12 July 2010
With all the recent fuss about alleged "manipulation" of property prices, which we discuss in our Conduit controversy article today, we think it is time to reset public expectations about the purpose of markets and reliance on market data, and it is also time for the Government and SFC to review their approach to "market manipulation" cases. Hardly a week goes by without some petty "criminal" being convicted for entering bids or offers into our stock exchange's order-driven trading system, but is this regulatory time and money well spent, and does the law and its enforcement create unreasonable expectations from investors about the information in market prices, volumes and order queues? We say it does.
What are markets for?
The primary purpose of stock exchanges is what their name suggests - to allow willing buyers and sellers (and issuers) to come together and exchange shares for cash at prices they find acceptable. It is only an incidental effect that it generates a stream of reported transactions, which might, if the market is deep enough, give you some guide as to what price your shares are currently saleable for. The displayed order queues of bids and offers are just that - binding bids which sellers may hit, and biding offers which buyers may take, resulting in executed transactions. The queues should not in themselves be expected to yield information about future prices, or about supply or demand which is not displayed.
But the SFC and the law adopts the view that investors should be entitled to an information signal purely by looking at the market activity and order queues, rather than, or in addition to, actually knowing anything about the company's fundamentals. This attitude encourages ignorance and gambling (or day-trading) rather than informed investing. Regulators think that a large bid queue should mean that a price is going to go up, and punters are entitled to rely on that signal and benefit from it, not that there are just lots of bids. Why should it mean anything more than that?
Numerous professionals and academics, with large amounts of computing power at their disposal, have tried to tease predictive value out of market data, either with short-term or long-term prediction horizons. Very few succeed. Where they do find a signal in the noise, their advantage is usually short-lived and competed away. Of course, if there was a clear signal in the market data, then we would all be able to profit from it, thereby creating a positive outcome in a zero-sum game, a logical impossibility. So at best it can be said that only the most skilful participants can glean any predictive value from the data generated by other participants' actions.
Logically, if the market data have no information value, then manipulating the data shouldn't make any difference to that information value. Unfortunately, global laws on market manipulation tend to encourage, and are founded on, the mistaken belief that market data do have some information value and should be relied upon and incorporated into investment decisions. A paradigm shift is needed.
Let's examine the taxonomy of market manipulation offences commonly seen in HK:
Type 1: affecting the bid or offer queues
Often, the thrust of the charge is that the wrongdoer "created a false and misleading impression of supply and demand" by entering bids when he was also selling (although the opposite is also possible - entering sell orders when you are trying to buy more of a stock you already hold). In our view, there is nothing wrong with that - any bid in the system is binding and may be hit by a seller. It is not in that sense a "false" bid.
What these punters are doing is what the professionals call "algorithmic trading" or "order management" - trying to mask your intentions by placing orders on both sides of the market, or posting small slices of the order you actually want to execute (sometimes called an iceberg order, because only the tip of the order is shown) in order not to push the market away from you by shifting the apparent supply/demand balance. The queues are not an "impression of supply and demand", so they cannot be a true or false one - they are only an impression of current orders, no more or less than that.
For example, let's say you intend to sell 1m shares of a company at the current best offer price, but you only offer 100,000 shares initially. Simply by not entering your full supply as an order, the result is that the offer queue does not reflect the full supply. Alternatively, you might put in a bid for 100,000 shares (at or below the best bid price) and an offer of 200,000, so that your net order is still the same. If both orders are executed, you will have sold a net 100,000 shares and made a small gain before costs. Still, you are not displaying your full intent to sell 1m shares, and you are on the bid too. Is that bid really a "false" bid? Is that market manipulation?
People who enter bids and offers, whatever their motive, are entering binding, executable orders. In so doing, they cannot reduce liquidity or make the bid-offer spread wider, and they often improve it. Prosecution of this offence simply risks depressing market activity, because someone who enters offers when they are trying to buy more of a stock they own, or bids when they are trying to sell, might be accused of manipulation.
Type 2: stock ramping
A second type of manipulation offence is longer-term (not intra-day) "ramping" of stock prices. This usually involves cornering the shares in a stock so that only a small percentage is held by people outside of the wrong-doers' syndicate. That's by necessity: if the stock were widely held, then it would not be so feasible to shift the price away from fundamental value. But is there really any victim in this? If you are one of the few outside shareholders, and you see a stock rising far above what you think is reasonable, then you are not a victim, you are a winner. You are free to sell, and you will often be hitting a bid from the syndicate if you do. And if you buy the stock at an inflated price without doing your homework, knowing nothing about its underlying value, then you are a gambler, not an investor. You are relying on a market signal which shouldn't exist. You only have yourself to blame if the bet goes sour.
The best regulatory approach to this is to provide good disclosure about the distribution of shareholdings in a company. The SFC does that with its occasional concentration warnings, but usually only after a price has been ramped - they don't normally investigate and issue warnings purely because of apparent concentration. Webb-site has an ongoing CCASS Concentration Analysis of the distribution of shares in the clearing system. While most CCASS Participants are not beneficial owners, this does provide some guide to the diversity of shareholders in a stock. Webb-site also occasionally publishes Bubble Warnings when time permits.
Type 3: fixing the close
In another type of market manipulation offence known as "fixing the close", almost every day of the week, we note a last-minute small transaction, or a small bid or offer, in one or more of the 30-40 small-cap stocks we hold, shifting the price up (or sometimes, down) by a few ticks (a tick being the minimum increment or decrement in a stock price). This, the SFC says, fools tomorrow's investors into paying more (or selling for less) than the previous price. Why should that be the case? Nobody has to pay more for a stock, or sell it for less, than they think it is worth.
