It is often assumed that the ability to trade immediately is a high priority for all investors. However, the variety of investor reactions to the NZX’s suspension of trading following the DDoS (Distributed Denial of Service) attacks in 2020 has shown that for many investors, a lack of immediacy can be an inconvenience, but it is not the biggest consideration in investment decisions.
The NZX, like most stock exchanges, is a continuously traded market, meaning buyers and sellers can usually trade at any time, while the market is open. A licensed market with continuous trading must also impose continuous disclosure requirements on listed businesses. This means there is an obligation for those businesses to continuously update investors with any information that may influence the market price or value of the business.
This continuous disclosure requirement is one of the reasons small to medium-sized businesses (SMEs) find traditional public listings unrealistic: The cost and resource required to make sure the business continuously discloses all material information can take the focus away from running the business. However, even ignoring the direct costs of continuous disclosure, for some businesses continuous trading may not be in the best interests of either the business or investors.
In research published by the Federal Reserve Bank of New York, trading on major continuously traded markets showed, “buyers and sellers tend to arrive in clustered fashion”. Simply put, the presence of buy and sell orders in a market will encourage traders to believe they will receive a fair price, encouraging more traders to submit their buy and sell orders. Conversely, the absence of orders increases the risk that traders won’t receive a fair price, which further discourages more orders.
This downward spiral of illiquidity can be seen in smaller business listings on many major stock exchanges, including the NZX. Their low trading volume further discourages investors, meaning until there is sufficient demand for regular trading, these businesses can suffer all the costs of being listed on a continuously traded market, without gaining many of the advantages.
Periodic auctions, a widely accepted method for transparently and fairly defining the market price for financial products, may provide a solution to the issues suffered by SMEs . Often known as “call auctions”, these auctions are used at the beginning and the end of the trading day in most stock exchanges, to determine opening and closing prices. Generally targeted at less frequently traded shares, a few stock exchanges even solely use call auctions, rather than allowing any continuous trading.
In a call auction, all orders are ‘batched’ together for simultaneous trading, at a single price, when the auction closes. The single price is determined by the value that maximises the volume traded, based on the total buy and sell orders. Buy orders at this price and higher, and sell orders at this price or lower, will generally be successful (but will all trade at the same single price). By bringing all willing buyers and sellers together at one time, periodic auctions can generate sufficient trading volumes that encourage more investors to trade.
Some investors may perceive periodic trading as a limitation, because when the market is open, they are not able to transact whenever they choose. However, for SME shares that don’t trade regularly, periodic auctions tend to produce a fairer price for all investors – and therefore may encourage more trading (liquidity).
In a continuously traded market, the costs for investors trading SME shares can be very high. Aside from the risk of getting a price that doesn’t reflect the true value of the shares, the economic costs include large bid-ask spreads, high commission, significant market impact of individual orders, and the susceptibility of orders to ‘front-running’. Front running is where other investors take advantage of the temporary price movement a large order may cause, to the detriment of the investor who made that order. This can discourage investors from trading, making liquidity even worse.
Periodic auctions reduce trading costs for investors by consolidating all order flow, over a period of time, and executing all successful orders at a single price. Consequently, this eliminates bid/offer spreads and the possibility of front-running. The increased ‘fairness’ in pricing can encourage investors to submit any orders.
As well as benefitting investors, any maximisation of liquidity can also benefit the listed businesses. Liquidity increases the desirability of shares, making it easier for the business to complete future capital raising, which can help business growth.
Beyond increasing liquidity for SME listings, with information disclosure required before each auction, rather than continuously, periodic auctions are a trading mechanism that reduces costs, resource requirements and the regulatory burden for SMEs considering a public listing.
A reduction in ‘short termism’ is another factor to consider. Continuous trading and subsequent media scrutiny can incentivise a focus on outcomes that have an immediate positive impact on share price. Publicly listed businesses are facing greater pressure from investors to deliver short-term results at the expense of longer-term growth. This can have a significant influence on formative business decisions that ultimately impact the long-term health of the business. You can read more about short termism here.
Catalist is New Zealand’s stock exchange for small and medium-sized businesses, allowing investors to trade shares, debt securities and other financial products using periodic auctions. You can read more about how Catalist’s auctions work here.
Catalist’s Public Market acts like a traditional stock market, but the use of periodic auctions is designed to lessen the cost and regulatory burden for SMEs. Businesses are able to publicly raise up to $20m per year without needing to complete a costly ‘regulated offer’. For these reasons, Catalist can also be considered a ‘steppingstone market’, where businesses can transition to a more traditional stock exchange, such as the NZX, as they grow. This provides SMEs with the benefits of a public market, without experiencing many of the disadvantages of a continuously traded market.
Interested? Sign up for a Catalist account to stay updated with upcoming investment opportunities, or register your interest more information about how Catalist’s markets could work for your business.
By Michelle Polglase