If you invest in small-cap shares, chances are you have a few war stories. Companies where the blue-sky growth story has failed to materialise, issues of revenue recognition (leading to accounting profits that don’t convert into hard cash) and sometimes downright fraud – as in the recent case of Patisserie Holdings.
Mature investors understand risk and reward, but what’s harder to swallow are perceived injustices in the way that markets function. Part of the excess premium for small companies is compensation for the fact they are harder to sell in a downturn, but private investors have been known to blame market makers if liquidity dries up and they get stuck in a sinking position. Likewise, when trying to buy into shares with less of a free float, some investors have complained about being unable to get their orders filled at the prices quoted on the exchange.
Fans of Simon Thompson’s small-cap recommendations have expressed exactly these concerns in comments on the Investors Chronicle website. One reader was frustrated at not being able to get an order filled after a stock had fallen in value: “Tried to buy after the fall on Friday last week. No luck. What’s the chances of being able to buy today after the ST [Simon Thompson] update. I’m guessing not a chance in hell. Not sure what the market makers are playing at here. My guess is they don’t know themselves.”
“Couldn’t buy more than a lousy 200 quid’s worth on Friday at 164p after the fall. If someone was selling, why couldn’t I buy any?”
What really provoked this commenter’s ire was that liquidity suddenly returned to the stock once the offer price had risen: “Surprise surprise, I can buy as much as I want now at 190p. This is not a fair market. It is corrupt.”
This is a strong allegation and clearly emotion runs high when there seems no logical reason for an order not to get filled. There are plausible explanations for some illiquid stocks trading outside the quoted spread. Make a basic Google search, however, and some of the extreme examples that pop up can feed suspicions that the hidden hand of the market makers is robbing honest retail investors.
Before going into the role market makers play after you hit buy or sell on your broker platform account, it is worth placing some of the highest-ranking online articles and posts on market maker conduct into context. We can see that much of the bad press relates to US securities, while the most well-read articles discuss alleged unscrupulous activity that occurred Stateside many years ago, in the dotcom boom. Practices such as ‘boxing’, ‘cross-trading’ and ‘locking’ were outlined at the turn of the millennium by a US blogger called Gary Swancy. His post uses as its examples trades placed on the order books in 1999, and the named malpractices are variants of market maker collusion to move prices in their favour and against investors.
Regulation has moved on a long way since then, on both sides of the Atlantic. In any case, due to its size and unrivalled culture of retail equity investing, the routing of orders in America has important differences to the UK market.
Regulatory focus on best outcomes for investors
Buying shares online via a UK execution-only stockbroker in 2018 is very different to placing orders in America 20 years ago; aside from 21st century technological advances, the regulatory environment is as different as night and day. At the beginning of 2018, Mifid II (the new markets in financial instruments directive) was implemented in the UK. This monumental piece of legislation from the European Securities and Markets Authority (ESMA) places transparency at its heart and there is an onus on brokers and market makers to deliver best client outcomes in deal execution. This means that, unlike in the US, it is illegal for market makers to incentivise buy-side brokers with commission for order flow.
In the US, where there are a plethora of market makers and several regional exchanges, paying for order flow is common practice. In the UK, however, the onus is on market makers to seek out liquidity to fill trades. Healthy competition on the London Stock Exchange (LSE) works to narrow spreads, and the requirements placed on retail stockbrokers by Regulatory Technical Standards 28 (RTS 28) to list their top five trading destinations is designed to maintain a focus on getting the best deal for clients.
Yet there are still instances, especially investing further down the market capitalisation scale, where retail investors feel aggrieved that prices are moving against them, unfairly they say, although the market makers themselves insist retail is treated no differently to any other source of order flow. Shore Capital (ShoreCap) is the third-largest market maker on the Alternative Investment Market (Aim) by volume of trades, and says that its focus is on gathering liquidity whatever its source. Retail flow is important for Aim, so it is not in anyone’s interest to treat it differently to trades placed by institutions – a healthy and well-functioning market relies on the whole liquidity universe that all investors benefit from.
