How could a fund buy a large set of shares?
Suppose a fund wants to buy 50,000 shares of company A.
Before decimalization, the market may have looked like the summary in figure 2
Fig 2
In order to buy 50,000 shares, you have the following strategies:
- Place a first market order for 22,000 shares.
This will cost you US$ 1375 more than placing the order at the bid, but at least the order will get filled.
This will however send a strong signal that "a buyer is there", making it more difficult for the left over 28,000 shares to be purchased at a good price.
- Place a Bid order.
However, since at the bid, 20,000 shares from another buyer have priority, the probability to be filled will be lower.
- You can try to buy 21,000 shares at the Ask, then sell 20,000 shares at the Bid, in order to push the price down, but that type of strategy is rather costly (because of the spread), especially when there are quite a few shares at the Bid.
Before decimalisation, lager players were moving the market, and you could see what they were doing. There was
market depth (also called
market visibility).
After decimalization, the scenario looks different. Let's suppose that the market book would be the following (20,000 shares at the Bid side and 22,000 shares at the Ask side, but separated into small orders placed at $ 0.01 intervals):
Fig 3
In order to buy 50,000 shares, you have the following strategies:
- Place a first market order (at the Ask) for 22,000 shares.
This will cost you $ 477 more than placing the order at the Bid (but still less than $ 1375, the cost of the spread that was effective before the decimalization).
This, however, will also send a strong signal that "a buyer is there", making it more difficult to purchase the remaining 28,000 shares at a good price.
- Place a Bid order. Since there are only 500 shares at the Bid, placing small Bid orders of a few thousand shares allows a slow accumulation of shares, as long as there is no other buyer who will push the price higher.
- Buy 9,500 shares at $10.20 (without pushing the price higher), and then sell 500 shares at the Bid, $10.19.
This would force the price down, and still enable a net purchase of 9,000 shares.
This small manipulation would allow you to accumulate shares at a good price without "showing your hand".
Decimalisation had the following consequences:
- It reduced the spread cost. As a result, bidding the price up was costing 6.25 times less than before
- The depth--the number of shares available at a given price--dropped significantly, because there was no advantage anymore for institutions to “show their hands” and place their orders in the queue. Indeed, when the spread was more important, a fund that wanted to buy shares had either to place an order at the Ask, increasing the price by $ 0.0625, or place an order at the Bid, but at the bottom of the queue. (Large exchanges respect the "first come, first served" rule, meaning that a new order takes the last position in the execution priority ranking of orders placed at the same price.)
- Block trading on the market became difficult and order fragmentation became the rule. Order fragmentation is when a fund places a large order by fragmenting that order into a series of smaller ones; these are usually placed at the Ask until a maximum limit is reached. When the limit is reached, the fund waits for sellers to appear and the price to decrease again before placing a new set of orders.