The Hindu Business Line : Separate platform for small-caps ideal

THE decision by the Bombay Stock Exchange (BSE) to allow listing of companies with post-offer paid-up capital of Rs 3 crore may increase the risk for investors.

The reason is that the characteristics of small-cap stocks are different from those of the mid-cap or large-cap stocks. These characteristics will provide ample opportunity to trader-cartels to manipulate small-caps, much to the chagrin of the retail investors.

Small-cap characteristics: Small-cap stocks carry low free-float due to their low paid-up capital. Low free-float translates into high impact cost due to low liquidity; impact cost refers to the change in the market price due to the change in the stock's demand-supply condition.

Suppose stock X trades at Rs 35, with average trading volumes of just 1,000 shares. What will happen if there is a demand for 25,000 shares on a trading day? The stock may move to Rs 45 due to the sharp increase in buy-orders. For the investor buying at Rs 45, the impact cost is Rs 10 per share.

Similarly, if an investor decides to sell, say, 25,000 shares, the stock may decline to Rs 25. Again, the impact cost for the investor selling the stock is Rs 10 per share.

Such high intra-day price movement, and the consequent high impact cost could be detrimental to the investors. Note that the cost of trading is high even if there is genuine demand for the stock.

What if a trader-cartel decides to push the stock price up? Price manipulation is easier in small-caps because of shorter time needed to create the momentum, and lower outlay required to buy shares.

The trader-carter has, hence, to place a buy order for a sizable quantity. This will create the momentum needed to push the price up. And because of the low free-float factor, the speed with which the stock moves up is likely to be higher than in the case of mid-cap or large-cap stocks.

Now, small-cap stocks are likely to be the domain of retail investors. The reason is that low liquidity will keep the institutional players uninterested. If trader-cartels manipulate the price of small-cap stocks, retail investors will be badly hurt. And that may have serious repercussions in the entire market. Why?

If retail investors lose heavily due to price manipulation in small-caps, they may cut exposure to equity as an asset class.

And that may reduce the overall demand for stocks in the market, which may slow down the speed of a market rally, or increase the speed of a market downturn.

The BSE cannot also effectively use the trade-for-trade segment to curb price manipulation in small caps. This is because the low free float and moderate price levels make it easier for trader cartels to take delivery and corner the shares. Cornering the shares will create an imbalance in demand-supply, pushing the price up sharply.

Separate trading platform: BSE should consider introducing trading in small-caps through a separate trading platform. This will help the exchange introduce different trading rules to suit the distinct characteristics of small caps.

To start with, the BSE can curb price manipulation in small caps, and also lower the impact cost by mandating market making in such stocks.

A market maker will provide bid-ask quotes for a stock at all times during the trading day; he or she has, hence, to have inventory of that stock.

Such inventory will prevent price manipulation due to cornering of shares. The reason is that a person wanting to buy shares will have to acquire them from the market maker, and not from the person accumulating the stock. The accumulator cannot, hence, command a premium for having cornered the shares.

A market maker will also ensure that the impact cost remains within control through reasonable bid-ask spreads. Of course, the market maker may sometimes quote high bid-ask spreads, depending on his or her inventory positions in the stock.

The BSE has naturally to draft guidelines and regulations to ensure smooth functioning of the process of market making. It could take a leaf or two from the book of the erstwhile OTCEI for this purpose.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Twisted policy

Knowledge-hungry yes, food-hungry no

A corporate body over board

Perverse logic

Separate platform for small-caps ideal

The all-important FDI flow factor

Pseudo-victory at Cancun?

`No standards world-wide for pesticide residues in soft-drinks'

Government audit

Social responsibility of companies