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Home » Business » Big traders provide liquidity, but wrongdoers must be punished
Big traders provide liquidity, but wrongdoers must be punished
March 28, 2015, 5:49 pm
by R.M.B Senanayake
When the Leader of the Opposition demanded the appointment of a Parliamentary Select Committee on the
controversial Central Bank Bond Issue, the Prime Minister agreed to it but insisted that its scope be expanded to
include whether insider trading and market malpractices had taken place in the stock market since 2010. He
threatened the culprits with fire and brimstone. Yes, there were serious allegations of malpractices in share
trading which were not investigated at the time because the two SEC chairpersons who wanted to do so were
pressurized to resign. No inquiry has therefore been held and it is necessary to do so since the stock market could
be an important destination for foreign capital inflows to the country.
Governments have generally stressed only the need to attract direct foreign investment. But portfolio investments
can be a useful catalyst to promote direct foreign investments. Foreign investors don’t like a rigged stock market
but want a level playing field. The same information must be available for all investors at the same time. Any
inside information, if available to particular investors either because of political or commercial links with
companies or brokers, allows for insider trading on such information. Stock market gains to some are always at
the expense of other investors or market players. Economists call it a zero sum game where aggregate gains
equal aggregate losses. So any allegations of insider trading must always be probed.
Market manipulation versus speculation
But apart from insider trading there are other malpractices in trading. There are two types of investors in the
stock market. There are those investors who will buy or sell shares after analyzing the quarterly or annual
financial statements such as the Profit & Loss statements and the Balance Sheets. If they disclose an increase in
earnings- profit after tax; or an increase in the net asset value of the company the prudent investor will either
hold on to his shares expecting more gains as the market price will go up. But if he thinks the market price is
already too high and far above its fundamental or intrinsic value he may decide to sell. He will buy only if he
thinks the company will do better in its earnings or net asset value and also that the company share is underpriced in the market. These are individual judgments, but since the facts are objective there may be several such
investors who are optimistic or pessimistic at more or less the same time. But if there are many sellers there must
also be buyers to enable them to sell. This is where speculators come in for we don’t have market makers but only
brokers.
There is another class of investors called traders who include big timers as well as small investors called retailers
in local parlance. They like to trade in the market and take advantage of short term fluctuations due to the actions
of big investors. He follows different rules. If he sees the market price of a share rising he will buy it expecting it
to go up further. He will buy the share irrespective of its intrinsic or fundamental value. But if he finds that the
share price has stopped rising he will decide to sell it expecting it to turn to a downward trend. While economist
advise investors to buy low and sell high, the traders follow
a different technique buying a share which is moving
up and selling it when it is falling These traders do not look at the financial statements but on graphs and charts
called technical analyses. The small traders often follow the big timers rather than depend on technical analyses.
The big timers have their own strategy. They know that other traders follow them. So when they want to push up
a share price they buy and word gets around about their purchases. They may of course even have some inside
information. But for no known or valid reason they may push up the price of a share knowing that others will
follow them. Then when it has gone up sufficiently they may sell out and then the price falls and may fall steeply.
While the early sellers will make a profit the others may not be able to sell at a profit or sell at all. This technique
has been called "pumping and dumping."
Now like in any other market the big players have a greater say in determining the price of a share. So the small
retail investor is at a disadvantage. The small traders have to follow the big players but the big players may take
misleading actions and may even create a false market. They or brokers on their behalf may spread false
information. They may corner the shares available in the market and create an artificial shortage before pushing
the price up. There may be also ‘wash sales" where some big timers buy for their own account under different
names with no change in beneficial ownership. The brokers may convey false information about who is buying and
who is selling and the reasons for their actions .All these constitute malpractices and are offences under the
Regulations of the SEC.
Speculators and traders create liquidity - an essential function
If the small retail investor wants to trade he must be constantly following the market. The market may move
rapidly or in fits and starts. The brokers are present in the market all the time and have a distinct advantage since
they also know the orders and the big players in the market. The Regulatory Authority has stringent rules that
restrict the trading by brokers on their own account. They are expected to give priority to the orders of their
clients for any purchases or sales. But brokers are known to use dummy clients and violate the regulations.
The Regulatory Authority is expected to monitor the price movements of a share and if they notice unusual
movements they are expected to suspend trading temporarily and ascertain from the company whether there is a
valid reason for its share price to go up or fall rapidly. But the Regulatory Authority staff must have market
experience to monitor effectively. They must be protected from unusual pressure brought on by the bigger market
players. Often the latter are politically powerful and have influence over the higher ups in the Regulatory
Authority. In such instances the regulatory staff must be protected when they take action against the big
investors. If the big players have political clout in addition to their economic market power, it will be difficult to
enforce the rules against malpractices and the regulatory official’s position is perilous.
According to the Modigliani-Miler theory of efficient markets all available information is already factored into in the
prevailing market price. If so there can be no possibility for traders to make short term gains. But the Efficient
Markets Hypothesis takes time in small developing country financial markets. So there is scope for gains in short
term trading.
Stock market is important for development
The stock market is a key to the development of the Capital Market. Companies are able to tap into funds through
the issue of equity as well as bonds or debentures. New Issues and Rights Issues are the way companies raise
capital from the capital market (includes the stock market). The stock market allows investors to bail out without
having to hold their shares until a director or major shareholder wants to buy them. It creates liquidly for risky
equity investments as well as for debentures. So the market is an important source for corporates to raise risk
capital. The stock market is an important institution that requires support from governments. It is not a casino.
Traders and speculators are needed to provide market liquidity.
Our stock market came to be formally set up in the mid 1980s to cater to the public through an open outcry.
(Earlier the Colombo Brokers Association met and traded shares among themselves.) I remember the important
role played by USAID in setting up the market we know today. U.S experts trained the brokers and conducted
courses. They held examinations before the brokers were licensed. Our market now requires new expertise not
available in the country.
Introduce hedging instruments to protect small investors
The market does not have any hedging instruments. They are necessary and we need to introduce trading in
options and futures to protect those who are risk averse. Remember the disastrous hedging transaction of the
Petroleum Corporation which cost billions of rupees to the country due to ignorance of the instrument by those
hedged. Our brokers and even the investing public need to understand these modern financial instruments before
they can be introduced into the market. Once they are introduced those whose risk preference is low can cover
the risk with an option bought in the market. Those whose risk preference is high can take the risk exposure
without hedging but it will be a deliberate decision. Then only speculators who want to take the risk will take the
exposure and reap either a profit or a loss.
The market has provided new capital and debentures for our listed companies and played an important role in
funding corporates. A volatile stock market is not necessarily a bad thing. It is this volatility that provides for
higher equity returns than interest on fixed deposits. The return on equity is the capital gains on the stock market
plus the dividend yield. With the Government and the Central Bank keeping
interest rates low to promote private
sector investment it is necessary to promote the public to invest in the stock market. The market needs both big
players as well as the small time traders to create a regular market so that shares are always available for
purchase and buyers for any sales.
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