Definition of Illiquid Stocks and the Negative Attributes They Represent

Illiquid stocks denote stocks that are not traded or are traded very infrequently in the stock exchange. As per earlier criteria defined by SEBI any stock not traded over a period 60 days was qualified as illiquid. This definition has undergone a change pursuant to the recommendations of the Malegam Committee dealing with investments by Mutual Funds. The period for determining illiquidity of any stock has now been curtailed to 30 days from the earlier 60 days.

Illiquidity represents a negative value, it can be better explained and understood by defining and describing the positive attributes of liquidity. Liquidity is the ability to convert an asset into cash equal to its current market value. Liquidity can be considered in respect of an asset, of an organization and also of a market as a whole.

• An asset is said to be liquid if the market for that asset is liquid. It should be possible to convert the asset easily/quickly into cash without loss, i.e. at a price equal to its current market value.

• An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can easily convert assets into cash. Assets can be converted to cash either through an outright sale of those assets or by using the assets to secure a loan.

• A market is said to be liquid if the instruments, which are traded, in that market can easily be sold at approximately current market prices. In a liquid market, large blocks of assets can be sold rapidly without significantly affecting market prices. Illiquidity on the other hand, as measured by the absence of continuous trading implies that there is an extreme mismatch between the available buyers and sellers at a given point in time at the market for that scrip.

Thus the virus of Illiquidity can diffuse from non-traded stocks and stretch to the financial stability of the holders of illiquid stocks in sizeable numbers. Where the market is flooded with large number of illiquid stocks the adverse qualification of being illiquid can attach in part to the market too i.e. stock exchange. Here the stock exchange fails to fulfill the prime objective of the secondary market. It fails to play the role to which it was set.

We know that one of the objectives of the secondary market is to provide liquidity to the stocks traded and thus to make short term savings, consistently flowing to meet the long-term needs of capital seekers. It is thus the function of the secondary market to provide liquidity to the listed securities by enabling a holder to easily convert the securities into cash. Thanks to the secondary market while individual investors hold securities for short periods, the corporates and other issuers of these securities are able to secure the benefit of uninterrupted provision of long-term capital to meet their needs. Where large number of listed stocks in a stock exchange are illiquid the stock exchange cannot be considered without qualification that it affords liquidity to the stock market. The very objective of the stock exchange therefore gets vitiated on account of illiquid stocks gathering in numbers amongst its listed equity stock list. The situation may ultimately lead to the liquidity vacuum. The successful floating of new issues at the primary market in these circumstances becomes difficult.

What is liquidity vacuum? “A liquidity vacuum is the nightmarish scenario that occurs when bid/offer spreads for the financial instruments, widen out to levels that make it prohibitively expensive to deal. In the worst kind of liquidity crisis, you can imagine the situation where bank dealers refuse to pick up the phone and make prices on over-the-counter products that they themselves sold to their customers. In exchange-traded markets, there is a legal requirement for market makers to show prices to their customers. In some markets, the bid/offer-spread size is capped. Market-makers are protected by the authorities of the exchange who will suspend trading in a particular instrument or who will temporarily stop trading if a particular instrument looks susceptible to a run.”
[Website of Financial Pipeline – from article titled “Risk Holes and Liquidity Risk”]

It is reported that out of about 7000 stocks listed in BSE and the regional bourses, as many as 4000 are thinly traded. These are termed as moribund stocks listed on the bourses. The daily turn over of traded quantities in the two primary exchanges of our country exceeds five to six thousand Crore of rupees, but the bulk of this turnover is restricted to hardly about 100 oft-quoted securities.

On this phenomenon a study was conducted a decade back titled “Liquidity, Stock Returns And Ownership Structure: An Empirical Study of The Bombay Stock Exchange”, by the authors, Dr. Venkat R. Eleswarapu, and Dr. Chandrasekar Krishnamurti. They point out as under:

“The Indian capital market has grown phenomenally due to the recently initiated liberalization process. For instance, between 1985 and 1992 the number of listed companies on the Bombay Stock Exchange (B.S.E.) increased from 4,344 to 6,480. In the same period, the market value of the listed companies increased from Rs.253 billion to Rs.3,541 billion (approximately US $110 billion). As a percentage of GNP, the market capitalization of the listed companies increased from 9.7% in 1985-86 to 57% in 1991-92. However, the stock markets in India are plagued by severe illiquidity with trading being very infrequent and concentrated in only a few stocks. Around 85% of the trading volume on the B.S.E is from the Group 'A' securities which constitute about 88 companies. In fact, 32% of the volume is due to only the 10 most active issues. In contrast, Joseph (1990) estimates that about 25% of the listed companies do not trade even once a year.”

This is a reflection of the conditions that existed more than a decade back. It is not any better now, but has aggravated further over the years. Latest statistics indicate that between March 31, 1996 and March 31, ’03, the number of illiquid scrips rose by 34%. The number of scrips traded has fallen to 2,283 from about 3,443. Only 8.8% of companies listed on the BSE traded for less than 10 days. About 67% of companies listed were traded for more than 100 days during ’02-03, while 32.3% of the stocks were traded for less than 100 days. Not more than 2,500 scrips were traded in 1999-2000, while the number of scrips traded during 2000-01 and 2001-02 were about 1,800 and 1,600 respectively.

The Federation of Indian Stock Exchanges (FISE) has pointed out that securities of about 2,400 companies remain suspended at BSE due to their failure to comply with various requirements under the listing agreement such as failure to submit annual, half-year and quarterly reports, failure to respond to queries, etc. This shows that trading is concentrated only among a limited number of stocks and is very thin in a large number. It is in this background the efforts of the market regulator to bring illiquid stocks to life are to be viewed. It is an anomaly that a small proportion of shares accounts for a large proportion of trading activity. Lack of liquidity in a large number of shares limits the stock universe available to both institutional and individual investors.

Due to this i.e. the stocks being illiquid and non-traded, the investors in these companies are unable to find an exit route and realise a fair value for their investments. Also, these companies are not able to raise fresh capital from the capital markets for their expansion plans, working capital requirements, etc. and this is not in the overall interest of the economy in general and the capital markets in particular.