Periodic Call Auctions for Illiquid Scrips

SEBI recently came out with circular (here) asking exchanges to transfer all illiquid stocks in call auctions from 1st April, 2013.

In this circular SEBI has said that

a) Allow Pre-opening Session in all liquid stocks.

b) Transfer all illiquid stocks in Periodic call auction.

From 1st April, 2013 all stocks, if they are liquid, would be available in Pre-opening session, which is a welcome move.

Also all illiquid stocks will be available only in call Auction. Let us first understand the meaning , features, advantages,dis-advantages and deficiency  of Call Auction and also its impact on price discovery.

What is Call Auction ?

Call Auction is trading mechanism where all buy and sell orders are pooled together and trade takes place at a equilibrium price at which maximum buyers and sellers are ready to trade. There is only a single discovered price for every call auction. The Price discovery process for call auction is same in Pre-opening session, except that you have more time for order placing, modification and cancellation.

There are around 260 Stocks which are illiquid as per latest NSE circular.

What are Illiquid Stock :

Illiquid stocks are stock which are infrequently traded and generates lesser trading volume. Generally stocks which have low equity, low Floating stocks , Stable stocks, or the companies which do not have more of speculative interest are mostly illiquid stocks,  but we should not infer that all stock which are illiquid are not fundamentally good companies. That may be true for some companies.

NSE criteria for illiquid stocks are High Bid - Ask Spread, Low Volumes, Higher Impact Cost, infrequent trades etc. SEBI has defined a broad criteria that Stocks which have average daily volumes of less than 10000 shares, and which have daily average of less than 50 trades are considered illiquid on all exchanges where the stock is traded. 

When would a stock become liquid from illiquid :

When the above mentioned parameter are not met by stock, it becomes liquid stock and it will be transferred to normal segment, but once stock becomes illiquid, it will be in call auction category for at least 2 quarters

The Salient Features of call auction as per SEBI circular are :

a) Call Auction for illiquid stocks would take place every hour during trading session. Out of 1 hour, 45 min will be allowed for order placing, next 8 minutes will be for order matching and last 7 minutes will be buffer / cooling off period. To avoid fake orders to distort price, the closing time of call auction will be random between 44th and 45th minute.

b) After the closure of each call auction, pending orders will be purged / cancelled.

c) Price bands will be applicable as per Risk Management rules of exchanges and It may also settled on trade to trade basis.

d) There is penalty on people generating false volumes by simultaneously being a buyer and a seller at the same price.

Are there advantages of Call Auction : Yes

a) Call Auction leads to better price discovery , also thereby reducing outlier trades.

b) A bigger order book can be generated using call auction.

c) It reduced volatility in stocks due to illiquidity.

Are there any Dis - advantages / Lacunae in Call Auction :

a) The Computation for Illiquid Stock of SEBI is flawed, because it looks only at volumes and not on any other parameters like Bid - Ask spread, Impact Cost etc. Most High value stock would tend to become illiquid as they may not pass the test of average 10000 shares

b) There are many prop desk who have different people working at different locations and on different strategies at the same time on different mandates, also their decision making is decentralized. They may also have Chinese wall between traders. In such scenarios it may happen that some trader at one office of a prop desk may be selling that stock and another trader of that same prop desk may be buying at the same time. Though such trades may not be artificial volumes but such trades will attract penalties.

c) The pending orders are cancelled after every call auction, hence a buyer or sell will lose his priority in case of UP or Down circuit. Also it will be cumbersome to give new orders and track trades after every call auction.

d) Intraday trading in this stocks will be marginalised.

e) Margins will be higher in call auction segment comparatively.

f) Disclosed quantity in orders are not allowed in call auction, hence bulk order and block orders will be disclosed in market before the deal taking place, which may put parties looking to buy or sell big quantities in disadvantage.

Once the bulk order or block order is discovered on stock, many traders would try to create nuisance value. The traders would try chasing the bulk or block deal.

Conclusion : Call auction are there in many international market and academics prefer call auction to normal trading in illiquid stocks and I would need to read more of academic papers to speak on international experiences. But I would like to put suggestion and experience about the same

a) Whenever in India if a stock is transferred in T2T segment, the stock most of the times tend to drift downwards, because liquidity players would not give quotes, Call Auction also reduces speculative element from such stock. So maybe we can see the price of stock always trading at discount to its fair value, till the time it is traded in call auction.

b) Can we look for Market Maker in such illiquid stock rather that trading in call auction. Many developed markets including US prefer market makers.

c) There is only one stock as of now which is listed on SME segment of exchanges, there is hardly any volume in the stock. These stock is only traded in call auction, can we get a pre-cursor of the happening. I would want to qualify that the view can be biased as there is only one stock as of now.

