The Reasons Behind the Rise in Number of Illiquid Stocks Over the Past Years

Illiquidity 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. Three elements constitute a buy/sell stock transaction, i.e. the buyer, the seller and the stock. Anyone of these three can contribute to a stock to become illiquid. To this can be added a fourth factor - the strength/weakness of the market/trading forum, i.e. the stock exchange, where the stocks are listed.

• One of the reasons why many scrips in the B1 and B2 category at BSE do not attract investor attention is on account of the perception of the buyer that the prices tend to be managed rather than discovered. This may be also due to lack of disclosure about the stock.

• These scrips are thinly traded due to more than one reason. High promoter holding leading to low floating stock, lack of adequate market information on these companies, a questionable track record are some of the other factors that drive investors to the more well known counters.

• Disclosure and corporate governance norms need to be continuously upgraded and expanded so that investors get adequate information to take an informed investment decision. The issuer companies in the case of the illiquid stocks are awfully wanting in compliance of this basic obligation.

• “Trading frequency is positively related to number of shareholders and shares outstanding. In addition, the ownership structure seems to matter, with concentration in the hands of insiders, government bodies and financial institutions having a deleterious effect on liquidity. Typically, about 40% of shares were held by insiders and about 15%-20% by financial institutions and government. At the extreme, public sector companies were wholly owned by the government of India and were absolutely illiquid. Even in larger private sector companies, it was not unusual to find governmental nominees sitting on the board of directors. The government and financial institutions do not actively trade in their shares and hence, their shareholding effectively reduces the number of shares available for trading in the secondary market

• “Demsetz (1968) states that one of the important determinants of secondary market liquidity is the number of shareholders. As the number of persons currently holding a particular share increases, the number of market participants interested in trading the asset increases in direct proportion. Therefore, the number of transactions per unit time also increases. The number of transactions and the volume traded are observed to be highly correlated in Demsetz's study. Another consequence of an increase in the number of shareholders is the reduction in bid-ask spreads.”
  [Liquidity, Stock Returns And Ownership Structure: An Empirical Study Of The Bombay Stock Exchange Dr. Venkat R. Eleswarapu, and Dr. Chandrasekar Krishnamurti

• “The consequent order imbalance can be cleared only if there exist traders who are willing to absorb the excess demand or supply at a price concession, of course. In other words, the traders who want to buy immediately can do so at a higher price and, similarly traders desiring immediate sale have to accept a lower price. In India the liquidity traders do not have this facility at this time, since there are neither any prearranged dealers for the stocks nor a mechanism for aggregating limit orders. Therefore, at a given time, if there are no liquidity-motivated traders on one side of the transaction, then one would expect no trade to occur.” [Liquidity, Stock Returns And Ownership Structure: An Empirical Study Of The Bombay Stock Exchange Dr. Venkat R. Eleswarapu, and Dr. Chandrasekar Krishnamurti] The proposed single call auction market mechanism attends to this prerequisite. However existing continuous screen trading system do no

• “Schwartz (1988) states that liquidity differs between assets traded within a market center. Such trading frictions have an impact on the price behavior of a security. Other factors being equal, thinly traded stocks are found to have wider bid-ask spreads and greater short-period price volatility. Also, market model beta coefficients are biased downwards. The issue of whether liquidity differences between assets traded within a market center have a substantial effect on asset prices is an important one. Amihud and Mendelson (1986) model the impact of liquidity on asset pricing. They measure liquidity by the bid-ask spread, which is the cost of immediate execution. Their theoretical model posits, and their empirical results corroborate, that assets with wider percentage spreads yield higher returns on average and that investors with longer holding periods should select assets with wider spreads” [Liquidity, Stock Returns And Ownership Structure:An Empirical Study Of The Bombay Stock Exchange Dr. Venkat R. Eleswarapu, and Dr. Chandrasekar Krishnamurti]. The system of call auction is structured based on this feature, while continuous market mechanism does not meet this investor disposition.

• Also, listed companies paid taxes at lower rates than non-listed companies. This may be one main reason for many stocks to list on the B.S.E. even though they have very few shares owned by outsiders. Consequently, there is little information put out by these companies nor any actual trading in the secondary markets. Joseph (1990) finds that for about 50% of the stocks, which did not trade even once a year, there is no publicly available earnings or dividend information!

• Recently, the regulatory agency, Securities Exchange Board of India (SEBI), has started permitting private placement of stocks, increased the minimum amount of investment in public issues, and allowed companies to raise capital from Euro-Issues. These measures undermine the secondary market liquidity of stocks. An ostensible reason for these measures is to allow companies to raise capital at lower issue costs. But adequate attention has not been given to the potential adverse impact of these measures on the liquidity of stocks.
  [Liquidity, Stock Returns And Ownership Structure: An Empirical Study Of The Bombay Stock Exchange Dr. Venkat R. Eleswarapu, and Dr. Chandrasekar Krishnamurti]

