I find this audio file rather illuminating. It is a recording of an exchange between a client of GNI Touch (Man Group) in the UK, and a broker from the firm. Have a listen, but be warned it is full of expletives and foul language
The funny thing is I tend to be on the side of the client! Whilst there is no excuse for the foul language and abuse, this exchange highlights some practices in the UK that are simply antiquated and leave the retail client subject to manipulation. If you can put aside the abuse, the client is making a sound point here and the broker is really trying to fob him off and cost him money at the same time.
Let's look at what I think happens in this call. I will fill in some details for the international reader.
- The client wants to buy 25k of Taylor Woodrow (which was one of the top 350 companies in the UK at the time) in the middle if a bear market whereby investors were dumping
- The broker 'goes to market'. In reality, this involves him calling the market makers and telling them he has an order to fill. In my experience, what usually happens is that the broker calls the 2-3 that he normally deals with or who he thinks normally hold this stock. As part of the unwritten 'convention' the broker usually gives the market maker an indication of the size
- All the market makers come back and say they can't fill the order. This then gives them an opportunity to raise the 'offer' price so they can take advantage of the situation
- The broker goes back to the client and suggests he tries to 'work the order' by leaving it on the order book. Again, this subjects the client to having the market raise the price on him.
Market Makers Abuse?
I want to point out a few things. Markets makers tend to know each other and in the City of London, great emphasis is put on the sociable aspect of networking and getting to know one other. Market makers and brokers are constantly doing 'favors' for each other. Unfortunately, these 'favors' can sometimes expose clients to unnecessary costs.
In this case, the client is-rather inarticulately-pointing out that he wants his order filled by the market maker and doesn't want to be subject to prices being moved against him. The stock is, after all, a mid cap UK Company. The broker keeps trying to get him to accept paying the cost of not being able to do this. This is why the client keeps insisting that he speak to someone who can fill the order. In other words, he wants to talk to someone who can call the market maker and say 'do me a favor and fill this clients order'. Eventually, he gets put through. I suspect it got filled.
How Market Makers Work
The essence of the problem, and cause of the invective, is the antiquated way in which market makers work. It is out of touch with modern day practices. I note the betting industry via exchanges such as Betfair has allowed consenting adults the freedom to trade with each other at a price that they see fit.
Why is it that the UK stock market can't do this too? Not all stocks are traded on SETS, and even many that are, don't get much liquidity from market makers. This is a serious issue. Investors are unnecessarily paying wide spreads in small cap stocks (market makers can't be bothered to make markets in small companies) and the system is open to abuse by chummy market makers and brokers.
It gets worse. I think that there is an 'AIM discount' that is being mentally applied to small cap stocks. Given some of the outrageous spreads that market makers gave investors in 2008, many will simply not trade these stocks again. I am highly reticent to buy a stock unless I can trade it directly via Level 2. Moreover, all investors are loath to buy a stock with a 3-10% spread and then be subject to manipulation from the very people who are supposed to be providing liquidity! This causes a problem for small companies because they won't get supported. Moreover, AIM market listings will slow if companies are faced with this problem.
The Financial Services Authority (FSA) should act to ensure individuals can trade with each other in an open and fair market. After all, it is the essence of capitalism.