Tuesday, August 19, 2008

Difficulties with a call auction market

by 011, who prefers to remain anonymous.

I love hunting grossly undervalued small and micro cap stocks on the Belgrade Stock Exchange. For some of them I would be more then happy to pay double their last price. The stocks I have in mind are all extremely illiquid, trading by the single price auction usually less then ten times a year. But even in days when they trade, I have slim chances of buying them due to BELEX trading rules.

Belgrade Stock Exchange functions as an order driven market with no market makers. Essential for the Single Price Auction Method of the Unregulated Market, where over 1500 small and micro cap stocks trade, is this: Trading sessions, comprised of four trading phases (pre-opening, auction, trading, and at-the-close-trading) are held every working day from 9:30 to 12 a.m. Single price is determined as one of the greatest trading volume. If the greatest volume can be achieved at more than one price, a price closer to the reference price (single price of the previous trading) is determined as the single price. Daily price limits are +/- 20%.

Rare sellers of the above mentioned grossly undervalued stocks are mostly workers or pensioners of these companies, who hardly know anything about stock exchange, and nothing about how to value stocks. They received free shares during the process of privatization, and are sometimes under pressure from top management to sell them their shares at reference price. When a worker agrees to sell, a manager's buy market order is first entered into the trading system, and later on the worker's sell limit order, nearly always at reference price.

Buy limit orders, even with 20% higher price, not only don't get executed on these grossly undervalued stocks due to the priority of a market order, they don't even influence a new price. On the other hand, if an uninformed seller doesn't request a higher then reference price for his stock (most workers and pensioners don't even know they can), the price may never increase, even though there are buyers willing to pay much more for it.

Here is what happened to me. In May 2006, I concluded that a Masinoprojekt Kopring stock (MSPK) was grossly undervalued. Its price at that time was 2200 RSD. Just to show to prospective sellers that there is a buying interest at higher price, on 18th May I placed a small buy limit order for 20 shares at 2600 RSD for the duration of 30 days. Hoping that someone would place a sell limit order at the same, 18.2% higher then the last (reference) price, I was ready to quickly place then a market order to secure buying the shares.

Three days I was eagerly watching from 10 to 12 a.m. the BELEX.Info real time quotes, but there wasn't any sell order. On May 23, at first I saw someone's buy market order for 411 shares, and shortly afterwards a sell limit order at 2200 for the same number of shares. My 2600 buy order didn't get the shares that day, and was still active. Four trading days passed then without sell orders and buy market orders. On May 30, again firstly appeared a buy market order for 107 shares, and later on a sell limit order at 1900 for the same number of shares. Single price fell to 1900. Not only my 2600 buy order didn't get the shares that day, but from the next day on it wasn't active anymore, because it was outside the +/- 20% price limit. Before my order expired, there was one more trade, on June 8, for 182 shares, again at 1900 RSD and with the same Buy Market Order That Knows Exactly How Many Shares Will Be Offered and When scenario. Should I say, the days between were without sell orders.

It is now August 2008 and this scenario repeats again and again on MSPK and some other stocks as well. Lifting the 20% price limit on call auction would not solve the problem. Even if someone places a large buy limit order, say at a 50% higher price in a situation without price limit, a BMOTKEHMSWBOW would, under present BELEX rules of determining the single price when the greatest volume can be achieved at more than one price, take all the offered shares at reference price, because uninformed sellers don't request a higher price. There would be no price change.

Neither would a continuous market do better, due to lack of sell orders. Large shareholders already know their shares are worth at least double their current price and are not interested to sell. Workers and pensioners who don't know the shares are worth much more, sell them nearly always to top management (informing them in advance of their intentions to sell on a particular date) at the last price, sometimes even for less. A mighty BMOTKEHMSWBOW will then be placed shortly before that sell limit order.

Unjustified stock price stagnation, or even a 13.6% decline, as in the example above, is caused by the way BELEX determines single price, when the greatest volume (number one criteria) can be achieved at more than one price. Single price would better reflect forces of supply and demand if it is determined, as number two criteria, by the best not executed limit order, in case it is better then reference price. BELEX rule instead, chooses reference price, as criteria number two.

Reference price as number two criteria for single price determination, and existence of market order in an order driven market for illiquid stocks, may easily prevent market forces to act. When this happens, not only is it harmful to the best seller (who receives considerably less for his shares) and best buyer (who cannot even buy shares), but to the public as well (who gets a misleading information about market price for the stock).

I am always puzzled what justifies existence of market order in a call auction for illiquid stocks. It can not secure a faster execution, but it can block market forces, as the MSPK real world example shows.

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