The stock market in India is a partial distributor of liquidity. Shares in as many as 1,173 companies were available for trading in September on the National Stock Exchange (NSE), the country’s No. 1 bourse. Yet, just 100 stocks accounted for 78% of the entire market volume during that month. More than 25% of the trading occurred in the top 10 scrips. The flip side of this concentration is extreme illiquidity for a majority of small companies, prompting some of them to head for AIM, London Stock Exchange’s international market for smaller growing companies.
There’s no reason why India, witnessing a sudden burst of entrepreneurial energy, should passively export this important segment of its capital market, depriving the local investment banking and brokerage industries of revenue and jobs.
India’s stock market regulator Securities and Exchange Board of India (Sebi) last month had invited proposals for a new exchange dedicated to small companies.
It will be interesting to see whether the proposed junior market will have room for specialist dealers who quote two-way prices in securities to buyers and sellers.
The current trend is against specialists and quote-driven market architecture. Computerized order matching, which brings together buyers and sellers in a continuous auction dispensing with market makers, is gaining in popularity globally. India’s own experience favours these types of bourses. In fact, its hugely successful NSE—the world’s second most active market for both single stock and index futures in September—started as an order-driven exchange in 1994, even as the London Stock Exchange switched to this regime for the top 100 UK companies only in 1997. Absence of market makers, however, does seem to be discriminating against smaller companies.
Almost one-third of the 36% surge in the market between 21 August and 5 November in the S&P CNX 500 Index, the bellwether for the broader Indian market, came from the steep climb in shares of just five companies, led by Reliance Industries Ltd and Oil & Natural Gas Corp.
Shares in smaller companies are missing out on the party as they don’t get regular order flows, and the resulting demand-supply imbalances often render prices more volatile than when dealers voluntarily provide continuous liquidity. A quote-driven exchange, such as Nasdaq or London’s AIM, may help. The only problem is one of precedent: India’s prior experience with market makers was a damp squib. The Over the Counter Exchange of India (OTCEI) set up by local financial institutions in 1992 at the behest of the government, was one of India’s early attempts toward modernizing its opaque, broker-owned stock exchanges.
The OTCEI, meant for small companies to raise equity financing, required any merchant bank sponsoring an initial public offering to arrange at least two market makers to provide continuous bid-ask quotes in the shares.
Market-making was new to India, as was screen-based trading, another feature of OTCEI. And yet, for all the innovativeness driving the project, the experiment came a cropper. The exchange is now defunct.
Sponsors, who wanted to earn fees from taking companies public, were nonetheless reluctant to make markets in the securities because the exchange mandated the maximum bid-ask spread at 5%, which was too low given the risk.
The failure of OTCEI may predispose the authorities against quote-driven market architecture while designing the new exchange for small-cap companies. And that might be a mistake. The problem with OTCEI, as noted by Ajay Shah, a former consultant to India’s ministry of finance, and other analysts was that it forced market makers to provide liquidity cheaply against their best judgement of risks.
Liquidity is key
NSE, which came into being a couple of years after OTCEI, didn’t bother with market makers. It instead depended on a centralized computer system to match orders. NSE became an instant success, quickly displacing the Bombay Stock Exchange as the market leader. The success of the order-driven market may now prompt the authorities to choose a similar exchange for small companies, albeit with more relaxed listing and disclosure norms. That, however, might not solve the problem of illiquidity for smaller stocks. Specialist dealers provide a useful service. Drawing lessons from the OTCEI debacle, Sebi might be able to find a role for them in the proposed junior market.
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