help me out on this one (I can’t figure out if it’s ok on an ethics point of view):
say you are a broker with a block of a million illiquid shares to sell OTC at a discount to market price. Say 5% discount on previous close.
you can sell half to long-term investors
you can sell the other half to arbitrageurs who you know will dump your shares on the open market
–> The logical thing to do it seems would be to sell the first half to the arbitrageurs who will push the stock down, then to the long-term investors who will buy at a lower price thanks to the arbitrageurs; everybody is happy. If you do it the other way around your long term investors won’t be very pleased about the share price crashing soon after they purchased the stock.
My question: something about it feels like market manipulation. What is your take on this hypothetical scenario ?
I understand that if you do a block trade, usually you have a counterparty on the other end of the trade who is going to chop up your block and sell it to someone else. But can you honestly say that you know why the final buyer is buying your securities or not? Is it an HFT guy? Is it a long-term investor? A swing trading hedge fund?
I think we’d have to have more certainty about who’s buying what and why before we conclude that market manipulation is going on.
If you or a buddy of yours plan to be one of the long-term investors benefitting from a dip in the price, that’s a different story. Here you’re using your firm’s market impact to generate a benefit for yourself, and that’s problematic. But anonymous buyers? I don’t think you have a huge case for market manipulation if you don’t know who they are and what they actually want.
Presumably, the bulk of the stock will eventually get into the hands of long term holders, because short term holders will by definition hold the stock for a short time. But by then, the market impact of your trade may well be over and corrected again.
In the case that I am describing the broker does know each of the buyers, i.e. he is not going through the open market to sell the shares. The shares go from account A to account B directly without going on the market. And he knows exactly what the buyers will do after they purchase the shares:
the arbitrageurs who bought the shares (at a discount to market price) will dump them,
the buy and hold investors will keep their shares, at least in the immediate future.
the broker is not benefiting from the market impact in any way (this is very important), he is just “optimising” the market impact between his buyers
That sounds like what an honest broker is supposed to do. As long as he’s not getting kickbacks for it, he’s allowed to provide services and best execution.
Long term investors probably won’t care too much about a blip in the price from arbitrageurs (as long as the effect is not larger than 1 daily SD or 1 daily ATR, since their decision to buy is not based on minute-by-minute pricing. They will appreciate a better price nonetheless, because - if you can get it, why not.
What is the size of the expected arbitrageur market impact as a fraction of daily SD in stock prices??
I’d bet a lawyer can make a case for manipulation, and probably a lot of market manipulation is argued as some kind of optimization. Still, if it’s a private sale to final buyers and not on an open exchange, you can name any price you want that they’ll accept.
I have a lot of experience with this, I’ve probably been involved with at least 75-100 block trades, probably about half of which we actually executed (the rest we passed), and have done this domestically and internationally in Asia.
The answer to your question is that the block traders need to facilitate the transaction for BOTH sides, both the buyer and the seller. So if you hose the buyer on the price first, he will go to another trader next time. There are not that many traders in the US, only maybe 3-4 firms that are really into the business (at least in small caps, which is where you get the 5% blocks usually). It has to be above board and honest, otherwise that trader loses the account.
To clarify, there are a lot of block trading desks on the Street, but very few that don’t do any prop trading as well (or whatever they call that now after Frank Dodd). If GS calls you with a block, they probably already passed on it for the firm’s account, so you get crappy inventory. If Jones calls, it might still be crappy, but at least you know they did not shop the block internally first.
This also works as a client – if you try to front run the trade by shorting a bunch or the price starts to move weirdly, you might be cut out of the flow next time. It’s not 100%, but people are fairly well behaved because they want to be in the flow over time. Also any skilled trader doesn’t flash a 5% block, they nibble strategically starting with the other largest current holders (not uncommon to have many 5% holders in microcaps depending on the stock and liquidity – many of these stocks trade by appointment only, there are perhaps hundreds of these in the US market, maybe over 1,000 depending on how you measure it).
A nibble might be, “I have 50,000 shares of this stock, and I might be able to do more – do you have interest?” That’s not much if the block is 1,000,000 shares but no one comes out and flashes a million shares.
Also the price usually does drop a bit during the block – even if you are not in the flow but watching the stock you can see it is trading funny, but it usually doesn’t get its face ripped off, down 30% or something, and it will usually bounce back up in my experience after the trade clears.
