The Hindu Business Line : Dealing with illiquid stocks

The growing problem of illiquidity of stocks needs an urgent solution in the larger interest of investors. Following a directive of the Securities and Exchange Board of India (SEBI), the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), on the basis of the criteria agreed upon between the two bourses and SEBI, have classified 1,585 shares constituting 59 per cent of the traded stocks on BSE and 304 shares accounting for 22 per cent of the stocks traded on NSE as illiquid securities during the month of June 2008.

In 2007-08, of the 7,681 shares listed on the BSE, only 2,709 (or 35.3 per cent) were traded, while on the NSE, the securities of 1,244 companies i.e. 90.1 per cent of 1,381 listed companies were traded. The rest were not traded even on a single day in the year. Both on the BSE and the NSE, 85-90 per cent of the traded shares were traded for more than 100 days in a total of 251 trading days.

These shares cannot strictly be called liquid. Liquid stocks are those one can buy or sell at around the ruling market price. Except the top 100 shares, the impact cost in terms of spreads between bids and offers in respect of the remaining shares are quite wide — exceeding 2-3 per cent.

Even assuming that the securities traded for more than 100 days are liquid, the rest can be categorised as thinly or marginally traded securities, while all other securities not traded even for a day in a year are illiquid securities. Listed securities can thus be categorised under three heads — highly traded, thinly or marginally traded, and illiquid.

Reasons for lack of liquidity

There are three major reasons for lack of liquidity. First, the equity base of the listed stocks of a large number of companies is quite low. There are several companies with equity capital of less than Rs 3 crore due to historical reasons, such as low base of capital, public holding, etc.

Second, the floating stock of listed securities, particularly those held by the public, is quite low.

As per a discussion paper issued by the Ministry of Finance in June 2007, only about 42 per cent of the shares listed on the NSE constituted the floating stock, of which the public held a meagre 13.35 per cent. The share of retail individual investors (RIIs) was hardly 5 to 6 per cent.

Third, there are no market-makers or specialists, as in almost all the developed markets.

How to improve liquidity

A multi-pronged approach is needed to improve liquidity in stocks. First, both the initial public offer and continuous holding thereafter should be raised to at least 25 per cent of the issued equity capital of a listed company, as proposed in the discussion paper of the Finance Ministry.

After tinkering with the minimum percentage of a public offer a number of times, SEBI, with effect from May 1, 2006, said the minimum public offer to be eligible for listing should be at least 25 per cent of each class or kind of securities to be listed.

However, a company making a public offer of at least Rs 100 crore with a minimum of 20 lakh shares being offered to the public and the issue being made through book-building, with 60 per cent of the offer being taken by qualified institutional buyers (QIBs), is also eligible for listing.

As regards continuous listing requirement, the Listing Agreement provides that a listed company shall maintain public shareholding of a minimum of 25 per cent. In the discussion paper, the proposal is to peg the minimum level of public shareholding, both initially and continuously thereafter, at a minimum level of 25 per cent. This proposal should be implemented forthwith.

Equally important is that the share of retail investors in the public offer needs to be raised from 30 per cent to 40 per cent, and the share of QIBs pruned from 60 per cent to 45 per cent while the share of non-institutional investors be raised from 10 per cent to 15 per cent.

Second, in respect of all thinly or marginally traded scrips, either specialists for each scrip, on the lines of the system in vogue in the New York Stock Exchange (all orders for sale and purchase of a scrip are matched by a single specialist) or at least two market-makers for each scrip need to be appointed by the issuer.

Specialists / market-makers must be supplied with shares equivalent to at least one to two per cent of the public offer at the offer price in the case of shares to be listed and, in the case of shares already listed, at the average of the high and low of the weekly prices recorded in the preceding six months.

Besides, specialists and market makers need to be offered proper facilities for borrowing funds, preferably at a concessional rate applicable to borrowers in the priority sector. They may also be granted other financial assistance, such as waiver of transaction levy on market-making operations, and fiscal incentives in respect of profits and losses incurred in market-making transactions by way of treating profits / losses on short term as long term, as in the United States.

Third, specialists and market makers may not be able to generate adequate liquidity in all the traded securities. In such cases, a call auction system is needed, wherein all buy and sell orders that flow in a day or even a week can be matched at the closing of the period, with the bids and offers being continuously displayed. A similar system is in vogue in a few developed markets.

Companies whose shares are not traded even for a day and whose issued capital is less than Rs 3 crore should be directed to enhance their capital to at least Rs 3 crore and the public shareholding to at least 25 per cent of the expanded equity capital, in addition to appointment of market-makers / specialists. A period of one year may be given to the companies. If they fail to comply with these requirements, shares of such companies should be de-listed after the shareholders concerned are given the option to exit, as per the SEBI guidelines relating to delisting of shares.

(The author is a former Executive Director, Bombay Stock Exchange. blfeedback@thehindu.co.in)

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