[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!)
