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A Liquidity Fairy-tale

Introduction

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:

  1. 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.
  2. 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.

Illustration

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.

Conclusions

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.

Mark Bentley

Director, ShareSoc

15 Comments
  1. Niq says:

    Thank you for that. I’ve encountered the kind of illiquidity you describe, and knew that I can place a (provisional) order at a price within the spread. But I had heard it described as some kind of Order Board. Your description of SETSqx is much clearer!

  2. Mark Lauber says:

    Thanks Mark for an excellent article which outlines the points well. Most developed markets trade on an order driven basis, and given that MMs often ‘run away’ in volatile markets or quote very wide spreads, order driven can be no worse. As you say, the ‘liquidity’ of quote driven markets is illusory, rather like seeing a dozen umbrellas in the stand of a hotel foyer on a sunny day. Try getting one when it rains!

    When you trade on a quote driven market, the MM has not only better information than you, but also control of the market. Is that perhaps why retail investors are often referred to as punters?

    Personally, I don’t see a need for all-day, five-day liquidity in a stock which might only trade a couple of times a day. While the SetsQX system partly addresses this, what if smaller stocks were designated to trade only at specific times – say Tuesday and Thursday, or every day between 10 and 12? That would concertina the liquidity into that window, improving prices for all (apart from the cut of the MM of course). Order driven would easily provide a better outcome.

  3. Alan Selwood says:

    A very useful article, Mark. I came across a ridiculous spread only the other day, and declined to trade.
    If many others do the same, this suggests that lots of potential business is lost anyway.
    The big problem, of course, is that unwary buyers and sellers will pay up and suffer financially.
    We need a revamp of the rules, so that everyone is treated fairly.

  4. Dominic Connolly says:

    Mark, good article and I hope it produces a lot of discussion. A few things need clarifying. The article you have referred to by Chad Langager talks repeatedly of order driven markets being markets where ‘all’ orders of buyers and sellers are displayed, as though it is some kind of definitive marketplace, which would naturally make the reader immediately question the value of quote driven markets.This isn’t the case, the ‘order book’ only consists of a fraction of what is out there and and what a buyer of seller wants to display; there could be all sorts of hidden orders and that’s before we go into dark pools of liquidity. Also proprietary traders aren’t the same as market makers, although you could argue one is a subset of the other. Proprietary traders answer to no one but themselves and their providers of capital. Market makers do have obligations to make two way prices and the NMS (normal market size is set by the exchange), although as you say, spreads can widen according to liquidity.

    Your article actually talks about two separate issues. The STRUCTURE of the market and whether it should be quote/order driven (or a hybrid) and secondly, ACCESS to that market, whether electronic or manually (phone or email).

    The structure of the market has to cater to a wide range of traders and investors, all with different objectives and time frames, Your example in CGI does illustrate this well. The one thing market making does achieve is to bridge timing issues. That stand in the middle of the guy who wants to sell today and the guy who wants to buy tomorrow, they take on that risk in exchange for the difference between the bid and offer. You get certainty of execution – at a price. A bit like insurance.

    DMA is something I have championed from day 1 and I don’t need convincing about, but it only became possible with the introduction of an electronic market and the introduction of fast internet (ADSL in the early days) but it is reliant on technology and an understanding of market structure and for a few years yet we will have a generation that didn’t grow up in the age of the internet. A trader will naturally want DMA, quote driven markets are not attractive to trade due to all the inherent costs.

    You know my background, I could write pages on this but in summary I would say this. It is over twenty years since we had the second big bang in 1997 and the current structure has stood up reasonably well to scrutiny. Yes, I would agree there is still much to be done in democratizing access to all both by making DMA more widely available and through education, which is what this article seeks to achieve.

    In terms of structure I am not convinced an order driven market would work through the full spectrum of stocks right to the bottom end of small cap, illiquid stocks. The smart investors still use the phone for these small caps as they recognize that the real market is not the ‘tourist rates’ displayed on the screen, but in the middle somewhere.

    • Mark Bentley says:

      Thanks for your comments, Dominic. I must begin by acknowledging that my own understanding of market operation was from your book: The UK Traders Bible (https://harriman-house.com/the-uk-traders-bible). Full members of ShareSoc can read a review of the book, here: https://www.sharesoc.org/book_reviews/the-uk-traders-bible-the-complete-guide-to-trading-the-uk-stock-market/ and I wholeheartedly recommend it.

      I did point out that my description of London trading was a simplification and that trading can take place on other platforms too.

