This article is about the prices you pay or get when you buy or sell shares. It may seem somewhat technical and arcane, but please bear with me, as those prices can have a significant effect on your investment results and hence this issue affects all investors. I will cite a specific example which illustrates how much existing systems that your broker offers are costing you.
Quote Driven Markets vs Order Driven Markets
There has been a longstanding debate about the merits of quote driven markets vs order driven markets. See, for example, this article, which explains the distinctions and claimed pros and cons.
The principal argument in favour of quote driven markets is that they provide continuous liquidity, whereas order driven markets cannot guarantee to do so. I.E. in a quote driven market, you can always buy or sell a stock whereas, at certain times, you may not be able to do so in an order driven market. I will argue that this is, in fact, a myth.
As explained in the article I cite above, in quote driven markets market-makers quote prices at which they’re prepared to buy or sell shares. Market-makers are proprietary traders (generally part of investment banks or corporate brokers) who risk their own capital and profit from the difference between the buy and sell prices they quote. In the days of yore (i.e. before 1997), all stocks on the London Stock Exchange (LSE) were traded in a quote driven manner, principally through market makers (fka “stock jobbers” in pre-big bang days).
LSE Trading Platforms
In 1997 the LSE introduced the SETS order driven trading platform. SETS allows brokers to submit bids (an order to buy) and offers (an order to sell) directly on behalf of their clients, and where a buyer and a seller find a price they can agree on, a trade executes at that price.
Nowadays most large and mid-cap stocks trade on SETS. I have read recent articles in which market makers (undoubtedly peeved to have lost business to SETS) have claimed that the interests of investors have been damaged by the introduction of SETS, because with less business flowing through them they can no longer support the market by offering prices as good as they used to. Please read on, to understand my views…
Smaller cap stocks, including most AIM companies, now trade on a hybrid LSE platform known as SETSqx. For most of the day, this operates as a quote driven platform, with market makers quoting bid and offer prices that investors can sell and buy shares at. However, five times a day a SETS style order book is opened on SETSqx and buyers and sellers can submit bids and offers directly. At those times, an auction is conducted to see whether a common price can be arrived at, at which buyers and sellers are prepared to transact. If such a price can be found, the transaction will take place and the price paid by buyers will be the same as that received by sellers.
The problem is that most execution only brokers and investment platforms do not offer access to the SETS or SETSqx order book to their retail clients. This is known as Direct Market Access (DMA).
Note that the above explanation is a simplification of the real trading mechanisms that brokers and market makers use, and there are other parallel platforms also available for trading (e.g. the RSP network, BATS, Chi-X, Aquis and NEX). Nevertheless, this explanation is good enough to illustrate the point I wish to make…
Problems with Quote Driven Platforms
My fundamental point, based on my own experience of wishing to trade smaller cap stocks is that during times of market volatility, i.e. when investors are most likely to wish to trade, the supposed liquidity provided by market makers simply disappears. It does so in two ways:
- Whilst market makers (MMs) are required to quote prices in stocks that they cover at all times during the trading day, the volume they are required to quote for can be quite small, so they may refuse to trade in larger sizes. This minimum volume is known as the EMS and for the stock I use to illustrate my point below, the EMS is only 100 shares (a value of only ~£1,000 in the example I cite). Market makers are perfectly entitled to refuse to execute any order larger than that.
- When volatility increases, market makers may increase the bid-offer spread they quote. In the example I cite below it has been increased to such an extent that no sensible investor would want to trade the stock in a quote driven manner, unless desperate to buy or sell almost regardless of the price.
Therefore, in practical terms, I argue that the supposed liquidity a quote driven system provides is an illusion and is not there when you want it.
The stock I will use to illustrate my point is the investment trust, Canadian General Investments (CGI). This company is, in fact, dual listed in Toronto and on the LSE. It trades in pounds sterling on the LSE’s SETSqx platform. From the investment point of view, I find it quite interesting, as it has performed reasonably over the years and adds geographical diversification to my portfolio. For anyone that is interested, Edison have recently published a full report on the company.
Now, the trust trades in London typically on a 30% discount to NAV. In recent times, the discount has blown out, despite its underlying holdings doing well. Therefore, I was interested in buying more. Just one problem: the spread being quoted today by the MMs was 1000p-1350p – a 35% spread! Who is going to trade with that sort of spread? Well some poor soul did, selling nearly 800 shares for 1050p – a terrible price. OTOH last Friday someone paid 1332p to buy 100 shares. A nice fat profit for the MMs of £282 on selling that small parcel to Friday’s buyers (given that they were able to buy the shares today from the seller at 1050p).
Unlike most individual investors, I am fortunate to have DMA via IG Markets, who do offer that facility. I was happy to buy 200 shares at 1200p, so placed a DMA order for that, which could be executed in any of the five daily auctions. There was no execution until the final auction of the day when, suddenly, a seller of 4,000 shares appeared on the order book, at a price of 1170p. Another buyer of 3,800 shares then appeared and I got my order filled at 1170p (a 44% discount to CGI’s NAV), as did the larger buyer.
Had Friday’s buyer been able to participate in the auction, they would have saved £152 on their trade. Similarly, had today’s seller of 800 shares participated, they could have received an extra £960 for their shares.
Note that whilst CGI is an extreme example, it is by no means an isolated case and many smaller cap. stocks trade on spreads that, quite frankly, I consider to be criminal.
IMO DMA needs to be made much more widely available to ordinary investors. Not only does the lack of DMA mean that those investors suffer poor executions of their trades, but gigantic spreads such as those quoted on CGI act as a big deterrent to trading, leading to a vicious spiral of MMs widening their spreads in response to poor liquidity, which results in even poorer liquidity! This, in turn, leads to pricing anomalies such as the one I’m taking advantage of with CGI.
Making DMA more widely available may result in even fewer MMs making markets in SETSqx stocks, but given that in cases like this the prices they quote are so poor as to effectively make a stock untradeable through them, this would not be a real loss. Once the SETSqx auctions are opened up to retail investors, those investors will learn that they can trade at much better prices by trading in the auctions, rather then accepting the continuous prices offered by the MMs.
Do add your thoughts in the comments below this article. ShareSoc’s board will collate views and consider what actions can be taken to make DMA more widely available.
One final footnote: if you trade regularly in smallcap stocks that suffer from spreads like this, but don’t have the time to monitor auctions yourself, you should consider using a full service broker. Such brokers do generally have access to DMA and can make the trades on your behalf. Even though their commissions are much higher than those of execution only platforms (typically 1.5% of trade value – but this is generally negotiable), this extra cost can be well worth it for the savings they can make you on the spread. Taking the example of the seller of 800 CGI shares, a 1.5% commission on that trade would cost them £140 but they could save £960 on the spread.