We should be happy that SEBI is working for better market place and  I am sure we can expect some amendments in current call auction procedure to make it more market friendly

This is not a recommendation to anybody whatsoever to buy OR sell this share, but it is my thought process and views on this topic.

I welcome your critical comments and suggestions.

Destiny of IFCI : Will it again be a PSU

On 24th Aug, The Cabinet Ministers of India decided to convert Optionally Convertible Debentures of IFCI to the tune of Rs 923 Crores at PAR. Post conversion government will directly hold 55.57 % of IFCI and up to 68.31 % of IFCI if we take into account the stake of other PSU in IFCI. There was full disclosure in the annual reports of IFCI about the conversion at Par subject to SEBI guidelines on Takeover.

We will also look at the background of IFCI,

The Industrial Finance Corporation of India (IFCI) was converted into a company incorporated under the Companies Act, 1956 on 31.3.1993. It was then decided that holding of Government controlled institutions in IFCI should be maintained above 51 percent.

In the wake of likely systemic impact of IFCI defaulting on its liabilities, in the year 2001, the Government infused Rs.400 crore as Tier-l capital of IFCI in the form of 20 year 9.75 percent unsecured Convertible Debentures. This was a cash neutral transaction.

Thereafter, in December 2002, the Government had approved a financial assistance of Rs.5220 crore to IFCI which was to be released over the period from 2003 to 2011-12. Out of the package of Rs.5220 crore, financial assistance of Rs.2932.31 crore (Rs.523 crore as loan in the form of OCDs and Rs.2409.31 crore as grants-in-aid) was released. In 2006-07 the company started making profit and it was decided to stop release of further assistance to IFCI. The OCD terms said that IFCI can repay OCD to government.

The equity holding of Public Sector-Banks / Financial Institutions / Insurance Companies remained over the threshold limit of 51 percent till March 2004. Thereafter dilution in the holding took place in 2005 and it came below 51 percent.

Further,

Committee of Secretaries was constituted, headed by the Finance Secretary and comprising of Secretaries from the Departments of Economic Affairs, Expenditure and Financial Services. The Committee, after due consideration and taking into account all the facts, has inter-alia recommended to convert the OCDs of Rs.400 crore and Rs.523 crore into equity at par and that the Government need not make an open offer to the shareholders of IFCI and instead take exemption from SEBI under Section 11(1) of the SEBI (Substantial Acquisition of shares and takeovers) Regulations, 2011. 

Let the understand the impact of this conversion :

a) IFCI will become a Public Sector Undertaking (PSU), which will come under the ambit of bureaucracy, which may lead to delay in decision making.

b) The Expected EPS of FY12 will fall from around Rs 8 to Rs 3.60.

c) The price of Equity shares before the conversion was around Rs 35/-, After the conversion keeping other things same and Increasing the capital and decreasing the debt by Rs 923 crores, The new value comes to Rs 21 /-. (Cost of Equity)

There is a direct diminution in the value of IFCI call for us to see it lens and raises the question of Bureaucracy against Minority Investors. There are several points to look into the conversion of OCD.

a) Can Government convert the OCD in Equity?  Yes It was in the terms when OCD of Rs 523 Crores were  issued, also the Prevailing Market Price at time of issue of OCD was below Par, We should also understand that IFCI has received grants to the tune of 2409 crores.

About the issue of OCD worth 400 crores , it was a cash neutral transaction to maintain Tier I capital of the company. Also IFCI has the right to Prepay these OCD, I am not too sure How can government convert it in shares, effectively values of that Rs 400 crores become much more because of conversion, whereas IFCI investment of Rs 400 Crores in GSec does not change.

b) Can IFCI challenge such conversion : I doubt about it, The conversion is as per agreements, but which may not be bad in law but it may be bad in  spirits ? It is an executive order by CCS, where Law and State Machinery are part of it.

c) What about Minority shareholders : Minority Shareholders stand to lose, because of conversion. There was a disclosure for conversion, along with that it was mentioned that the conversion will have to follow Takeover guidelines. As per the guidelines, The government will have to buy 26% shares from minority shareholders as per SEBI formula of offer Price. But Instead the government choose to take exemption from SEBI u/s 11(1).

As per section 11(1), The SEBI board can grant exemption from making an offer for acquiring shares under the regulation after recording the reasons in writing from acquirer and if it is in the interest of investors in securities and the securities market.

