OTCEI: An Interview

What should the real role for OTCEI be?

Internationally, when we say "Over The Counter", we don't mean "Exchange". The OTC market worldwide is mainly about customised, bilateral deals that are done between big players in investment finance and their customers. There is a huge "OTC derivatives" industry, which consists of trades in options or futures or more complex contracts, between two people, without any exchange being in the picture. In this sense, it is a little odd to say "OTC" and "Exchange" in the same sentence.

In India, we can think of the role of OTC as being that of trying to create liquidity for relatively illiquid stocks. I think that is the most useful way to define the objective of OTCEI: to find techniques of making smallcap stocks more liquid than would be the case on the other major exchanges.

What is wrong with what the other exchanges are trying?

The dominant form of market in India today is the "electronic limit order book (ELOB) market", or the order-matching system that is seen on NSE or BOLT. This is an extremely successful form of market organisation worldwide, and the fact that both BSE and NSE in India are using this idea has made India's markets very advanced by world standards.

The ELOB market works very well for problems like trading Reliance, or futures on Nifty, etc., where you can expect a huge number of people from all over the country to be interested in trading the same thing. The trouble with smallcap stocks is that there are just too few people who take interest in each of the stocks. This makes life difficult when using the ELOB market.

In this sense, there is nothing "wrong" with what the other exchanges are trying. It's just that their focus is on doing the best thing possible for the biggest trading volumes to be found in the country, i.e. problems like trading Reliance or SBI or Nifty futures. It is possible that smallcap stocks require a different approach.

How could one make smallcap stocks more liquid?

There are basically two alternative methods of building a market which is better suited for awkward problems where the ELOB market doesn't work so well: market making, and call auctions.

What's a call auction?

Call auctions are like the pre-opening phase at BSE or NSE. Here orders are put into the computer, but trades don't take place immediately. The computer constantly recalculates the "equilibrium price" where the maximum number of shares could be transacted. This process goes on for half an hour or so, and at the end of this the computer says DONE, and all the trades take place. A key feature of the call auction is that there is no bid-ask spread, i.e. all the trades take place at the same price.

Earlier I said that the ELOB market works very well "under normal conditions" with lots of traders and a healthy order flow. Call auctions have been used with a good deal of success, worldwide, in abnormal conditions. For example, NYSE opens every day with a call auction, and whenever circuit breakers are hit, the market drops out of continuous trading into a call auction.

OTCEI has not done so well with market making. Is market making a bad idea?

Market making could intrinsically be a good idea. There have been many problems in the way market making has functioned in reality at OTCEI.

For example, with T+3 settlement, and without borrowing and lending of shares, we lose speculative traders, and that hurts market efficiency and liquidity. Hence OTCEI should either move to weekly or fortnightly settlement (like other exchanges in India), or they should get a facility for borrowing and lending shares.

But at the level of the bye-laws itself, I have a few problems. Let me start by defining what a market maker is: he is someone who sells liquidity services, and the bid-ask spread is the price that he charges for that service. For example, if you go to a grocery store and buy bread, then the store is holding inventory to be ready to offer that service to you, and the markup that the store charges (as compared with the price at which it buys bread) is the bid-ask spread, or the fee that the store earns for supplying instantaneity.

So liquidity is a product, and the bid-ask spread is the price. In that case, we can't force someone to supply the product, and we can't regulate the price. Trying to force someone to supply liquidity at a low price is as pointless as trying to force a farmer to sell wheat at a low price.

If someone is forced to make market out of contractual obligations, then he will basically slip out of this responsibility by charging an absurdly high spread. Market making will work when market makers feel happy in giving out two-way quotes, supplying liquidity, and making money out of it.

What if the spread is too wide? The market maker could earn too much profit.

Let's go back to my store example. If one store charges too much of a markup and sells things at high prices, then entry will take place. I.e., others will start stores, and the competition will drive down the markup. Hence, if we want to keep market makers under check, and produce a low spread, then we should make it easy for people to get in and out of market making on a given stock. This is a better way to keep the spread under control as compared with trying to regulate the spread.

What we have here is perhaps a sequencing problem. Even if there are some problems, even if market makers charge spreads which are too wide, it is important to first have a flourishing market, and then to go in closer and improve the bye-laws.

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