Block trading is among the most fun I’ve ever had in the stock market. My old boss (who is crazy) used to run into my office and say, “There’s 5% of this company up for sale, it’s a million (or multi-million dollar bet), I need to know in an hour, try not to f–k it up.” Inevitably it was some obscure microcap I had never heard of, so fun
in illiquid stocks, since the order book is so thin, an arbitrageur with access to a significant number of shares @ a discount can and will push down the price until he reaches his purchase price, theoretically. So in this case, the market impact will be the size of the discount given on the block trade. This is theoretical, but I have seen it happen this way in microcaps.
when you say that you go to the owners that already own blocks of the stock (in your example 5%), not sure about the USA, but in continental Europe this info would be public. So where is the broker’s value added ? Can’t the original seller of the block not contact these counterparties directly to cut the broker out of the deal ?
when you say that as a client you might be cut out of the flow next time if you start shorting right away, that is precisely the purpose of my OP: how about selling first to these clients, and then after selling to the long-term investors ? I understand in any case that you cannot sell too much to arbitrageurs, because you will crash the price and the person holding the original block won’t be happy about it.
as per your funny example with your crazy boss who asked you to recommend on a block trade within an hour : on these types of deals, what was your firm’s strategy ? Arbitrageur or long-term investor ? Blend of both ?
No, if this was unclear let me clarify: The broker interacts on behalf of buyer and seller. If you want to sell, you go to the broker. If you want to be a sometimes buyer, you establish a relationship with the broker. He/she then plays both sides. If you went directly to a potential buyer not only would that be time consuming, but they would definitely front run you. The information is public per 13G/D and 13F filings.
I don’t understand your second question, can you clarify?
Long-term investor, I don’t recall we ever flipped blocks but maybe we did if we bought one and later decided we didn’t want to hold it. It’s competitive though, it helps to be the fastest gun in the West, which we definitely were. If 5% of a trade by appointment stock is up at a big discount, it’s not going to stay up forever. They will usually trade within 1-2 days tops. It was a big advantage if we could pull the trigger within 1-2 hours. We had some errors of omission like one stock that was a big homerun (we passed because I got the CEO on the phone and it sounded like he was drunk and sucking a jolly rancher during the call – who eats candy during a business call, wtf?!) but I don’t recall we ever bought something that tanked later.
what do you mean by "If you went directly to a potential buyer not only would that be time consuming, but they would definitely front run you" ?
Sorry, I guess I wasn’t very clear: what I mean is that imagine that you are a broker with a block to sell @ a discount to previous close. Ideally, you only have clients that you know will keep the shares, like say, equity funds. In this case there is no market impact because the shares don’t even reach the open market.
Yet imagine that you have both types of clients: the clients that you know will dump the shares on the open market, and clients that you know will keep the shares. Assume that you need both types of clients to sell your block. My idea was to sell first to the ones that will dump it. The immediate consequence is that the price will drop. Then, with the price down, sell the remaining of your block to the long-term investor, so everybody wins.
If a random seller contacted you about purchasing a large block in an illiquid stock and the negotiation revolved around price, why wouldn’t your incentive be to try to knock the price down? That makes sense. Of course they would do that. If you have a trader represent both sides, that is no longer an issue because they are trying to get paid from both sides, so the interests are more balanced.
It does usually trade at a modest discount, so there is still a market impact but it is minimized. Almost all the funds participating in sub-100mm market cap blocks are longer-term equity funds to begin with. An arb fund trying to flip the blocks would hate this business since it is so illiquid and they are relatively expensive to trade anyway. The only funds in this business over time are practicing time arbitrage, which is a different arb than what you were talking about in your original posts.
You don’t need both types to sell your block. Anyone who buys and then dumps blocks on the open market is going to be out of business sooner rather than later because they will be selling most of those at a loss. Let me stress how illiquid many of these blocks are. The term used is “trades by appointment only.” Your scenario requires a sucker, and there are no suckers long-term in this market.
I’ve seen blocks trade in under 5 minutes. Realistically it would usually take 1-3 days on average for the entire block to clear but it depends on the company and the size of the block. We had a big advantage because the guy I worked for is the fastest gun in the west.
Hopefully that answers your questions, I think you are overthinking this a bit, there are no microcap block flippers, that business doesn’t exist. The closest equivalent to that is people taking large open-market stakes in stocks before the quarter, but that only works in highly liquid stocks. You have to realize that most of institutional Wall Street is managing a significant capital and is actively avoiding stocks under $250mm, and arguably under $500mm – which is why the greatest inefficiencies in the market occur in these cap ranges. Above a $1B and it’s significantly more competitive still.
I know in theory that you are right about the microcap liquidity problem for eventual arbitrageurs(you just have to look at the order book, it is so thin that you only need to sell 10.000 shares to massively crash the price).
But when volume doubles on the day that the block is traded, it is either that some shares of the block are hitting the market, or that existing holders that are not involved in the block trade are selling, right ?
It depends what you mean volume doubles. There are $2.00 stocks that trade 20,000 shares a day. So the volume doubles and $80K of stock trades instead of $40K. So? It could be just two algos getting together in the same price range, which may or may not have anything to do with a potential or ongoing block sale. Your question seems to answer itself – for there to be any transaction, existing shareholders have to be selling (by definition).