• “It seems reasonable that many investors might require higher expected returns on assets whose returns have higher sensitivities to aggregate liquidity. Consider, for example, any investor who employs some form of leverage and faces a margin or solvency constraint, in that if his overall wealth drops sufficiently he must liquidate some assets to raise cash. If he holds assets with higher sensitivities to liquidity, then such liquidations are more likely to occur when liquidity is low, since drops in his overall wealth are then more likely to accompany drops in liquidity. Liquidation is costlier when liquidity is lower, and those greater costs are especially unwelcome to an investor whose wealth has already dropped and who thus has higher marginal utility of wealth. Unless the investor expects higher returns from holding these assets, he would prefer assets less likely to require liquidation when liquidity is low, even if the latter assets are just as likely to require liquidation on average. The well-known 1998 episode involving Long-Term Capital Management (LTCM) seems an acute example of the above liquidation scenario. The hedge fund was highly levered and by design had positive sensitivity to market-wide liquidity, in that many of the fund's spread positions, established across a variety of countries and markets, went long less liquid instruments and short more liquid instruments. When the Russian debt crisis precipitated a widespread deterioration in liquidity, LTCM's liquidity-sensitive portfolio dropped sharply in value, triggering a need to liquidate in order to meet margin calls. The anticipation of costly liquidation in a low-liquidity environment then further eroded LTCM's position. (The liquidation was eventually overseen by a consortium of 14 institutions organized by the New York Federal Reserve.) Even though exposure to liquidity risk ultimately spelled LTCM's doom, the fund performed quite well in the previous four years, and presumably its managers perceived high expected returns on its liquidity-sensitive positions.
  ”[Liquidity Risk and Expected Stock Returns By Lubos Pastor and Robert F. Stambaugh]

• Accumulation of illiquid stocks in the Lists of BSE & RSE can be also explained as a historical development. Over the years the BSE and RSEs, which together controlled the market earlier, did not develop investor based active trading in the spot (cash) market. They heavily relied on Badla and ALPM as a means of inflating turnover, which in turn was instrumental for resulting in a number of stock market scams. Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot market but not actually do settlement. The "carryforward" activities are mixed together with the spot market. Suppose you buy 1,000 shares of Infosys at Rs 3,500, your cash outflow is Rs 35 lakh. Instead of paying cash, you can ask your broker to find a lender to finance your trade. This process of buying stocks with borrowed money is badla trading. The Joint Parliamentary Committee on Irregularities in Securities and Banking Transactions, 1992 (JPC of 1992) discussed the issue of "carry forward of deals" and observed that this system was not functioning appropriately as there were lot of irregularities in the stock exchanges in the form of non-enforcement of margins, non-reporting of transactions and illegal trading outside the stock exchange. Finally SEBI had to abolish badla and introduce derivatives trading. Only NSE accepted whole-heartedly the change and adjusted to Derivatives trading controlling 90% of the market. BSE and other major exchanges like CSE (Calcutta Stock Exchange) and Delhi stock exchange all lost their business with the discontinuance of Badla system. BSE, which was also permitted, by SEBI to conduct derivatives trading could not make headway in the derivatives market. The present problems of the stock exchanges and the illiquid stocks can be directly traced to the over dependence of these bourses to badla trading earlier and neglecting development of a pure spot market on the basis of a rolling settlement.

• It is moot question therefore to discuss whether illiquid stocks acted as a burden on the stock exchanges to bring about their business detriment or that the failure of the stock exchange resulted in the stocks being not traded in adequate turnover and turning illiquid.

• The organizational framework of the stock exchange is also a determining factor. Here again we may compare the positive (successful) example (NSE) with that of those that fail continuously (BSE & RSEs). NSE is organized as the first demutualised stock exchanges in the country, where the ownership and management of the Exchange is completely divorced from the right to trade on it, which in other words - is that the ownership, management and trading is in the hands of three different sets of people. Though the impetus for its establishment came from policy makers in the country, it has been set up as a public limited company, owned by the leading institutional investors in the country. NSE is owned by a set of leading financial institutions, banks, insurance companies and other financial intermediaries and is managed by professionals, who do not directly or indirectly trade on the Exchange. This has completely eliminated any conflict of interest and helped NSE in aggressively pursuing policies and practices within a public interest framework. The NSE model however, does not preclude, but in fact accommodates involvement, support and contribution of trading members in a variety of ways. Its Board comprises of senior executives from promoter institutions, eminent professionals in the fields of law, economics, accountancy, finance, taxation, etc, public representatives, nominees of SEBI and one full time executive of the Exchange. While the Board deals with broad policy issues, decisions relating to market operations are delegated by the Board to various committees constituted by it. Such committees include representatives from trading members, professionals, the public and the management. The day-to-day management of the Exchange is delegated to the Managing Director who is supported by a team of professional staff.

• On the other hand BSE was organised as an association of person as also two of the 20 RSEs at Indore and Ahmedeabad. The other stock exchanges were organised as companies limited by Guarantee or shares. All stock exchanges whether established as corporate bodies or Association of Persons (AOPs), are non-profit making organizations. As none of these stock exchanges were demutualised, there was no segregation of members' rights as owners and traders. The stock exchanges consequently suffered from number of deficiencies.

• Stock exchanges owned by members tend to work towards the interest of members alone, which could on occasion be detrimental to rights of other stakeholders. Division of ownership between members and outsiders can lead to a balanced approach, remove conflicts of interest, create greater management accountability, and take into consideration the interest of other players.

• To cope with competition, stock exchanges require funds. While member-owned stock exchanges have limitations in raising funds, publicly owned stock exchanges can tap capital markets.

• Publicly owned stock exchanges can be more professional when compared to member-owned organisations. Further, as a result of the role played by shareholders, strengthening of the management and the organization, there is greater transparency in dealings, accountability and market discipline.