Idiots Guide to the London Stock Exchange's SETSmm
18 Jan 2008
The LSE recently decided, in its wisdom, to extend the SETS
system to less frequently traded shares, and to ensure permanent liquidity,
they combined the SETS order book with the continuous liquidity provided by
firm two-way quotes from market makers.
Those of us who have traditionally invested in small cap AIM
listed stocks are familiar with the SEAQ trading system, where the share
trader/investor buys from and sells to a market maker, via his stockbroker. The
market maker is the middleman. His job is to do exactly as his name suggests -
make a market. Without a market maker, if you wanted to buy some shares, you
would have to ring around other shareholders and find one willing to sell to
you at a reasonable price. If you wanted to sell you would have to find a
willing buyer.
But the market makers relieve investors from such drudgery
by providing a point at which - within specified limits set by the LSE - we can
buy or sell as many shares as we wish. If the market maker doesn't have any
shares, then it's up to him to find some when we want to buy. He is also
obliged to take in shares, even if he has more than he really wants, if we wish
to sell. This exposes market makers to risk, and in return for shouldering that
risk, market makers expect to be paid. Their payment is the difference between
the price they are willing to sell at and the price they are willing to buy at.
In any one stock there will usually be several market
makers. Each will have his own set of buy and sell prices. For the purpose of
deciding what price investors can buy or sell at, all prices from the
individual market makers are set alongside each other, and the "best"
price rules. i.e. the lowest "offer" (the price at which the MM will
sell shares to you) and the highest "bid" (the price at which the MM
is prepared to buy shares from you). The gap between the two prices, often
quite large, is known as the "spread" and the so-called
"mid" price is halfway between them.
When an investor buys or sells stock from/to a market maker,
the transaction is reported to the stock exchange. Each transaction is, of
course, both buy and sell. You are the buyer or seller, and the market maker is
the other party in the transaction. However, only one trade report is required.
The transaction reports are published by the stock exchange with a trade type
of O, and services such as ADVFN,iii and MoneyAM, who have a "feed"
of information from the exchange, will list the transactions on their Monitor/Watchlist
and Trades pages. Some years back, all the online services thought it would be
a good idea to attempt to list these transactions as buys or sells, and devised
a guesstimate system - if a transaction is executed at a price above the
mid-price, it is placed into the buy column. If executed below the mid-price it
is placed in the sell column.
Now, unless trading is intense and prices moving rapidly,
these buy/sell columns are fairly accurate, and represent a reasonable estimate
of the amount of buying/selling BY investors FROM/TO the market makers. Some
large trades which are multiples of the Average Daily Turnover are published up
to three days after execution, which can distort the numbers. (See the LSE
website for the post-MIFID parameters re: the new reporting regime.) But by and
large they enable a reasonable overview of supply and demand.
So that's SEAQ. Love it or hate it and its big spreads, most
punters are familiar with it and some even understand how it works. You could
describe it as "the devil you know"!
In the meantime, on the main market, for the big boys, there
has been another trading system. Known as SETS - the Stock Exchange Electronic
Trading Service - it was introduced at Big Bang time in 1997, when the LSE
moved from its traditional trading floor, where brokers and market makers met
in the flesh to do their deals, to an automated system run by computers. Used
for the trading of shares in large companies with high liquidity (i.e. lots of
buying/selling activity) SETS cuts out the middleman.
In simple terms, those who have access to the SETS order
book and have shares for sale will enter a sell order on to the book. Those who
wish to buy will enter a buy order into the order book. The system will
automatically match up buyers and sellers who match on price - often one large
order will be matched up with several smaller orders on the "other
side". The matched orders are removed from the book, and a transaction is
executed between buyer and seller. Again, each transaction is both buy and sell,
and again, only one transaction report is required. These automated trades have
a trade type of AT.
The LSE recently decided, in its wisdom, to extend the SETS
system to less frequently traded shares, and to ensure permanent liquidity,
they combined the SETS order book with the continuous liquidity provided by
firm two-way quotes from market makers. The result is SETSmm - "or the
devil we don't yet recognise!"
SETSmm is gradually being extended further and further down
the liquidity rankings, and now there are many AIM stocks - mostly those with
market caps that are, or have been, £100 million or more - traded on the SETSmm
system. More recently, post-MIFID, the parameters of SETSmm have been extended
to the entire SETS system - thus providing liquidity via the order book AND
firm two-way quotes from market makers across all stocks, even the FTSE 100.
