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Are market makers knights of OTC trading?
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CHINA’S long-dormant over-the-counter equity market may be resuscitated with the introduction of a new market-making system to facilitate capital flows.
On August 25, 42 brokerages began acting as market makers for trading in shares in an over-the-counter operation known as the New Third Board.
According to the National Equities Exchange and Quotations, operator of the market, 2,897 transactions were completed during the first day, with 94 percent of them facilitated by market makers who issue buy and sell quotations for a guaranteed number of shares.
Trading turnover was 80.38 million yuan (US$13.2 million), of which nearly half was attributed to trades closed by market makers. That was an impressive start, considering that only 43 of more than 1,000 companies listed on the board have participated in the market-making operation.
“The adoption of a market-making mechanism is significant in diversifying the channels for transactions and improving the function of the over-the-counter market,” said Sui Qiang, assistant general manager of the over-the-counter operation. “It will help to establish a valuation system for growth enterprises and open up financing options for them.”
China set up its first off-exchange market in Beijing’s Zhongguancun Science Park in 2006 as a pilot project to provide a financing channel for non-listed start-up firms in the park that often had difficulty borrowing money from banks.
In 2012, the market was expanded to technology development zones in Shanghai, Wuhan and Tianjin.
The over-the-counter board gained a further boost last year after the regulator expanded it nationwide, allowing qualified companies across the country to sell shares.
In the first eight months of this year, 774 companies were listed on the board, more than double the entire number of the previous seven years. However, compared with the Shanghai and Shenzhen stock exchanges, the OTC market is still underdeveloped, largely due to stagnant trading activity and lack of liquidity.
According to Industrial Securities, shares of more than 60 percent of companies listed on the over-the-counter market have never traded since the market was established. Only 10 percent of company shares were traded in August, prior to the launch of the market-making system.
Analysts blame an inefficient trading system for the board’s failure to provide cash flows for small firms.
Prior to the adoption of the market-making system, equity transactions were made through a so-called “negotiated transfer system,” under which buyers and sellers reached agreements through negotiation.
“This method led to higher costs and thus impeded market activity,” Jiang Jinfeng, analyst with Huatai Securities, wrote in a report.
Limited liquidity resulted in the undervaluation of shares on the New Third Board.
In 2013, the average return on equity ratio for companies listed on the board was 0.12, higher than the 0.09 ratio of companies listed on the ChiNext board, a bourse designed for start-up technology firms. But the price-to-earnings ratio for the over-the-counter market was only 15.10, compared with 60.35 on ChiNext.
Under a market making system, a market maker holds a certain number of shares and is ready to buy or sell at displayed bid and offer prices.
The system is supposed to ensure continuous market activity and improve liquidity.
“With a better knowledge about underwriting companies, market makers are able to offer prices that can better reflect the fair value of a company,” said Jiang. “The valuation of companies listed on the board is expected to get a boost following the implementation of the market-making system.”
Tang Zipei, analyst with Orient Securities, estimated that annual turnover on the over-the-counter market will rapidly expand to 56.2 billion yuan in 2018, up from 3 billion yuan last year.
However, the reality seems to be less optimistic.
Despite a surge in the number of transactions, turnover on the first day of market-making slumped by 46 percent from the previous trading session as investors turned wary.
China’s securities regulator imposes less stringent requirements for companies listing stocks on the over-the-counter market. For example, applicants are not required to be profitable at the time of listing. That results in an uneven quality of listed companies and requires a high level of market expertise to place sound investment bets.
Moreover, there is no daily limit on price movement of shares as there is on the Shanghai and Shenzhen exchanges. That creates the opportunity for extreme volatility. In one example, the movement of shares in Shanghai New Eyes Medical Inc reached 351.67 percent on August 25.
In an effort to avoid an orgy of speculation, the securities regulator has set high thresholds for investment in the over-the-counter market. Under current rules, only individual investors with securities assets of 5 million yuan or more are allowed to invest in the market.
Gui Haoming, chief analyst of Shenyin &Wangguo Securities’ research institute, said the threshold is too high, keeping most investors out and impeding liquidity.
Less than 0.3 percent of securities trading accounts have assets of more than 1 million yuan, according to Gui.
“Market makers alone are not enough to ease the liquidity crunch,” said Gui. “It’s necessary to lower the investment threshold to create a wider investor base and more liquidity in the market.”
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