New electronic systems for trading stocks could end the financial abuse suffered by investors when buying and selling small, over-the-counter (OTC) stocks. Such systems can spur economic growth, benefiting investors, business firms, and employees.
In the OTC market, dealers set bid/ask quotes that represent the price at which they will buy from an investor (bid) or sell to an investor (ask). The larger the bid/ask spread, the larger the trading cost–middleman cost–to investors. Electronic trading systems enable investors to split the bid/ask spread and effectively eliminate the middleman cost.
From an investor’s perspective, how big is the middleman cost? I recently bought an OTC stock for a price that finally became low enough to interest me. With the figures rounded, the quote was 9 bid by 10 ask. This means that a buyer pays $10, but a seller receives only $9. So I paid $10. If I hold the stock for one year, and then sell it when the quote is the same 9 bid by 10 ask, I will receive $9. Hence, I would lose 10 percent on my investment even though the quoted stock price did not change. The Wall Street dealers would make money.
Middleman trading costs cause Main Street businesses to slow their expansion and hiring. Why? Suppose you owned a small firm and went to the bank to borrow money for expansion. Instead of borrowing at an expected 10 percent, you are told that 20 percent is your cost of borrowed capital because of an extraordinarily large surcharge. Consequently, you borrow less or nothing at all.
It works the same way in the stock market. Investors price stocks to achieve a satisfactory return after paying taxes and trading costs. High trading costs are a surcharge that lowers stock prices. This signals management that their cost of equity capital is higher, resulting in less expansion and hiring.
With new electronic ways to trade stocks, buyers and sellers can avoid middleman markups, and equity capital for small firms is spared the surcharge. Instead of a buyer paying $10 and a seller receiving $9, new electronic trading systems enable buyer and seller to split the bid/ask spread and trade at $9-1/2. This strikes at the heart of the age-old Wall Street argument that large bid/ask spreads are needed for less liquid stocks.
Wall Street asserts that a heavily regulated, “national market system’ is the best way to “protect” investors. In practice, such a system blocks the development of trading mechanisms that facilitate direct contact between buyers and sellers. It is noteworthy that Wall Street trading abuses occur because of the opportunities for self-dealing by middlemen who stand between buyers and sellers.
The upcoming debut of the Chicago Match, operated by the Chicago Stock Exchange, will further expand the number of major electronic or proprietary trading systems. Regrettably, the stocks that benefit the most from circumventing the OTC marketmakers have not yet received much attention because of their low volume of trading. But small trades can be “packaged” into sizable volume via electronic auctions at periodic intervals. Hence, a genuine business opportunity exists for one or more of the electronic systems to centralize trading in illiquid stocks. Depending on a stock’s trading volume, electronic auctions could be assembled daily or weekly.
Such periodic auctions would provide unequivocal evidence of substantial reductions in trading costs vs. the existing OTC dealer market. Management increasingly would learn that their stock prices would be higher if investors in their stock were able to split the bid/ask spread. As a result, investors could radically reduce unnecessary trading costs, companies would reduce their costs of equity capital, and OTC dealers would awaken to the need for restructuring their industry.
The OTC dealer market’s worst nightmare is a system that gives both retail and institutional investors a choice, during normal trading hours, of how their orders are executed. Many investors do not need immediate execution, especially since waiting for a periodic electronic auction would eliminate the bid/ask spread and give deeper liquidity.
Electronic trading is in its infancy. If the bureaucratic process of obtaining Securities and Exchange Commission approvals and the vagueness of existing SEC regulations can be kept manageable, electronic trading eventually could be available to everyday retail investors, not just institutions. With more competition, the U.S. stock market will evolve into a more efficient marketplace–benefiting investors, businesses, and their employees alike.
Written for The Heartland Institute by Bartley J. Madden, a partner in the Chicago firm of HOLT Value Associates. A longer version of this essay appeared in Pensions & Investments.