And thereby lies the rub. Private investors used to SEAQ are
finding it difficult to get to grips with SETSmm, and many do not even realise
it is now a dual system: a SETS order-book driven system supported by firm
quotes from MMs, running in parallel with a SEAQ-like off-order-book system.
The way it works is this:
Those with Direct Market Access can - and do - enter buy and
sell orders at specified prices on the relevant side of the SETS order book.
Orders on each side of the book are listed by price, with the best at the top,
and where there is more than one order at a given price, in order of the time
the order was placed. Orders are matched against each other using these
priorities. Order matching and trade execution, followed by the single
transaction report, are carried out exactly as per SETS. However, because there
may not be sufficient activity on the order book in the less liquid stocks to
enable a fair price to be set and to enable trading on demand, MMs also show
their firm quotes on the order book. Their "buy orders" and
"sell orders" - familiar to us from SEAQ as the volume and price at
which they are each prepared to trade - are treated the same as any other orders,
except that their ID code is placed alongside their orders, whereas other
orders are anonymous.
Where buyers and their brokers do not have access to the
order book, shares are bought and sold away from the order book using the
familiar investor-broker-market maker chain as under SEAQ.
All well and good. The trouble starts when the transaction
feed from the LSE hits any of the online services used by most retail
investors. We have described above how each transaction carried out on or off
the order book is both a buy and a sell, for which only a single trade report
is required.
Trades with a type of O are the same as they have always
been - an off-order book transaction between an investor and a market maker. As
such, each individual trade can be said to represent a buy by an investor or a
sell by an investor.
But AT trades, as we have just seen, are trades directly
between buyers and sellers, without the intermediary of the middle-man. So what
are they? The online services will tell you they are buys or sells, depending
on whether the execution price was above or below the current mid-price. But in
fact, they are neither one nor the other - they are BOTH. Hence the way AT
trades are treated by all of the online services such as ADVFN, MoneyAM and iii
is misleading, both in terms of total volume and in terms of buy/sell balance.
Let's try an example.
I want to buy 50,000 shares in Acme Widgets Ltd. You want to
sell 25,000 shares. Your wife also wants to sell 25,000 shares. Our brokers do
not have direct access to the order book, so when we have placed our orders
with our brokers, they approach the market makers and get us quotes, which we
accept. The transactions are then executed. My buy will generate a trade
report. Your sell, and that of your wife, will each generate a trade report.
All will have a trade type of "O". We will see on our monitor or
watchlist a total volume of 100,000 shares, 50,000 buys and 2 x 25,000 sells.
Now suppose we all have direct market access via our broker,
and can instruct him to place our buy and sell orders direct on the order book.
Let's say the current price is 24 - 25p. I want these shares quite badly, so I
am willing to pay up to 24.5p and my buy order goes on to the book with a limit
price of 24.5p, and becomes the new "best price". Your sell order,
and your wife's sell order, both go into the sell column "at best".
My buy order of 50,000 is matched against your two 25,000 sell orders. A trade
is executed and a trade report generated showing a trade type of AT. The trade report
will be for 50,000 shares at 24.5p.
When that transaction hits the online services it will
probably be put in the buy column, as my "best price" of 24.5p has
now been taken out, and "best" is back to 24p. We will now see total
volume of 50,000 shares, all buys.
As you can see, although we have all bought and sold exactly
the same numbers of shares in each scenario, what we see on our PC screens is
only telling half the story re: the AT trades which have been executed on the
order book. In these circumstances, it's not surprising that traders and
shareholders used to the SEAQ system are misleading themselves? and therefore
putting themselves at a serious trading disadvantage - about (a) total volumes
and (b) buy vs sell activity as shown on ADVFN, MoneyAM, iii etc.
There is little that the online services can do about it, to
be honest. Although they could ensure that all AT trades were automatically
placed in the ??? column to differentiate them from the O trades.
In the meantime, for every AT trade that appears in the buy
or sell column on any watchlist or monitor, it's vital to remember that there
is an equal and opposing volume in the opposite column. O trades do represent a
fair picture of buying and selling by investors. AT trades only show the half
of it! Literally.
Source Article Proactive Investors