by R.M.B Senanayake
The Securities and Exchange Commission clamped down last week on the stock market introducing a rule that stock prices must operate only within a band of 10% of the previous day’s close. This has sparked off a controversy as to whether such a rule is desirable. The brokers oppose it because it more or less eliminates the day traders who buy and sell stocks looking for a profit from the difference between the buying and selling prices within the day. So when the SEC limits the price changes to 10%, the scope for day trading is severely limited. But Mr. Vignarajah speaking on behalf of longer term investors welcomes it.
There are two kinds of investors- those who buy shares as investments and hold them to benefit from the growth in profitability of the underlying company and those who buy and sell stock as a trade. Both groups of investors are needed for a market. In fact the momentum of a market depends more on the latter group. In recent weeks day traders, or rather short term traders, have concentrated on a few shares which have displayed high volatility (perhaps created by their own buying and selling).
Day or short term trading requires volatility in the particular share targeted and hence shares which are less volatile are not considered suitable for the purpose. The allegation is that there is market manipulation. It is always possible for a person who has deep pockets to keep on buying a share and then send its price up and up. But however deep his pocket, those who push up the price of a share cannot sustain it at the higher level unless everybody else thinks that the share is worth that price. The day trader has no intention to hold the shares he buys and must sell to realize his profit. So the price must first be down and then purchases push it up.
Stock Markets are based on ‘expectations’. There are two kinds of expectations: those called bulls who are optimistic about the future and expect prices to go up and the bears who expect prices to come down because they think the current prices are too high and not sustainable. These become self fulfilling prophecies depending on which group is in a majority and count more votes in the market as buyers or sellers. Stock markets all over the world are very volatile and there are price swings much higher than in commodity markets.
Since our stock market doesn’t have short selling, the only way is to buy first and then sell. Invariably if the stock prices rise to unsustainable levels (in the absence of short selling) and then comes down sharply some players will be adversely affected. There will be market corrections as investors take profits. During such corrections some will suffer losses while others realize their profits. Those who lose look for scapegoats and day traders and speculators are the scapegoats. But why did they go into speculative shares in the first instance?
Speculation
If the SEC considers there has been excessive speculation then it must address that problem. The problem is caused by excessive leverage and the solution must be to limit leverage - not fix prices. In the past such day or short term trading was confined to those who were physically present in the trading place. But with the electronic systems in place it is no longer necessary to do so and investors can trade from their laptops watching the market in their homes or workplaces. They can trade more actively since orders need not be routed through the brokers as in the past provided they hold sufficient portfolios.
The leverage problem arises with the margin traders. These are the traders who borrow from the stock broking firm and trade with the funds of the brokers. One employee with Rs 30,000 monthly salary bought 2,000 Ceylon Leather Products shares at the price of Rs 247 hoping it will go up further. But the price decline began and the share hit a low of Rs 199. The employee could not meet the loss and the broker had to carry it. Margin transactions involve speculating in securities with borrowed funds. The ease with which such transactions are allowed by the brokerage houses, and the absence of any scrutiny by the broker of the personal credit of the borrower encourage the purchase of securities by persons with insufficient resources to protect their accounts in the event of a decline.
In my opinion the spate of speculators is due to the laxity in enforcement of the margin finance conditions. Brokers are allowed to give credit to customers up to 50% of the value of their portfolios. But this is checked only on two days - the 15th and the last day of the month and even then only the aggregate is checked and not the individual customer accounts to verify if the rule is followed or not. This enables window dressing.
A common saying in financial literature is ``higher the risk, higher the return.’’ So the present rule of limiting price changes to 10% interferes with the fundamentals of stock market investments.
Free Market versus Regulated markets
The current crisis in the stock market has renewed the debate about the roles of governments and markets in protecting investors from themselves and from one another. Should government regulation lean towards a completely free market without any intervention and allow consenting adults to buy and sell as they wish? Or should government regulation tilt toward paternalism and constrain the choices of consenting adults in order to protect them from themselves and from others and to protect the rest of us from them? Those who value freedom and who doubt the capacity of governments to act in the public interest would lean towards completely free markets while others would depend on regulation.
The dispute here however is not about the need to regulate the stock market. That is generally accepted. The issue is whether the regulatory body should limit prices as the present rule does? Stock markets all over the world are volatile and see much fluctuations in prices. Fluctuations here are more because we do not have short selling or derivatives. The day traders are an essential segment of the market for it is they who provide the momentum for the price movements. The 10% rule effectively eliminates them for prices cannot vary by more than 10% a day. Surely a 10% gain is not a sufficient reward for taking a risk to buy shares which are not fundamentally sound?
What this rule does is to reduce the liquidity of the market. A may have bought a share a few years ago and may want to sell because he needs money for an operation. He cannot hold the asset because of his need for cash. But at the going price he may not find any buyer for his shares. Nor can he reduce his asking price below 10%. So if he cannot find a buyer for 10% less, he would have to wait. He would have preferred to sell at 15% below the market price of yesterday because of his need for cash but he cannot do so. Does this help to promote liquidity of the stock?
The whole issue is whether to allow day traders or to eliminate them. As far as I am aware there is no stock exchange anywhere which has laid down a band like the SEC. Some countries impose what are called circuit breakers on individual shares which may go up too much in a day or a sessions trading. Trading is halted at the limit say 10% and then inquires are made from the listed company about any price sensitive information which the company’s directors are privy to but which is not generally available to the investing public. Invariably the listed company will deny any knowledge but the veracity of their denial must be followed up. If they have lied they should be fined. Anyway such halts are only temporary, perhaps an hour or so. The Colombo Stock Exchange has previously resorted to such circuit breakers. Of course the point which sparks off a halt should be sufficiently high. The rationale is not to interfere with the price mechanism but to treat all investors equally since insiders only may be in the know of something material to the share price.
``Myidea is that affairs of trade are best regulated by natural law. The careless banker has lost his reputation; the careless investor has lost his money; and the result of it is, more care will be taken" (Charles Flint). But there are others who think differently. They are against speculators not realizing that forward prices and future prices are always to an extent speculations. Damn speculators and you lose some important elements in a market. Speculation is not a dirty word as some people seem to think. Everybody has some idea of what a future price is likely to be and if there are financial instruments available for those who wish to protect themselves from such price falls, would it not be a good thing? But that requires counterparties who take a different view.
Remember the CPC hedging operation. Someone has likened the transaction to a wagering contract and argued that it is a prohibited act under the Penal Code. I wouldn’t know if it is a penal offence but if so it would have to be amended before the Stock Exchange introduces derivatives trading in the local market.
source - www.island.lk
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