I fail to understand, how exemption is in interest of Investors or Market, It seems these section is invoked to not make open offer.

d) Can SEBI look in the Matter : NO and Yes. SEBI cannot stay the conversion as they are as per terms and condition of OCD, but YES SEBI can take a stand on Open offer, I don't know how can SEBI get convinced that such exemption is in the interest of the Investors and markets. These will be a case for SEBI , where its stand for Investor Protection may be compromised.

As of now It does not seem that SEBI will be able to stand for Investor Protection and its stand may be compromised.

What about the future: IFCI as an institution is regaining its dominance, but after the conversion  there are areas where clarity will emerge only in future

a) Decision making may become slow.

b) IPO of one of its subsidiaries will be delayed, reducing its valuation

c) The talks of inducting a strategic investor will be a thing of past

d) Its biggest blessing in disguise may be that they may get a banking licence , which is also in distant future.

The returns of IFCI minority shareholders in long run will vindicate government action for conversion of shares.

I welcome you critical comments and suggestions

The MCX Equity Exchange : Can it make a mark ?

Yesterday, MCX got a permission to start an equity exchange, sounds good as it will add to product list which can be traded, but can we make a list of what may or may not happen after this development.

It makes me think that with a long history of being an oldest exchange, if BSE is struggling with volumes, how would new exchange garner volumes. BSE generates volumes in derivatives only because of LEIPS (Liquidity enhancement program), where the traders are compensated for the statutory cost else there is no volumes in derivatives exchange

Then how can MCX make its mark ?

a) MCX intends to replicate success of MCX commodities and to some extent Currencies in Equities, but we must know that i) MCX & NCDEX started trading at around the same time, when neither had lead nor volumes.ii) Today MCX has volumes but if we dissect the volumes, they are mostly speculative and only in Metals, where delivery in very miniscule, whereas NCDEX commands higher volumes in Agri Products and huge quantities are marked for deliveries. iii) There is miniscule institutional participation in MCX whereas Big Trading houses and Many MNC procure through NCDEX. 

In Equities , to garner volumes you need the participation of Retail Investors, Traders, Prop Desk and also Institutions, but if we look at the above instance Institutions don't trade on MCX. It needs to be seen, How can MCX get institutional investors on board.

b) The biggest advantage of MCX, is that it has trading software and the required domain expertise in creating a back-end of trading in place. Thanks to support of its parent Financial Technologies. ODIN software (A front-end software for trading) was the only player until before some time, but now there are many other software vendors, but its still the leader.

c) I am also concerned about the risk management and work ethics in MCX, They need to come out with strong risk Management and strict code of secrecy and work ethics of its employees.

What can MCX do to make a mark ?

I believe that MCX  will have to differentiate their products to attract more players and different breed of players.

a) The first and foremost is they should try with delivery based Stock futures and options : There is a strong demand for delivery based derivatives in Indian market, but NSE is reluctant to introduce this as there is a fear of loss in volumes and NSE trading structure for cash and derivatives segment is different as such that they cannot introduce deliver based derivatives, whereas IF MCX goes on lines of Clearing members and Trading Members for equity brokers also, they will be able to introduce delivery based derivatives.

Incidentally all institutions are for delivery based derivatives and this is an opportunity that MCX can grab, because if Big breed of Institutions trade in MCX, then others are there to follow.

The Basic rational is Institutions have to run VWAP on Expiration day to close their positions and they expect volumes for VWAP, which they get only in NSE as of now, but if the stock futures are delivery based, they need not worry about the delivery, but volumes will follow as stocks will be marked for delivery.

b) In the same manner , they can trade in American options instead of European option and institutions would be a  more comfortable in such trades and it will also create sophisticated arbitrages opportunities for complex trades, which they will love.

c) The biggest obstacle wold be INDEX, It will have to create its own INDEX to trade, but they have opportunity like they can also introduce trading in MSCI index and other such index, which are maintained by big institutions and tracked by foreign investors.

d) SEBI guidelines for Derivatives market  mandates the structure of Trading Member and Clearing Member, such structure in Equities will also help MCX to garner its long list of small brokers and avoid Risk Management issues.

MCX will also have to overcome some regulatory issues like :

a) SEBI may move to supreme court for a stay in ruling, further increasing the waiting period.

b) SAT has mandated to reduce their stake in MCX below 10% in 18 months, which will impact its valuations.

Looking forward, we can look at MCX equities exchange as an opportunity for different class of investors and to satisfy their investment needs.

I welcome your critical comments and suggestions

The Current State of Issue of Shares: Will it make or Break

Since last one year there were very few IPO in Indian Market, but there were many changes which has taken place in terms of Rules, Regulation and Guidelines by SEBI / FMO on public issues. We will discuss these laws and how it will impact investors, its sentiments and how it may impact price discovery process?

