The Hindu Business Line : Illiquid stocks — Call auction design may not help

SEBI proposes to revive trading in illiquid stocks. At present, there are about 5,000 such stocks on the Bombay Stock Exchange (BSE). The capital market regulator proposes to use call auction design for the purpose. But such an auction design does not lend itself to active trading in stocks. Besides, the presence of day traders, who contribute largely to the daily trading volumes, makes it necessary for the market to have a continuous auction design. These two reasons may, perhaps, frustrate SEBI in its attempt to revive trading in illiquid stocks. SEBI may do well to leave trading in such stocks to market forces.

Call auction design: In such an auction design, the price is fixed at a level where the total demand for a stock is equal to its total supply. Suppose 10 buyers place an order to buy 10,000 shares of a particular stock at Rs 20. Assume that there are 15 sellers wanting to sell 12,000 shares at Rs 25. The price cannot be fixed because the sellers' price does not match that of the buyers'.

The broker or the auctioneer has to propose another price. Suppose the price is increased to Rs 22, at which level there are 7,000 buyers and 7,000 sellers for the stock. Because demand is equal to supply, the price will be fixed at Rs 22. Notice that this auction design is a time-consuming process because demand has to be matched with supply for a particular price. It for this reason that call auction was substituted with the continuous auction design that most stock markets now follow.

Active market: Investors prefer buying stocks that are active. The reason is that active stocks typically lead to volatile movements. And volatility provides scope for good returns. When prices are "fixed" once or twice a day for each stock through call auction design, scope for intra-day trading virtually ceases to exist. This removes the day traders, a large class of investors, from the market.

The upshot is that the quantity demanded and supplied on a daily basis in each of the stock will be low. The reason is that only investors with a longer time horizon are bound to trade in such stocks. But if all or most of the investors have a longer time horizon, trading in the near term may not take place daily. That leaves limited scope for investors to exit for liquidity reasons. Hence, few investors may actually want to trade in such stocks in the first place.

Moreover, a call auction design does not help in the price discovery process. This is because information arrives in the market on a continual basis while the price for each stock is "fixed" at certain times during the day. Note that information could be stock-specific, sector-specific or factors that affect the market as a whole.

Market making: The situation would be no different if were to adopt a market-making design as was adopted by the Over the Counter Exchange of India (OTCEI). A market maker or a specialist provides buy-sell quotes at all time during trading hours. A person may be market maker for one or more stock. Because illiquid stocks are inherently risky, few brokers may be willing to become market makers. And even if they do, such market makers may choose to buy at a low price and sell at a high price. Such a high bid-ask spread would itself thwart active trading in such stocks.

Market forces: Transporting a call auction or a market making design for trading in illiquid stocks may not help. In fact, no market design is likely to revive trading in such stocks. The reason is that there is nothing wrong in the current market design. Investors buy and sell shares because they want to profit from such transactions. That they prefer to buy only the 2,000 active stocks in the market means that they do not consider the rest of the stocks worth investing. For, some of these companies do not exist and most of them are not performing well enough to warrant an investment.

If these companies were to report a turnaround in performance, investors are likely to demand their shares. Supply will automatically come from traders who hold these shares. In other words, market forces will ensure active trading in these illiquid stocks. Till then, merely changing the auction design is unlikely to tempt investors to trade in such stocks.

(Feedback can be sent to bvenky@thehindu.co.in)

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