When you have small, thinly-traded stocks with wide bid-offer spreads, the price can bounce around between the bid and the offer like a ping-pong ball. For example, if it is bid at $0.48 and offered at $0.52, it is just as likely to close at $0.48 as it is at $0.52, an 8% range, depending on where the last trade is printed. There is no unique "correct" market price. If the price stands at $0.48 a minute before the close, and someone then puts in a single board-lot order at $0.515, then if nothing else happens, the last quoted price will be 7.3% higher than $0.48, but 1.0% lower than $0.52. That doesn't make the closing price in any way "wrong" or misleading - it is just a closing price, and is in fact closer to the mid-point between what other bidders are willing to pay and what other sellers are willing to offer. In that sense the manipulation results in a "fairer" price.
If investors place any reliance on the previous day's prices, when judging what bid or offer to make the next day, then they should be looking at the VWAP - the volume-weighted average transacted price, not the closing price. Webb-site calculates VWAP daily for each stock - just enter the stock code at the top of any page and choose "Raw Prices".
Type 4: volume inflation
Another type of market manipulation offence involves not prices, but volume. A group of closely related traders will place similar or matching bids and offers, executing trades without increasing or decreasing their combined shareholdings, and thereby raising the volume and number of reported trades. Here, the offence relies on the implicit view that investors are entitled to regard past volume as a guide to future volume. But why should that be the case? In individual stocks, and across an entire market, volume can ebb and flow. If everyone wakes up one morning and is happy with what they own, then there will be very little volume. If a popular stock has been accumulated by long-term investors who see value in it, then its volume may shrink until one of them is willing to sell. If there is a lot of uncertainty about the future of a company, good or bad, then volume will usually increase along with volatility. So all that investors can assume about volume is that in the long-run it usually is proportionate to the number of freely-held shares or "free float" (outside of directors and controlling shareholders). It is irrational to assume that a substantial increase from the long-run average is sustainable, and that reliance should not be encouraged.
By making volume-inflation an offence and then occasionally prosecuting, lawmakers and regulators have created an expectation that investors should be able to depend on reported volume as a guide to future volume. They shouldn't. Free float is a guide to potential volume, and that is about all.
Derivative fraud offences
In our view, the only victims and wrong-doing arising from the above activities is when there is a "derivative fraud" against persons who are not unrelated buyers, sellers or holders of the stock, but are holding some other financial instrument which is priced by reference to the stock, or are receiving fraudulent advice in relation to the stock. For example, if someone inflates the market price of a stock in order to boost the value of a mutual fund, and then redeems units in that fund or collects a performance fee as manager of the fund, then he has defrauded the fund holders.
Another example is where someone depresses a stock price and then gets his listed company to grant share options exercisable at the depressed price. That's a fraud against the company and its shareholders.
A third example is when a stock or group of stocks is momentarily depressed in order to trigger a "knock-out" in a related option (when a target price is reached), such as a Callable Bull/Bear Contract. There, the fraud is against the contract holders, but not against people who were lucky enough to buy stock at depressed prices in the market.
A fourth example is where someone who is involved in a stock-ramping scheme advises clients to buy into it - otherwise known as a boiler-room scam. There, you have fraudulent advice to clients.
In all such cases, with sufficient evidence, prosecutions for fraud should be brought, and that is where the focus on trading-related offences should lie.
Shill bidding in auctions, and eBay
Outside of stock markets, a similar area of misguided legislation in some places around the world relates to shill bidding - that is, bidding for your own items in an auction using a "shill" - a nominee or different name. This is similar to what the SFC might call a "false bid" in the market from someone who is selling shares, except that there is usually only one item in an auction rather than the continuous auction in markets. Again, if you want to bid for an auction item, and know what something is worth to you, then why should it matter what someone else bids for it, shill or not? You don't have to outbid them if you don't want to. If the seller wins the auction, he usually incurs costs and has to re-auction.
A buyer shouldn't expect other people's bids to tell him what the item is worth to him or what it might resell for. Yet in many countries it is an offence to bid in your own auction. Recently a UK eBay seller set a world precedent by pleading guilty to bidding for his own items on eBay, saying he didn't know that was illegal - and why should it be? He had also committed fraud by clocking back a minivan's odometer, but that is a different offence.
Amazingly, online auction leader eBay has a shill bidding prohibition policy which defines shill bidding far more broadly as "when someone a seller knows bids on the seller's item. This includes family members, friends (including online friends), roommates or employees." That's even if the person is bidding for their own account and not on behalf of the seller. eBay says they don't allow shill bidding because "people the seller knows might have information about the item that other members don't, which might give them an unfair advantage." How, exactly?
Let's look at both cases.
- If the friend has positive information, then she might bid higher than those without it, and win the auction. The winner gets a "better" item than the one described in the listing, which just means that the seller might receive a lower price than if all bidders had that positive information, and can only blame himself.
- If the friend has negative information, then the item is worse than described (e.g. faulty or defective) but the winner has recourse for fraudulent misrepresentation, having bid based on the listed description. That's true whether or not there is shill bidding.
Either way, it is hard to see how the shill bidding in itself disadvantages other bidders. In reality, it is almost impossible for eBay to prevent shill bidding, since it doesn't know who you know, and by claiming to prohibit shill bidding, eBay creates unreasonable expectations from members that it will be successful in enforcing the policy. If anything is deceptive here, it is the policy itself. It would be a far more sensible approach to remind members that "the seller, or someone the seller knows, may be bidding in this auction". Real bidders would probably still bid what the item is worth to them.
© Webb-site.com, 2010