The Major changes in the guidelines are

Increase in application size of retail investors from Rs 1,00,000/- to Rs 2,00,000/- (already discussed in my previous blog) : As discussed in my previous blog it will reduce the returns on IPO market and may shy away investors. These has already taken place in market where there are no new issues and investors also do not have appetite and when good issue came in market the returns on investment in IPO was dismal (MCX). 

Finance minister has said that it will reduce the application time and it intend to do it by bringing in  IPO through stock exchanges: Finance Minister has gone on record to say that IPO process will be streamlined which will reduce application and allotment time and also it will streamline whole IPO process. They intend to do it by selling shares on Stock Exchange. In this process the investor will be expected to apply for shares on stock Exchange terminal using brokers, the allotment would be done as trade confirmation and shares will be credited in investor account using clearing house mechanism. So maybe by evening you will know your allotment and listing may happen in few days. Seems simple what will change?

a)       The issuer will save money on commission as they won’t be obliged to pay to brokers soliciting clients (There are many people who make a living on IPO forms, they will be heavily impacted and maybe the marketing of issue will be impacted)

b)      You will have to pay brokerage for applying through brokers.

c)       Now if you apply in shares you can apply it through ASBA (Wherein you can earn interest on that money till the date of allotment), but if you apply through broker you will have to give money to him in full and then only he will be eligible to apply on your behalf (It may happen that clients would be expected to pay before few days to avoid last minute rush) and will also put question on risk management of broker.

These may not impact much to investors apart from brokerage but these will be that way you apply in future.

New category of “Offer for sale” introduced by SEBI using Stock Exchange Platform: To bring IPO process under the ambit of stock exchange SEBI has created a new category of IPO “Offer for Sale” . In this category the promoters or Major stake holders can sell shares directly to investors.

The mode of application for these shares is same as discussed i.e. by putting bids through brokers, these offer is open only for one day and on listed top 100 stocks. So you know the allotment by 3.30 pm

What’s the difference in this category?

a)       We pay brokerage to apply for these shares, but we also may get allotment at discounted prices.

b)      The sellers would be promoters who want to reduce their holdings to meet SEBI guideline of Maximum 75% promoter holding by June 2013.

c)       The best part of this segment is the seller pays STT and can save capital gains tax.

d)      You can trade on those shares in 2 trading days.

There are successful, unsuccessful and controversial issue in this segment which includes ONGC flip flop.

New category of “Institutional Placement Programme” introduced by SEBI using Stock Exchange Platform : There is also a category like above but wherein only the Institutional Investors can apply. Other rules and guidelines are same as offer for sale but I have my reservation of this category. These can be misused by promoters to place their holdings with these Institutional investors maybe with some arrangement, which may be detrimental to interest of minority investors. I am sure SEBI can plug the holes in it.

SEBI law says any IPO with issue size of up to 25 crores would have pre opening session for price discovery and will be traded in T2T segment of 10 trading days post listing: SEBI say that all IPO below Rs 250 crores would be traded in T2T segment (Compulsory delivery, No Squaring off allowed) for first 10 trading days, Also on day of listing the stock will be in pre opening session for 1 hour for price discovery process.

Such steps were taken by SEBI to reduce huge volatility on the day of listing, but in turn it has taken the essence of trading from these stocks, Lets discuss what is happening?

a)       As there is no square off, traders keep away from these stocks.

b)      Because of that it reduces liquidity on the counter, it increase the cost of entry and exit.

c)       People apply in IPO is earn price appreciation on allotment but if traders move away, it reduces the probability of higher price (As there will be many investors who want to sell at the open and buyer may shy away knowing that or it may reduced its bid price)

d)      Because of these I believe listing gains would get capped and in short run its flavor.

SEBI law says any relisting and scheme of arrangement (Except for stocks in F&O segment) would have pre opening session for price discovery and will be traded in T2T segment of 10 trading days post listing: These stock will also trade in T2T segment which will hamper price discovery process in short run.

The above rules changes the way we trade in newly listed stocks and It will definitely impact the price discovery of these stocks on lower side,

But needless to say, that price discovery process and its impact on stock price will be there in short run but longer term performance of these stocks will only depends on its fundamentals.

I welcome your suggestion and comments.

Introduction of Futures and Options on Global Indices on NSE

As per SEBI guideline and permission, NSE is set to launch Futures and Options contracts on " S&P 500" and only futures contracts on "Dow Jones Industrial Average" (DJIA).

