5 Regulation and operation of the exchanges
5.5 Bid, ask, large blocks and the third market
Note that Rule 325 is curiously phrased:
No member or member organization doing any business with others than members or mem- ber organizations, or doing a general business with the public, except a member or member organization subject to supervision by State or Federal banking authorities, shall permit, in the ordinary course of business as a broker, his or its Aggregate Indebtedness to exceed 2,000 per centrum of his or its Net Capital. . .8
This is a very curious ‘limit’ indeed, as it is tantamount to 2000 percent leverage; a huge amount. Exchange members can leverage their capital at that high rate, while non-members are granted credit of only 20 percent according to the rules laid down by the Fed – and rightly so. Moreover, specialists can seek credit on ‘any mutually satisfactory terms’, which seems to further extend the elastic ‘limits’ to leverage.
capture the message conveyed by bid/ask spreads, traders and investors must refine their tools, use high frequency financial data and undertake data-mining. Other- wise they miss the market switches, making difficult if not impossible a sustained profit.
Market information is recorded inticks. A tick, up or down, is the minimum possible price movement in a market. Different commodities have different ticks. A one point move in Treasury bond futures is equal to $1000 per contract and it corresponds to thirty-two ticks. An uptickrule by regulators says that short sales can only be implemented at a price above the preceding transaction.
Bids, asks, spreads and ticks are valid metrics for normal exchange transactions, characterized by open bids and lots of reasonable sizes. Sometimes, however, investors’
buy or sell orders are outside what is considered to be normal size limits. As such they require special procedures for handling them.
Large blocksare oversize equity orders, often in the range of 5000 to 300 000 or more shares, bought and sold through a transaction. The background to large blocks may be market speculation, but there are also other reasons like underwriting, different bonuses, or special motivations. Society at large enjoys no particular advantages from the existence of large blocks, but the financial industry likes them.
Such block trades have risks. Experts suggest that everyone bidding for business in the hypercompetitive market of larger blocks seems to get in trouble at some point.
For instance, the market thinks Goldman Sachs suffered a sizeable loss in a transaction involving a block of Vivendi shares that it bought in the opening years of the twenty- first century.
As another example, on 29 March 29, Goldman bought 9.4 percent of Telenor, the Norwegian telecommunications operator, from that country’s government. The price at which it bought the stock was not disclosed, but according to at least one report the bank paid 48.60 Norwegian kroner (5.77 euros) a share, for a total outlay of 8.2 billion kroner (980 million euros). Telenor’s stock, however, fell 5.4 percent after the market was shaken by the arrest of terror suspects in London. Goldman, which had been selling stock at 48.90 kroner a share before markets opened, had to reprice its deal at 48.50 kroner a share.
On the price Goldman reportedly paid, it would have taken a loss of about 2 million euros had it sold all its stock. However, the bank was left with a stake on its books. The investment bank did not disclose its holding. What is known is that Telenor’s stock sank. This may be bad luck. But it also reflects the razor-thin margins that banks leave themselves when they bid to win big deals. The lesson for long-term investors is:
Do not try to second-guess the market, and
Do not deal in block trades, but focus on normal quantities.
Large blocks of securities may be offered for sale by institutions or individuals, and their handling requires a well-tuned machinery because the auction market is not broad enough to do so unaided. Formerly, some sort of manipulation was employed to raise the price and stimulate sufficient activity to absorb large blocks of securities on offer.
After the 1934 Act, however,secondary distributionshave been used.
Large blocks are offered by the board, immediately after the close of the stock exchange at about the closing quotation of the day.
To channel large blocks in the market and find a counterparty, brokers and dealers receive either a commission or a price concession from the seller.
In 1942, the NYSE developed a plan ofspecial offeringswhereby members acting as brokers for public buyers, who pay the public offering price without extra commission, receive their commission from the seller. Ordinarily, this special commission is greater than the regular brokerage commission for securities.
This plan by NYSE has substituted a negotiated settlement for an auction market, and it is known as thethird market. There are brokerages that specialize in such transactions. While members of NYSE must, according to the rules, execute all listed stocks on the exchange, non-members can trade OTC in NYSE-listed stocks. Critics say big blocks are planned efforts by an individual, group of individuals or entity, to make the market price of a security behave in a way irrelevant to underlying supply and demand.
On the buy side, big blocks are traded through special bids beyond the normal exchange acquisition.
On the sell side, they are handled through special offering, secondary distribution and specialist purchasing procedures.
These are common practices in the USA. In Europe, legislation and regulation varies significantly from one country to the other, though in the European Union (EU) there is on-and-off talk about a harmonizing regime accompanied by some half-baked meas- ures. For instance, in late 2003 the EC wanted to replace the current, ten-year-old, ineffective law on investment services with a new version which would harmonize regulatory regimes across all member states of the EU.
The aim is to break down barriers to cross-border trading, in pursuit of a single financial market across the EU. For this reason, the Commission is anxious to get the European Parliament to pass the law before the next elections. But opinions diverge.
France and Italy are its staunchest supporters; Britain and other countries oppose it (see also, in Chapter 3, the downside of a single pan-European exchange and capital market).
The City of London generally supports the aim of harmonizing regulatory regimes, but it is balking at greater regulation ofoff-market(third market) transactions. This is the price that apparently must be paid for creating a common European regulatory regime. In the EU, off-market trades are fairly common:
In London, where investment banks do deals for professional clients, matching buy and sell order without going through the stock exchange, and
In Frankfurt where big banks conduct similar transactions, and risk losing a lucrative business.
This is not a problem in France, Italy, Spain and Greece where such deals have up to now been forbidden. To allay concerns in Mediterranean states with less developed financial markets, that investors who trade off-exchange might be vulnerable to being ripped off, the European Commission is proposing that there should be pre-trade transparency:
Investment banks would have to make firm quotes public ahead of a trade,9and This requirement will only be lifted for transactions above a certain size, as parties to it could be assumed to be sufficiently knowledgeable.
This EU proposal is not liked by investment banks, which protest that it constitutes too great a regulatory burden. In their opinion, the obligation to honor pre-trade prices runs counter to the need to adapt to market circumstances. Contrarians think that the big banks’ reaction is not based on a strong argument, because, no matter which may be the specific regulatory regime for fair trading purposes, a facility must be provided that records up-to-the-minute information for investors on price and volume of all big-block transactions in a given equity or other commodity,
Whether these trades are on an exchange or in the third market, and Whether they concern purchases or sales of large blocks of securities.
Moreover, if corporate insiders are buying or selling equity, then this company’s shareholders have the right to know immediately how their management teams are exercising the power vested in them by their stakeholders. Big-block trading can dearly affect a company’s capitalization and, in a way, its fortunes. They can also be a covert way to bypass regulations, as well as to provide a basis for switches in ownership of an entity which may be against its shareholders’ interests.