Wheels within deals: Market-makers are the lifeblood of the London stock market and enjoy special privileges because of the risks they take. But critics now say they have too good a deal - at the expense of investors. Rupert Bruce reports
Sunday 10 July 1994
Market-making is the lifeblood of the London stock market, and the market-makers, who are often paid up to pounds 80,000 a year plus a bonus, are unique to the UK and Ireland. In virtually every other financial centre, dealers simply match buying and selling orders. If there are no buyers or sellers at any time, those markets can grind to a halt.
But in London, market-makers, who used to be called jobbers before the Big Bang reforms of 1986, claim to be able to keep trading in the most difficult conditions, balancing their books by adjusting the prices of shares and fixed-interest stocks.
These hardened negotiators are now under fire. The charge made by investors, and underlying two reviews into the business of market-making, is that they have carved out too good a deal for themselves at the expense of investors - private shareholders and the people who own pension funds, unit trusts and other savings vehicles.
Investors are growing increasingly impatient with the British way of doing things. Harold Bradley, vice-president and director of trading at Investors Research Corporation, the US investment manager for the Twentieth Century family of mutual funds, calls the London Stock Exchange 'inefficient, non-transparent, and the least desirable of the major financial markets in which to deal'.
Two separate reviews are questioning the privileges that are granted to market-makers under Stock Exchange rules. The Securities and Investments Board (SIB), the City's chief regulator, has asked for City comments in its discussion paper Regulation of the United Kingdom Equity Markets, which is a wide-ranging review of the stock market. The Office of Fair Trading is also canvassing City opinion as to whether market-makers' privileges are anti-competitive.
Traditionally, market-makers have been given privileges over other market players to make up for the fact that they are obliged to quote share prices at which they are prepared to deal when the market is open. This is a risky business, and without the privileges - so the theory goes - market-makers would be less willing to operate, and it would become more difficult to deal in large numbers of shares.
On very volatile days, market-makers may trade in billions of pounds of stock and can make or lose large sums of money. They are also required to do single deals that total tens of millions of pounds.
This can require nerves of steel, and an ability to recover from setbacks costing huge sums. It does not require a probing intellect. Trainee market-makers have traditionally been recruited from among the streetwise kids of London's East End.
Derek Riches, a director of Smith New Court, the securities house that runs a leading market-making operation, said: 'Much of it is down to basic instincts of riding the marketplace and the way it is moving. So you develop a sixth sense.
'Others may be very good in terms of analytical thought; market-making requires an unfettered brain. You have to able to change your mind very quickly, and you have to be able to recognise very quickly that you have made an error of judgement, because if you don't and you persist in your judgement then you may get hit again and again.'
Mr Riches is anxious to dismiss the popular image of market-makers as semi-literate Essex yobs who wear white socks. Smith New Court's market-making division interviews about 1,000 applicants each year. Of these, a maximum of 20 will make it to the trading floor. They may be from university or straight from school.
'There is no book written on risk-taking, it depends very much on the individual,' said Mr Riches. 'Some people are built for it, and some people are not.'
Most of the large users of the Stock Exchange agree that there is a trade-off between the generosity of privileges granted to market-makers, and their willingness to execute large trades at all times. But some in the City think the 29 market-making firms have used their strong position on the board of the Stock Exchange to negotiate too good a bargain for themselves. The chief complaint is that there is not enough disclosure of prices. This applies to both the rules in the inter-dealer broker (IDB) market and the disclosure of large trades.
A senior director at one of the largest British institutional investors said: 'There is a considerable interest as to whether there is a proper disclosure of prices. The way it is working may enhance the profitability of those inside the market at the expense of those outside it.'
In particular, he points the finger at the IDBs, saying they may be making large profits. Unfortunately, the degree of profitability is difficult to ascertain because none of the four IDBs - Tullett, First Equity, Cedar Street, and Garban - discloses profits.
David Manning, head of UK equities at Legal & General, one of the biggest investors in the market with more than pounds 30bn under management, said: 'If we have a criticism of the system it is the role of the IDB, where basically you have a two-tier pricing system - the price that we see on the screen, and the price that the market-makers see on the IDB system. It makes life a bit too easy for the market-makers.'
The IDBs, who according to critics make market-makers look distinctly civilised, quote much keener prices than market-makers. Large investors are obviously annoyed that there appears to be a market within the market.
But the most vociferous critic of market-makers' privileges is the London International Financial Futures Exchange (Liffe). It complains that the delayed disclosure of large trades and the secrecy surrounding IDB quotes are stifling the equity options market.