Now instead of Tracking these indices and taking queue over here, we might as well trade on such indices or hedge on such indices.

Before discussing the impact of such indices, let us understand its features.

S & P 500 DJIA How it will show on NSE F&O Screen FUTIDX S&P500 FUTIDX DJIA Lot Size 250 25 No of Contracts available 6 6 M1, M2, M3,Q2,Q3,Q4 M1, M2, M3, Q2,Q3,Q4 Expiry 3rd Friday of Every Month 3rd Friday of Every Month Last Trading Day Same day as Expiration Same day as Expiration Settlement Cash Settlement Cash Settlement Underlying Currency Indian Rupees Indian Rupees Types of Option European Not available Margins Span Margin Span Margin Settlement Price Opening Price of S&P 500 on CME Opening Price of DJIA on CME There are several Advantages of trading in Global Indices in India They are mentioned as below a) S&P 500 would be traded on stock Exchange outside USA for the first time. This would also enable many FII to take position in India but as of now only Resident Indians as per SEBI guidelines can trade. b) This will enable investors to take positions or Hedge on International markets. c) Simplicity : It is simple as we trade in nifty as the underlying is traded in Indian rupees. There is no currency exposure. d) Easy Access : It will give easy access to all investors in every part of the country. e) There is a facility to see live quotes of CME to take position. f) There is trade and settlement guarantee fund of NSE, which will enable security of our settlement. g) New strategies can be introduced in market based on Nifty, DJIA & S&P 500 and its movement and correlation h) Updates on development in these index will help up see broad trends of industry globally. i) There are benefits of cross-margin between  DJIA and S&P 500. There are some thing to be understood before trading a) You will have to pay taxes and STT as per Indian law only. It may lead to price distortion between prices in India and abroad. b) The Settlement price of these contracts are computed based on opening price of all its stocks. That is termed as SOQ( Special Opening Quotations). Please understand that opening price of Index is not same as SOQ price. there is a slight difference.      Normally when market opens we get quotes and opening prices at the open of trading but there would be some stocks which will trade after some time may be minutes or after an hour. In the meantime there may be many prices which would have been derived on DJIA and S&P 500. What SOQ does is, it considers opening prices of all its constituents, (though they may have been traded after some time) and derive a opening price such price is called as SOQ prices which would be the final settlement (we will discuss more on rationale of SOQ later).     What it also means that if you have position at the close of settlement, you are not aware of the settlement price till the opening of American markets and then only you will know the settlement price which may be different from Dow futures or S&P futures which you may see our market times. c) Initially there wont be participation of FII in these segment of market and as such there wont be a live trading on underlying which may result in illiquidity, higher bid-ask spread, outlier trades. d) Trading in DJIA and S&P is almost 23 hours, because there are 2 types of trading on CME. a) Pit Trading and Globex (Electronic Trading. These electronic trading system is open for 23 hours.) but there will be problem of liquidity on these exchanges at odd hours (when there is night is USA and we Trade.) To sum it up, it add one more tool for trading in our arsenal but we may play blind bets on overnight positions where there will be volatility in that market and the price will change over there and we will only be the price taker at the open of trade over here. Some more FAQ, if you are not bored : a) How do we trade : It is on individual preference, but as mentioned price discovery on underlying will take place only in American markets, when our markets will be closed. The initial strategy would be to trade by taking positional view on these index (may be for 3 - 4 days) or create a hedge for position in Indian assets. b) Why is the final settlement at the opening price ?                                              There are market makers / Specialist in that markets appointed by the companies and Exchanges. These market makers / Specialist are obliged to give quotes during the day and absorb all demand and supply of individual stocks. So when the market opens these people absorb all demand and supply at the opening price with the obligation to make sure that there is lowest possible drift from previous closing price. Because of these, arbitrageurs in that market who have positions between underlying and Index buy / Sells at opening price to track SOQ prices. Opening price in such markets is a good indicator.(of overnight information change, overnight  liquidity needs and Noise (Fama))These prices are equilibrium price as it absorbs all demand and supply at the open.and If we compute the opening prices of all such underlying stock we get SOQ which is perceived to be a good and equilibrium opening price. Many other exchanges in America (like CBOE) use SOQ prices for settlement. c) How about trading in Options : You can trade in options only on S&P500. The queue of Implied volatility will come from CME only and the would be little higher in India (because of Illiquid Indian markets for these products)  .     In the Money calls will be cheaper (because of higher STT on Exercise). Also the cost of adjustment will be higher because of bid  ask -  spread. I welcome your comment, suggestions and queries.