By Research & Planning Department

52 By Research & Planning Department Few if any stock exchanges operate a pure market-making mechanism; most are now order-driven and some have hybrid mechanisms. Some more established exchanges in North America retain market-making in mid-cap or small stocks. However, market-making for small stocks in Hong Kong remains problematic. There has recently been renewed discussion of market-making for the Hong Kong stock market. At present, certain forms of market-making are permitted for particular product categories listed on the Stock Exchange, but the stock market has no market-makers. Noting the low liquidity and price volatility of second-line stocks, some commentators have suggested that market-making be introduced for these securities. Accordingly, this article looks at what market-making entails, and whether it would be a good solution for second-liners. First, the concept of market-making in the stock market is discussed. Overseas exchange experience of marketmaking is reviewed and exchange practice compared with trading practice on the over-the-counter, or OTC, markets. Market-making has been discussed extensively in Hong Kong before; the article reviews the arguments put forward in the past. Finally, the article explains how the present position has been reached. Overview of Stock Market Mechanisms The discussion below focuses on market-making in the Stock Exchange. Market making is employed in derivatives markets too, for example in HKEx s stock options market, but considerations relating to derivatives lie beyond the scope of this article. In an exchange context, the market-making mechanism can be defined by contrast with the continuous auction mechanism. Under a market-making mechanism, the execution centre is the intermediary, the market-maker. Usually, there will be a number of market-makers who compete with one another. The market-maker quotes two-way prices in the security, and customers who may be investors or other intermediaries give their orders to the marketmaker to be executed at those prices. There is normally an understanding, or a rule, that the market-maker s quotes are good for a certain minimum quantity of the security. The market-maker will adjust his prices depending on the state of his book. If the book is not balanced, ie if customer buy and sell orders in hand, aggregated with his house positions, do not match, he will lay off or cover his position by initiating trades with other parties, or by drawing on borrowing lines with stock lenders, or possibly by utilising derivatives. The market-maker thus needs substantial capital and quite sophisticated systems. A market based on market-makers can be described as quote-driven, ie the price formation process is driven by market-maker quotes. In a continuous auction market, the centre of execution is the exchange. Investors orders usually limit orders, ie orders to sell at or above a minimum price, or orders to buy at or below a maximum price are routed to a central order book and are executed against one another automatically. The computer algorithm will normally execute in first price then time priority. Such a market can be described as order-driven. Intermediaries (brokers) have no role in the execution process; rather they channel the investor s order to the marketplace and provide related supporting services. The intermediary thus does not take any position vis-à-vis the orders, and does not

need to commit his own capital although he will act as counterparty to the clearing company on his client s behalf. Key differences between the market-making and continuous auction system can be summarised as in Table 1 below. Table 1: Comparison of market-making and continuous auction mechanisms Aspect Market-making Continuous auction Execution by Intermediary Exchange Intermediary s role Principal Agent Price and time priority No Yes Transparency Lower Higher Immediacy of execution Higher May be lower Investors equal access to best price Lower Higher Formal, regulated market-making is a demanding activity requiring substantial capital and sophisticated trading and risk management systems. It can only be undertaken by well-capitalised firms with experienced personnel. It is important to distinguish formal market-making from informal notions of market-making which are popular in markets such as Hong Kong or the Philippines. In this informal sense the term market-maker is applied to someone who is essentially a dealer, trading for his own account in stocks and incidentally providing liquidity thereby. However, such informal market-makers do not maintain continuous quotes or have to comply with performance obligations, nor are their activities necessarily supervised. The contribution of these informal players to market quality is therefore marginal. Other Mechanisms The market-making and continuous auction mechanisms are two polar models. However, some exchanges employ other mechanisms, or hybrids of the two. Call auction. This mechanism, commonly employed (as in HKEx s securities market) in the pre-opening session, involves a single auction process. Limit orders are entered during a defined period and accumulated. Then at the end of the session, by means of an algorithm the computer finds the price at which the maximum order volume can be matched. Such price then becomes the opening price of the day. In some markets, where there is insufficient volume for continuous auction, there are periodic calls throughout the day. Specialist market. The specialist market is mainly found in North American exchanges such as the New York Stock Exchange (NYSE). It is basically order-driven, but a specialist is appointed for each stock in respect of which he plays a number of roles. Like the market-maker he commits capital to provide liquidity where there is order imbalance; however, his intervention is not continuous, and only a small percentage, probably less than 10 per cent, of orders will be executed against him. His primary role is in fact to maintain an orderly trading, to ensure that prices do not move too abruptly. While market-makers are usually competing with one another, the specialist has a monopoly for the stocks in respect of which he is appointed. In Taiwan, rather than match orders continuously the system is designed to batch them up and then match them every few seconds. This is in effect a periodic call mechanism, although the frequency of the calls is so high that the market mechanism is regarded as more or less continuous. October 2004 53