'The existing structure of the Stock Exchange does not provide the options market with a current accurate tradable price,' said Karin Forseke, director of equity products at Liffe. 'It is well known that the majority of trades take place within the yellow strip. That would not be a problem if all trades were published immediately.
'Without some improvement we do not see how we will be able to develop the options market any further. We make options in about 70 stocks, but the market is considered very underdeveloped. The UK is one of the oldest options markets, and it is one of the least developed.'
Stockbrokers, who have to deal with market-makers on behalf of clients, naturally chafe at the privileges. Richard Jeffrey, head of research at Charterhouse Tilney Securities, argues that the market-makers' herd instinct tends to accentuate wild swings in share prices and lead to overreactions in one direction or another.
''I think the biggest problem we have with market-making is that there is far too much capital available to market-makers in totality and they are occasionally tempted into taking on positions that are far too big for the underlying market to unwind easily and thus increase volatility,' he said.
'The other problem is that the market-makers do tend to act as a group. Because they are so vulnerable to moves in the market, the market tends to move in such a way as to discourage customer business. What we have seen in the UK in the last four months is, I think, an overreaction to concern about the economy and the overreaction is driven by market-makers.
'They were long of the market in January. Suddenly the market corrected and they strove to unwind their positions. Then, as any news has come out that they can react badly to, they have, and have marked their prices lower in order to avoid buying more stock.
'You can bet your bottom dollar that when the market starts to turn the market-makers will move it much higher, because they will not want to get caught short of stock.'
Mr Bradley, at Investors Research Corporation, is especially critical of the IDB system and believes that the system's quotes should be revealed to the market as a whole. In the United States, the Investment Company Institute, an institutional investors' trade association, has recently forced greater transparency on to a similar market-within-a-market on the Nasdaq (National Association of Securities Dealers Automated Quotations System) stock exchange.
Mr Bradley says that he deals with fully automated systems, such as Instinet, an electronic system run by Reuters, whenever possible because they are cheaper than dealing through market-makers and give investors greater certainty that they are dealing at a fair price.
This is because Instinet allows investors to post anonymous orders on its screen to buy or sell stocks. When orders match, a trade takes place. Investors like it because it is low-cost and lets them see the price at which other investors are prepared to carry out trades. A similar system called Tradepoint is due to be launched this autumn.
Stephen Wilson, a director of Tradepoint, says his firm is aiming to pick up only a small percentage of the institutional business that passes through the London Stock Exchange. Tradepoint will break even if it attracts between 1 and 2 per cent of the institutional business.
The appeal of the system is clear. Quite apart from the investors being able to see what prices others want to deal at, Tradepoint aims to transact business at a cost of O1 per cent of the deal. Market-makers currently cost 0.2-0.25 per cent.
The key type of customer targeted by both Tradepoint and Instinet is the index fund. These funds rely on computer programmes to select groups of stocks for them that will track chosen stock market indices, and they are growing in popularity.
Legal & General is the second largest manager of indexed funds in the UK. Mr Manning says that if an index fund wants to buy 200 different securities through a programme trade, it would choose a market-maker to do it.
The problem is that an order-driven system could not guarantee that all the business would be done, whereas a market-maker could. 'If someone gives us a lump sum of money to invest we will do it through the market. If we are rebalancing the portfolio, then we will do it through Instinet,' Mr Manning said.
Harlen Flint, director of marketing at Instinet, believes that investors are increasingly conscious of the prices they pay for deals. After all, he says, the people who end up paying are those who hold pension funds and other institutional investment funds.
'The market-makers provide an amazingly useful function in the market,' he said. 'Sometimes there are gaps between matching orders and sometimes investors need liquidity.
'But the fund management community is not homogenous. Some people need to trade immediately and others have more time. People are beginning to look at trading as much more of an integral part of the process, and a better process equals better performance.'
For all the publicity given to the new order-driven systems, it looks as though they will become niche players rather than big competitors of the market-makers. In particular, the new Stock Exchange Alternative Trading Service (Seats) is likely to start transacting an increasing amount of smaller companies' business under initiatives being considered by the Stock Exchange.
But pressure is building for some changes to the market-making system. An academic study recently commissioned by the OFT has concluded that being the only people who know the details of large trades for some time after they have been executed is definitely to the market-maker's advantage. It found that large trades affect the prices of shares for a long time.
The present reviews may well lead to the IDB market becoming more transparent and to market-makers being subject to less favourable rules governing the disclosure of large trades.
But market-makers are dealers at heart. If they have to retreat this time, the odds are that they will be back, to bargain their way into a better position. They know no other way.
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