The problems faced by retail investors are generic in the small-cap space. As Simon Fine, co-chief executive, and Nick Conyerd, head of marketing, at ShoreCap explain, the difficulty with some Aim stocks is that, thanks to the positions of a few large institutions who are viewing interesting companies as a long-term investment, the real free float of stock available in some companies can be quite small. Market makers make a price, but if there is significant news or a sudden flurry of speculation caused by a research report (at Investors Chronicle we must acknowledge our reports can affect the price of small-caps), then combined with large investors sitting on their hands it is inevitable that prices move due to the laws of supply and demand.
There are rules on the normal bargain sizes a market maker must offer, but ultimately if there isn’t enough stock and there is a spike in demand, to buy for example, then some orders won’t get filled and the price must move to tempt more sellers on the market. Unlike other participants, market makers have the advantage of being able to position themselves either side of the trade when there is a rise in orders on a stock. If there wasn’t liquidity before, they will provide it, but they are profit-driven, so take advantage of heightened activity to widen the spread between what they pay (bid) for a stock and what they sell (ask) it for. If there is a sudden rush of bids by investors on the back of a piece of research, then the market makers will need to purchase more stock, which puts the risk on them. They will demand a decent spread to compensate for that risk.
The LSE’s main electronic order book, SETS, is designed to pool liquidity for all investors. This is technologically a far cry from the brokers and jobbers (the colloquial term for trading floor market makers) in the old days, and facilitates rapid order-driven trading. The LSE does, however, also offer some facilities for larger investors seeking to take positions in illiquid stock. The request for quote (RFQ) functionality facilitates greater order sizes going through on exchange but off the order book. As big funds are more powerful buyers of less liquid stocks, they can determine the level they wish to buy in at (with more certainty that their order will be filled) and the RFQ signals to market makers that there is business worth competing for.
These deals are subject to exchange rules, and matching large buyers and sellers in this way improves transparency compared with over-the-counter arrangements. There are even other implied benefits for smaller investors; Ben Jowett, head of business development at Winterflood Securities, says that, if all trading was order-book-driven it’s possible there wouldn’t be competition to make offer prices on some stocks at all.
The role of market makers is to mop up liquidity from all sources and lubricate trading and Mr Jowett acknowledges that retail flow is sought after, especially for small-caps. For FTSE 100 shares, 5 per cent of trades relate to retail. This is significant, but the proportion rises considerably down the market-cap scale, with nearly 29 per cent of the trade in small-caps conducted by retail investors according to Winterflood Securities. This begs the question, do private investors deserve a better deal in the form of tighter spreads on small-caps in return for their business? Mr Jowett suggests that retail investors aren’t doing too badly in this regard thanks to Mifid II best execution regulations. The requirement to consider all the client’s financial considerations when making a trade means that, as retail clients have already paid a commission to their broker, the market maker doesn’t attach further commission to their trade, as they would with institutional clients.
What lurks in those dark pools?
Regulatory developments have been very much on the side of the retail investor, but what about technological evolution in the way securities markets operate? Thanks to books such as Michael Lewis’s Flash Boys, the activities of high-frequency traders (HFTs) and the operation of multilateral trading facilities have become the subject of suspicion by investors and regulators alike.
It is difficult to quantify what the exact impact of HFTs has been on retail investors, but that’s probably because brokers and market makers themselves don’t know. With sophisticated algorithms and super-fast execution effectively enabling them to front-run orders, HFT teams are creaming profits ahead of other investors, although they would argue they are adding liquidity. The question is what proportion of their profits comes at the expense of the market makers on the spread and what is at the expense of investors by moving the price?
Another innovation that has been helpful to institutions as well as fast traders is the introduction of dark pools of liquidity. These enable big players to work large orders into the market without showing their hand. A large order can get filled without the offer price moving too much against the bidder. As destinations that compete for business and order flow, stock exchanges have been keen to keep pace with demand for these innovations. The LSE has partnered with large market participants to introduce the Turquoise exchange, which facilitates demand from institutional investors for dark pool liquidity.
