RIYADH, 27 June 2005 — When buyers or sellers are few (i.e., thin trading), there are two potential problems: (i) price discovery and (ii) manipulation of prices. Regulators and investors would need an arsenal of weapons to deal with these problems.
In this report, we focus on “market makers” i.e., specialized buyer/sellers of shares, who stand ready, as a last resort, to buy/sell shares when there are no other buyers/sellers in the market. We buy our daily needs like toiletries, food, etc., from shopkeepers. A shopkeeper, in essence, is a firm specialized in selling what we need.
Typically, it specializes in selected items and maintains an inventory of them, standing ready to sell to anyone at specified prices. In a competitive environment, competition, transparency and nondiscrimination ensures that the price we pay is fair and based on fundamentals (i.e., cost of production). Without shopkeepers, i.e., in barter systems, buyers and sellers do not know each other’s existence and have to engage in a costly search each time they need something, with no guarantee that they will find a seller or pay the correct price. Such specialized shopkeepers, called market makers, in stock market parlance, do not exist in the Kingdom. When one wants to buy shares, there are no specialized sellers with an inventory of the shares to turn to. Instead, the buyer’s order is put in a queue and executed only after a matching sell order from another investor is found (essentially an extremely sophisticated barter-type system).
The system can match orders only if there are orders to match. Moreover, the price established through this mechanism tends to be momentum-driven and is only as good as the last trade; there is no assurance that it reflects fundamentals or market equilibrium (e.g., 10 local companies have P/E ratios that are 7 times the market average; one is 53 times). A big danger is market manipulation (e.g., entering matching buy and sell orders at a pre-arranged price). When there are specialized brokers and market makers, they will analyze each stock and quote prices based on fundamentals.
Most stock markets around the world have a market-making system where a few carefully selected brokers are allowed to be “shopkeepers” of last resort for selected stocks in such a way that all the listed shares are covered. Market making is not allowed in many regional markets because of past problems.
However, we do not do away with shopkeepers of, say salt, because they can manipulate salt prices. With a more sophisticated business environment and new technology, it is easier to monitor a few licensed brokers/market-makers instead of each and every transaction.
Market making ensures liquidity and fair prices in thin markets. And, as a whole new class of financial entities, they offer new job opportunities for Saudis. The new Capital Market Authority (CMA) allows brokers to trade shares for customers or their own accounts (thus, increasing depth). The next steps will be to select market makers in such a way that all stocks are covered and develop appropriate market conduct rules/guidelines for them.
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)