54 All the foregoing market mechanisms revolve around the entry of a single order, be it a market or a limit order. In principle a more sophisticated approach is possible. Investor demand can perhaps be more fully expressed as a demand curve, with a greater readiness to buy at lower prices and sell at higher ones. In the late 1990s, a mechanism was developed with the aim of enabling investors to express their full demand curve. This was the OptiMark system, which was adopted by the Pacific Stock Exchange in the US and subsequently by the Osaka Securities Exchange. However, it proved too sophisticated for users and was subsequently decommissioned by Osaka in June 2001. Which Market Mechanism is Best? In many markets around the world, the merits of the various market mechanisms have been fiercely debated. However, it appears that each mechanism has its strengths and its weaknesses. The advantage of the market-making mechanism is that it is designed to assure liquidity. It is also argued that prices in quote-driven markets are intrinsically more stable than in order-driven markets. However, these benefits come at a price. The market-maker has to maintain a wide enough spread to cover the cost of his capital and provide him with a profit. Moreover, the playing field for investors in a quote-driven market is not necessarily level. Institutional investors will usually be able to negotiate execution within the quoted spread, while retail investors may be executed only at the bounds of the spread. Further, transparency within a quote-driven market is less high than within an order-driven market. Marketmakers are usually allowed a delay before reporting their executed trades in order to protect their position. However, trades executed on HKEx s securities market are released to the market as soon as matched and are then available to all investors who subscribe to information services at virtually the same time as they are to the brokers. Nor does the quote-driven market necessarily deliver its promised benefits of liquidity and price stability. In fast or volatile markets, specialists or market-makers are observed to widen spreads or respond less promptly to quote requests. In any case, market-makers are usually required only to achieve an average standard of performance over a period of time, not to perform continuously. Since market-making has a significant cost, intermediaries are generally more interested in making markets in larger more active stocks ie stocks that are already more liquid. In less liquid stocks, market-makers are generally less willing to commit resources. Thus from the point of view of liquidity there is the risk that market-makers will be there when not needed, and not there when needed. The specialist market is an exception: the specialist is required to make a market, at least some of the time, in all his assigned stocks. However, the specialist will generally be assigned liquid as well as illiquid stocks, and so presumably will be able to make sufficient money on the liquid ones to offset losses on the less liquid. The cost of the specialist s market-making in the less liquid stocks will therefore tend to be covered by a form of cross-subsidy. Market-making has external costs as well. The required standards for market-makers can be quite subtle or complex, and to monitor and enforce compliance with these requires the exchange to invest in skilled manpower and resources. Both the external costs and the direct costs of the market-maker s own capital, systems and personnel have ultimately to be recovered from the investor.

OTC Markets Market-making is the normal mechanism in OTC markets such as those for bonds and currencies. This is because these markets are institutional, and so trade in large size. An institutional investor with a large order will tend to be reluctant to expose his demand to the market in the form of a limit order, since this effectively provides all the other players with a free option to trade against him. Institutional investors therefore often prefer to approach a market-maker and obtain a two-way quote from him before revealing their hand, and then trade against the quote. The institutional investor thus values the market-making service and is prepared to pay for it. Following this, it would appear that exchange markets which resemble the OTC markets in being predominantly institutional would be more suited to market-making. This is arguably the case in the UK stock market, where trading is dominated by institutions. Thus market-making is still an important mechanism on the London Stock Exchange (LSE). However, as discussed in the next section, in recent years the share of London trading passing through the market-making mechanism has been declining. In a market like Hong Kong where the retail element is very substantial (40 to 50 per cent of total volume), market-making is less appropriate. Order flow is sufficient, at least in the larger stocks, for the continuous auction mechanism. The continuous auction mechanism also has the advantages of greater transparency and fairness for retail investors, which in turn tend to boost investor confidence and hence liquidity. Overall, it is suggested that each of the market mechanisms has its niche, as shown in the following chart. Chart 1: Market mechanisms and their role Transaction Size Brokered (very illiquid stocks or block trades) Call Market-making (larger orders and/or less liquid stocks) Order-driven (retail orders in blue chip stocks) Global Exchange Experience Liquidity Historically, securities markets were thin, and the broker played a major role in locating buyers and negotiating trades. Then, as securities markets expanded and trading became continuous, many of these brokers developed into market-makers within a formal quote-driven mechanism. Thus, by say the beginning of the 1990s, many of the established stock exchanges in Europe and the Americas were quote-driven. Two leading examples were the LSE and Nasdaq. These markets are considerably larger than Hong Kong, and in contrast with Hong Kong the majority of listed companies are owned by public shareholders. And in the London market, at least, institutions are the predominant investors. October 2004 55