Regulators are generally suspicious of dark pools and worry that too much order flow is being directed through them. While some participants benefit from the cloak of anonymity, many buyers and sellers prefer transparency and measures have been taken by ESMA to limit volume leaving the main order books. Only 4 per cent of the market capitalisation of a stock can be traded in any one dark pool and there is a limit of 8 per cent being traded in all dark pools.
Retail investors won’t have their orders executed via dark pools as the trades are just too small, so the impact would be limited to any knock-on effect to liquidity and pricing on main order books such as SETS. Broker Hargreaves Lansdown (HL) says the average size of trades by its clients is £6,000, so there is no instance where a dark pool would be used. When asked whether high-frequency trading has had an impact on the prices private investors can get, HL’s spokesperson told us: “Market makers have improved their systems and this has reduced the quote window time, but [there is] still plenty of time and competition to get clients best prices.”
Mifid II has achieved a greater focus on the quality of trade execution, which is welcomed by platforms where this is an area in which they are competitive. Hargreaves Lansdown uses 32 market makers to get the best quotes for clients and Barclays Smart Investor scans up to 20 market makers on any one trade – a process they say helped improve prices on 90 per cent of trades in the 2017-18 financial year.
Where there is competition and liquidity on the order book, private investors aren’t getting a bad deal. The LSE rules on market maker obligations have been updated since Mifid II and there are obligations placed on registered market makers to honour the quoted spread in order-driven markets at the normal market size (NMS), which is calculated at 2.5 per cent of a security’s average daily turnover over the previous 12 months and reviewed quarterly.
Technological innovations at the LSE also help private investors, with safeguards against irregular trading activity including active market surveillance and algorithms monitoring order flow. Some innovations are designed to make the exchange more attractive as a listing destination and some participants have questioned whether they confer any benefits to investors. For example, the quote-driven market maker intra-day auctions that occur on SETSqx, the LSE’s order book for small-cap shares, have been described by one institutional-facing market maker as having no added benefit above and beyond trading on the order book. This feature does offer a degree of flexibility for quote-driven pricing that helps differentiate the LSE from competitor exchanges such as the Chicago Board of Exchange (CBOE), which may suit some companies looking to raise capital.
The advantage of a quote-driven auction is that all orders will get filled – but it’s literally a seller’s market. In an order-driven market, the market makers are obliged to fill the NMS, but if a flood of orders bids up the price then a new equilibrium must be found. If investors have placed a limit order (put a ceiling on what they’ll pay) with their buy-side broker, then their order won’t get filled. The auction may be needed to flush out more sellers to increase supply of an illiquid stock – but, clearly, this won’t be at the same price that private investors initially saw quoted.
Regulation has benefited small-cap investors, but there is a downside
In the past, there were complaints that some retail brokers were all too often offering execution at prices outside of quoted spreads. There has always been an obligation to offer best execution, but now, thanks to Mifid II, the scrutiny brokers are under – especially with RTS 28 requiring transparency on how orders are routed – means there is a lot less scope for retail brokers to cream any extra profits off the spread.
Inevitably, there are some unintended consequences of regulation as far-reaching as Mifid II. By common consensus, the worst aspect of Mifid II is predicted to be a negative impact on the volume of sell-side research covering smaller companies. Traditionally, analysts produced detailed notes on companies as a value-added service. While this was not entirely independent (after all, its purpose was to boost sales of stock) it raised companies’ profiles with investors and was a valuable starting point for independent research. Since Mifid II, however, the rules requiring best pricing for clients on all activities has required separating out the cost of research, which is expensive to produce. Sell-side brokers can no longer cover this cost by adding it on to the commission they charge institutional clients. The result is that brokers are cutting down their research teams, and fewer companies – especially in the small-cap space – are getting coverage. The concern is that less research will mean less trading activity for some stocks, which means less liquidity and a lower NMS. On the one hand, the price may be lower. But if there is a spike in activity on an exciting piece of news for a stock, the lower liquidity will mean trades struggle to get filled until the price has risen.