under those circumstances, the price might move a lot before a buyer or a seller could be found – that is, prices would be volatile. And the greater the risk of large, inexplicable price fluctuations of a share, the less prepared investors would be to hold it. Its price would be more stable and market larger if some broker was prepared to hold stocks and smooth out price fluctuations. Market makers or jobbers enabled an exchange to deal in shares of smaller companies. This is how they emerged in many markets.
If a market maker is legitimately holding stocks and offering them to all comers, there is nothing to prevent him from buying cheap and selling dear. Only competition can prevent that; the fewer the specialists in a stock, the greater the chance that a market maker can use his monopoly to make unjustified profits. To prevent that, market makers generally work on preannounced margins; the difference between their bid and offer price is higher than the market average. The higher margin compensates them for holding stocks.
But once trading goes electronic and anonymous, it becomes difficult for a few market makers to earn higher margins. Orders are being continually entered on the electronic screen; as soon as a bid and an offer price coincide, the trade is made and recorded. Orders no longer get concentrated in the hands of known market makers, and they cannot maintain large margins. The dispute in NYSE arose because specialists have survived into the age of electronic trading, and have become suspect when they fulfil customers’ orders out of their own stocks.
Another change in NYSE is a reduction in tick size. It was 1/16 of a dollar; that made New York quotes uniquely unreadable. Then, when NYSE reopened in the new millennium, the fractions were replaced by decimals. Thus in January 2000, the tick size fell from 6.25 cents to a cent. The finer pricing reduced the spreads and hence transaction costs. But orders could now be placed at more price points, order size went down, and it became more difficult to put through large block trades; the average size of trade fell from 2303 shares in 1988 to 666 in 2002. When a block purchase was put in, it would start taking shares at a certain price and, as sell orders at that price were exhausted, would move to a higher price. Someone who was watching the screen could see the strike price moving up. He could buy straightaway and sell at a higher price while the block deal was going through; or he could sell spot and buy forward, knowing that once the block deal was through, the price would fall. Speculators have worked out computer programmes to do this sort of trading. This trick is similar to front running; we may call it curve chasing. A front runner places his order before that of a block buyer or seller and profits from the resulting price movement; whereas a curve chaser spots the surge caused by a block deal and chases it.
NYSE has only one specialist for each share; Nasdaq has many. They compete, and that keeps down their profits. But for them the risks are higher than if they were the sole market makers; so they do not hold such large stocks. As a result, a good deal of trading in shares listed on Nasdaq has moved away to the new electronic trading web sites. In 2002, only 18 per cent of the trading in shares listed on Nasdaq took place on Nasdaq; the corresponding figure for NYSE was 82 per cent. In other words, an investor interested in a share listed on NYSE was likely first to go to an NYSE broker; one invested in a Nasdaq-listed share was likely to do it through the web or through one of the big investment institutions like Fidelity.
In India, liquidity was provided by the presence of jobbers in BSE. They did not have the capital to hold large inventories; instead, they were assisted by badla, which enabled them to postpone settlement indefinitely into the future. The government in a fit of pique banned badla; that sounded the death knell of BSE. Futures are not the same thing; futures transactions have to be squared up at the end of three months at most, so they do demand liquidity, and BSE traders do not have the money.
A futures market reflects views about the likely movement of a share price. If the forward price is inconsistent with the spot price and interest, an investor can profit by taking opposite positions in the forward and the spot markets. But to do so he must be able to take the prices as given; they must not be affected by his entry. That is why liquidity is important, and why trading has got ever more concentrated in a handful of big companies’ stocks.
That is also why trading has declined in minor shares, and why thousands of them have become infrequently traded. These are the shares whom market makers would impart liquidity. But market makers have died out in the Indian markets; the two phenomena – their disappearance and the illiquidity of minor shares – are interconnected. The more “efficient” the Indian stock exchanges become, the more useless they will be as a source of capital for smaller companies.
(Here ends this series of Tuesday columns, which I began in 1994 and have continued for nine years with only one interruption – 489 articles in all. The readers they brought me in touch with were varied and fascinating; they brought sparkle to my life. Their interest fired me to view the world with fresh curiosity; their expectations taught me to write. I thank them, and wish them a bright future, bonne chance!)