56 As markets around the world increased in size, and with the advance of technology, it became possible to sustain continuous trading without intermediary intervention. And investors themselves became more demanding. The lack of transparency associated with market-making, and the possibility of abuse, led many of these older, established stock exchanges, and most if not all new ones, to introduce order-driven mechanisms. Market-makers, where they survived, were relegated to mid-cap or smaller stocks, or had to compete with a central order book in the main market. As a result, the number of pure quote-driven exchange markets in the world has been declining. In the 1990s, the LSE and Nasdaq both introduced an order-driven mechanism to supplement the market-making. Nasdaq did so following allegations that market-makers were conspiring to rig prices against investors 1. Under threat from the alternative trading mechanism of Tradepoint (subsequently merged into Virt-x), the LSE introduced its orderdriven trading system SETS alongside the existing quote-driven SEAQ. As the LSE explained, order-driven trading is now increasingly accepted as the optimum method of trading more liquid securities for the trading efficiencies it delivers. 2 A recent survey 3 found that 76 per cent of surveyed exchanges had pure order-driven systems, and the rest hybrid systems (ie market-making combined with an order book). Nonetheless, one recent study, while confirming the desirability of the order-driven model, adds that dealers in less liquid market segments are preferable 4. The NYSE s specialist mechanism has survived, but is currently under pressure. According to a study, the market impact cost of trading large-capitalisation stocks on the NYSE is three times as much as that of trading small capitalisation stocks 5 a counterintuitive result. It is alleged that such higher cost results from pennying, where the specialist bids the stock up or down one cent trading for his own account ahead of investors 6. One institutional investor, Fidelity, urged the NYSE to abolish specialists altogether. Following an investigation by the US Securities and Exchange Commission, the NYSE s five largest specialist firms agreed to pay US$240 million to settle charges that they stepped ahead of customer orders 7. In the Asia-Pacific region, most of the markets are retail-dominated, and thus at least for those recently developed like Mainland China the order-driven mechanism was the natural choice. In some older markets, like the Philippines or Hong Kong, the intermediaries were perhaps less developed, or the volumes were insufficient, to sustain the capital-intensive activity of market-making. In the one market that had high volumes, institutional presence and large intermediaries Japan the saitori exchange members emerged. However, the saitori in fact had a minimal role in the market mechanism, and in recent years have been phased out. Hong Kong Experience The Hong Kong stock market has always been order-driven. However, market-making has been considered on a number of occasions. In May 1988 the Securities Review Committee, reporting in the aftermath of the October 1987 stock market crash, recommended that Hong Kong should not move to a market-maker system. The Committee noted that some submissions argued for the introduction of competitive market-makers to improve liquidity. However, the Committee observed that the introduction of a market-making system would raise significant operational issues for the Stock Exchange, including which stocks should go on the system, who should be market-makers, what should 1 NASDAQ innocent but no angel, Pensions and Investments, 31 October 1994. 2 SETSmm Evolution for success, LSE, page 3. 3 World Federation of Exchanges Trading Survey 2003, 0 Hara, Cornell University, page 10. 4 The Impact of Architectural and Institutional Features on World Equity Market Performance, Swan & Westerholm, draft 10 May 2004. 5 Elkins-McSherry, Q2 2003 figures, quoted in Trading Places, Institutional Investor, November 2003, page 29. 6 Ibid, page 30. 7 Investor Payouts on NYSE Fines won t be much, Asian Wall Street Journal, 20-22 February 2004.

