IR and Market Makers in the Mix

Pretty much everyone who deals with small-cap stocks in Canada has complained about sluggish trading volume at some point. It is often an issue for companies with small floats or market capitalizations - "pico-caps", as one portfolio manager fondly calls them.

Other than market cap itself, growing companies face other barriers to becoming actively traded. Often the stock is closely held, and it may seem like only a few people are even aware of the story. For such companies, it can be very difficult to get on the radar of the big traders, and as a result the stock is not likely to be a hot commodity.

Management should remember that the company's stock is essentially one of its products. Just as with regular inventory, there should be turnover. A good indication of liquidity may be a one-times "turn" every year. Many small companies will never witness this, though there are some tricks in the IR toolbox that can help. These include a well-presented strategic message, a solid communication program, and market-makers. In fact, the three work hand-in-hand, but it’s important to understand the role and mechanisms of the sometimes-maligned market-maker.

Very simply, a market maker is an investment dealer who, accepting the relative risk of carrying an inventory of shares in order to facilitate trading, commits to both buy and sell orders and hopes to profit from even small variations in a stock price. Confusingly, a wide range of obligations and benefits characterize market making in different stock exchanges and OTC dealer markets.

For example, CNSX has a voluntary market-making system with multiple market makers allowed in each stock. CNSX specifically requires designated market makers to… “maintain firm, two-sided quotations … reasonably related to the current market for at least one board lot on each side.” This is accomplished by the market maker placing orders in the electronic order book alongside client orders so that the client orders do not lose priority. The first order in at a price is the first order to trade at that price, no matter whose order it is. This keeps the spread – the difference between buy and sell prices – tight and facilitates fair trading.

Some exchanges, notably the NYSE and AMEX, used to have a so-called market "specialist" who acted as the official market-maker. In exchange for their services, specialists were granted some advantages in both trading execution and company information. Unfortunately, this type of arrangement can be perceived as unfair, though the obligation of the specialist is to help maintain an orderly market. NYSE recently dropped its specialists altogether and allows multiple firms to be market makers.

Dealer markets that operate without a central order book, like some which still operate in the US, suffer from poor reputations due to the lack of a trading system that ensures client priority. Moreover, the LSE AIM market, for example, is currently facing some pointed criticism because through the autumn of 2008 several market makers picked up stock at ‘distress’ prices, sometimes as little as ten percent of their quoted bid. This type of behaviour serves to cement bad opinion, which in fact has some basis in history.

Years ago, broker-dealer market-makers were supplemented by shady characters who would contract to have stock issued from treasury in order to trade on the company's behalf. A more stringent regulatory environment in Canada has thankfully put paid to this practice. The one potential advantage was that the shady guys would pester the company for news so that they could talk the stock up, and getting all the news out is a necessary component of an efficient market.

No matter the history, the market maker plays a key role in providing liquidity for the shares of emerging public companies. CNSX, understanding this, has developed a strong program which is free to all listed companies (unlike some situations, where the company covers the cost of the market-making itself.) When a new company lists, notice goes out to the trading community, and firms interested in market making submit applications. The market makers use their firm's capital to buy and sell, and commit to maintaining a two-sided market for a minimum of 90 days. They are rewarded with trading fee rebates for passive trades in their designated stocks. That means that they are rewarded for placing orders in the book that investors can trade with, thereby providing liquidity.

Despite the distinct qualitative differences, market makers today still require regular news from the companies they cover. They need up-to-date public information in order to establish fair bid/ask prices. (It is important to note that market makers should not be privy to information not in the public domain. CNSX market makers are governed by the Exchange Rules and the Universal Market Integrity Rules followed by all marketplaces in Canada.)

Market makers work in real time - they should be able to connect with your IR contact about your stock at any moment of the trading day, just as you keep an open line for the investing public. IR communications are the most effective conduit for market makers to get the regular information they need to help provide liquidity and reduce volatility. Ensuring that your IR contact and your market maker have a good working relationship can be an important part of the overall IR program, which will provide all participants with current information, thereby engaging interested investors and liquidity-enhancing market makers.