      IMO SETSqx is the ideal compromise for trading of less liquid stocks, offering a combination of quote and order driven trading. The principal issue is the unavailability of DMA to most retail investors. I also agree with Mark Lauber’s comment that reducing the auction frequency might be desirable, to concentrate liquidity. We recently responded to an LSE consultation which asked about this, amongst other matters: https://www.sharesoc.org/consultation/lse-consultation-on-market-structure-and-trading-hours-n18-19-our-response/

      Whilst using a full service broker is a good solution for investors who invest mainly in small cap stocks, it is not really effective for me: my largest portfolio is in a SIPP and most of my trades are in more liquid stocks. I use AJ Bell’s platform for this, which is very cost effective and I couldn’t justify the much higher cost of transferring my SIPP portfolio to a full service broker, just to get better execution on a few trades. I would love to be able to use DMA from my AJ Bell account. In the CGI case, the last purchase I made a few weeks ago was through IG’s DMA platform and I then managed to arrange a broker-to-broker trade from them to my SIPP – but that’s an inefficient and unnecessary hassle (but saving me hundreds of pounds in better execution). Once DMA is widely available, ShareSoc’s educational mission comes to the fore and we can explain to the investor community how it works and how to use it.

      • Dominic Connolly says:

        Mark, thanks for the mention, it’s a bit out of date now and past its shelf life now, desperately could do with someone writing a modern version.

        I’ve been with iDealing for years, the kids JISAs are there and I had my SIPP there until EMSL went pop, now with Curtis Banks. What I like about iDealing is that I can pick up the phone and their broking desk will go into the market on my behalf, at no extra cost, although they don’t seem to publicize this service. I’m wondering if you were aware of that?

  5. jffcarter says:

    An interesting article. I trade on the Paris and London markets. While the market in some french small caps is tiny what I do like is seeing the buy and sell open orders. However a recent sell order I placed in London was dealt at over 10% below the LSE price shown on their site and in this case the MM agreed to cancel the trade. It shows an advantage of dealing through a broker.

  6. Ali Haouas says:

    i do not have a deep understanding of this phenomenon but the injustice of it is depressin. I hope sharesoc will add this issue to its agenda of fighting for the retail investor

  7. Darryl Webb says:

    I am in the unfortunate position of holding Canadian General Investments via a platform which doesn’t offer DMA. All I can do is wait for the spread to contract back to more normal levels. CGI is in a particularly bad position as it can’t repurchase its own shares due to its legal structure. The funds main holdings include very large multinationals such as Amazon, Apple and Mastercard so the discount is particularly frustrating.

  8. Amin Mohammed says:

    I appreciat the problem with wide spreads at times. However from a practical viewpoint, in such circumstances why cannot all investors protect themselves by placing a limit order. I do not have DMA, so that is what I do when a spread is unacceptably wide, or if I fear that the market may be illiquid even if the quoted spread is narrow.

    • Mark Bentley says:

      Hi Mohammed,

      Without DMA, a limit order will only execute if the offer/bid matches your limit in the case of a buy/sell. Unless you set a very unfavourable limit, this is highly unlikely to happen and your order is very unlikely to execute.

      In the case of CGI, a reasonable price to sell at might be 1200p and you might set a limit at that level. When the quoted spread is 1000-1350p, it is highly unlikely that the bid will shoot up 20% to 1200p for your order to execute (despite the fact that I was a willing buyer at that level). Without DMA, only your broker will be aware of your limit order and there is no opportunity for you to trade with me. With DMA your limit order becomes visible and is available to be filled by any willing buyer.

      Limit orders alone do not solve this problem.

      Best,
      Mark

  9. Nero says:

    The system for buying and selling UK small cap stocks is an absolute scandal. Have a look at Japan if you want to see how a small cap market should function – DMA, minimum lot sizes and daily movement limits.

  10. Graham Fraser says:

    Hello Mark,
    I think the problem could be elsewhere. I asked Interactive Investors if they would put up a bid for me on SETS and they said that they would gladly, however was I really sure that I wanted to do that because it would mean every time my bid was hit it would incur a dealing charge ? So for example if I were to put a bid on SETS for 50,000 of 10p I could conceivably end up with charges of 50,000 time £7.50 !
    Regards,
    Graham.

    • Mark Bentley says:

      Hi Graham,

      That’s interesting, because II’s website does suggest that they can take telephone orders for SETS trades – but I rang to ask whether they could place a DMA order for CGI and was refused – told they didn’t do that anymore.

      It is strange and unfortunate that they claim a commission on every fill. IG don’t – just a single commission for any execution of a trade, irrespective of the number of fills.

      Best,
      Mark

  11. Chris Spencer-Phillips says:

    Excellent article Mark and well explained. To a relative novice it looks rather like a stitch-up when you get large spreads. Chris

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