be their rights and obligations, and how they should be capitalised and supervised. The Committee concluded that there was no pressing need for a market-maker system in Hong Kong because: (1) there was no evidence that the existing order-based system failed in the events of October 1987 (ie the market crash); (2) the costs to the Stock Exchange and members of establishing a market-maker system might be considerable; (3) only heavily capitalised dealers could take on the risks of market-making; which might result in a handful of international securities houses monopolising the system; (4) the need to deal through market-makers might reduce brokers profit margins and could undermine small brokers independence; (5) it might be difficult to find firms prepared to make continuous markets in Hong Kong s illiquid stocks, particularly in bull or bear markets, as the potential costs could be high; and (6) it would be unlikely to improve liquidity in fundamentally illiquid stocks; a dealing system cannot of itself create interest in a stock 8. In February 1996, the Stock Exchange issued its Consultation Paper on Market Making and Other Proposals to Improve the Liquidity of Second Line Stocks. In its consultation conclusions, published in July of that year, the Exchange concluded that it had no mandate to introduce market-making into the equity market; however, would bear market-making in mind for any potential new markets. Only 10 written comments on the consultation were received, with very diverse views. Taking account also of press comments, the Exchange summarised the arguments as follows 9. Arguments for introducing market-making were that, (1) informal market-making already existed and served the market well; (2) market-making would remove the concerns of institutional investors in trading second line stocks; (3) market-making could improve the liquidity of second line stocks. Arguments against were that, (1) the Stock Exchange s existing trading system was a good one; there was no need for change; (2) the liquidity of a stock is determined by its fundamentals, ie poor stocks deserve poor liquidity; 8 SRC Report 5.36 to 5.37. 9 Report on market submissions and press comments on the consultation paper issued in February 1996, Market making and other proposals to improve the liquidity of second line stocks, page 1. October 2004 57

58 (3) London experience did not support the view that market-making brings liquidity; (4) market-making would have negative implications for market fairness and transparency; (5) a few market-makers would dominate trading activity; (6) there would be an increase in trading costs borne by investors; (7) substantial changes to the current regulatory regime would be required; (8) the involvement of major shareholders in market-making would be against good corporate governance and would invite insider trading and market manipulation. With a view to supporting other possible products, in January 1999 the Stock Exchange s trading system, AMS/3 (the Third Generation Automatic Order Matching and Execution System) was specified to incorporate a form of market-making into the order-driven mechanism. And, pending the launch of AMS/3, in May 2000 the Exchange s Pilot Programme was launched for the trading of Nasdaq-AMEX stocks and exchange-traded funds (ETFs) without initial public offering (IPO) with market-making under AMS/2. Then in November 2001 the market-making features for AMS/3 were rolled out. The market-making facility under AMS/3 is essentially a mechanism for the Participant to post orders AMS/3 being an order-driven mechanism into the order book and update them in an efficient manner. More recent developments include the following. In December 2001, Liquidity Providers mandated for structured products (eg derivative warrants). During 2002 the then Financial Services Bureau s Task Force on Financial Market Development explored a number of issues relating to the securities market. It is understood that marketmaking was one of the issues discussed with the brokerage community. However, as on previous occasions, there were diverse views and it appears that no viable model presented itself. During the current year, the Exchange has been exploring the possibility of extending market-making to ETFs launched by IPO. Conclusion Based on overseas experience, and on discussion in Hong Kong over almost two decades, it appears that marketmaking is intrinsically less suitable as the core mechanism for the stock market. The existing order-driven mechanism has worked well, and is in line with the mainstream global trend. Some segments of the market, for example second- and third-line stocks, remain illiquid or experience only sporadic liquidity. In some overseas exchanges, such as the LSE, market-makers do perform a role in relation to mid-cap or small stocks. However, in Hong Kong, the illiquid stocks are mostly very small, to the extent that they would not be an economic proposition for formal market-makers. Few if any of the large firms who have the capital and systems for formal market-making would be prepared to do it in small stocks because the earning potential from these small stocks is so low. And these stocks, in common with almost all stocks listed in Hong Kong, are controlled by the major shareholder, who would be able to trade against the market-maker and take advantage of him. Market-making is thus not an attractive solution for Hong Kong s second-line stocks.