Floor price rule: How good intentions invariably turn into bad policies

Covid-19 has forced many of us into hard choices. Life came to a standstill for all of us and industries needed to adapt to survive. In a matter of days our nation, alongside the world, realised life would not be the same for the foreseeable future. Covid-19 came in suddenly like a tsunami and decimated lives, livelihood and business. And the impact has taken its toll on the stock market.

Since the middle of February till March 18, the Dhaka Stock Exchange General Index (DSEX) fell from 4,768 to 3,603. This sudden selloff in stocks forced regulators to enforce a drastic rule: a floor price for all listed shares.

The rule was simple. For all the stocks listed in the stock market, take the average closing day prices of 5 days before March 19, and decree that no stocks can trade below its newfound floor price.

The ultimate purpose was to ensure a complete shutdown of the selloff. This brought the market and its turnover to a screeching halt. Investors had no clue about what suddenly transpired and needed a few days to comprehend the impact of this rule. By the time they did though, the stock market was shutdown as the Government of Bangladesh declared General Holiday on March 26.

Fast forward two months and the stock market finally reopened on May 31 under a new Commission team in the Bangladesh Securities and Exchange Commission (BSEC) headed by Professor Shibli Rubayat. Investors started participating in the "new" stock market, where prices of the underlying assets could not go below a specific predefined price.

Investors and traders abstained from this synthetic price discovery mechanism as appalling low daily turnover came back in the stock market (numbers unseen in the last decade). Daily turnover before FPR in the Dhaka Stock Exchange Ltd. (DSE) was around BDT 400 crore. After FPR it averages around BDT 60 crore a day.

The FPR created a barrier for fair price discovery between market participants based on demand and supply, information and speculation. It "saved' the portfolio value of thousands of investors without actually adding any actual value to their equities.

This implementation of the FPR was lauded by the majority of retail investors (and still does) alongside few 'experts'. I would argue they never stopped to think about the unintended consequences of the rule and what it would imply for their investments going forward.

One of the consequences of the FPR was the sudden illiquid nature of the stock market. Where one would see the majority of stocks change value daily in a routine environment, most stocks are now stuck on floor price days after days.

Only a handful of stock currently trades in the DSE. For reference on March 1, 315 shares changed value with 53 remained unchanged. On June 17, only 37 changed value versus an overwhelming 232 stocks did not see any shift in price. This cannot be considered a functioning stock market.

Fund managers, especially foreign fund managers who needed to sell their equity positions due to mass redemption calls from their investors, starred stunned at this sudden illiquid market. Some even publicly remarked against this BSEC rule and threatened future boycotts (not investing in Bangladesh again).

To cater to this growing number of redemption calls, an additional directive was issued and implied on June 14. A change in block market trading. Block market is a tandem trading board whereby large buyers and sellers can transact large quantities of shares privately.

There are a few fundamental differences between the main market and the block market. The main difference being in the main market, any investor can participate by buying or selling a minimum of one stock regardless of the value of that share.

In contrast, in the block market, the minimum amount of any transaction has to be Tk500,000 irrespective of the number of stocks. Traditionally block markets are used by high net worth investors or institutions for carrying out more substantial quantities of trades.

Before the June 14th directive, block market transactions couldn't occur below the floor price. To facilitate larger investors/institutions to transact below the floor price, the circuit breaker rule was amended for only the block market. Now one could transact at an even lower price than the one set for the main market (an additional 10 percent discount below main market price for most equities).

This essentially created a dual pricing market between investors who qualify for block market trading due to their broader investment scope and those which couldn't trade since they simply do not have the scale to participate. Say farewell to fair price discovery twice over.

A dual pricing market is detrimental to our stock market. Imagine an investor decided to invest BDT 200,000 of his hard-earned savings on a historically reputable company such as Square Pharmaceuticals. The floor price for Square Pharma is set at Tk172.50 and has been trading at that price for days on now. If this investor put in a buy order at Tk172.50, it will be executed in less than a second as the number of sellers of Square Pharma far outstrip buyers.

However, imagine this investor's surprise when he finds out that Square Pharma is trading at a different price in the block market, as much as 10 percent lower.

This investor has the right to ask why he/she would necessarily pay a premium on the same stocks, which another investor can buy at a discounted price. Logically it will discourage investors from investing in such a distorted market.

So, the FPR has resulted in an illiquid market which essentially means an inaccurate price discovery method.

Another way this rule is impacting pricing is by making Price Sensitive Information (PSI) inadequate. In a previous article, I brought forward the case of Heidelberg Cement. Heidelberg Cement declared no dividends on April 23, 2020 citing losses from the last fiscal year and the foreseeable danger due to Covid-19.

When companies like these declare zero dividends, they automatically get placed from "A" category (investable grade) to "Z" category (non-investable grade). However, the company's stock is still priced at Tk137.30, where under normal circumstances the stock price would have seen significant concession due to terrible dividend declarations. Negative PSI  necessarily cannot have any impact on the stock price anymore.

This was mostly what the FPR was meant to do. No matter how bad things got due to Covid-19, stock prices are not allowed to fall. But stock prices cannot quite go up either.

The FPR is like gravity. Without any positive PSI or buyers outbidding sellers, most stocks will always sink to their floor rate. Even with positive PSI or net positive demand on a stock, it seems the stock necessarily cannot rally either.

Lack of market liquidity is the primary reason why most stocks with positive PSI cannot sustain a rally. A sudden spike can occur for a day or two. However, without more buyers coming in to endure the rally, stock prices will eventually head back close to its floor price rate. Frequent buying and selling (market participation) help fuel rallies.

The current situation is also detrimental to the industry as a whole. Capital market intermediaries are suffering.

For example, brokerages facilitate and execute orders for their clients. Lack of client investment activity in the stock market means drastically reduced revenue for these companies. Most of these companies were operationally non-profitable, to begin with, due to unfavourable stock market conditions in the preceding years.

The current situation is practically starving these companies, and many will soon have to decide whether it is feasible to continue operations.

In the long run, enforced artificial pricing of assets will harm the very investors it was meant to protect. Potential new investors will avoid investing in stocks where there is a massive discrepancy between the value of the asset and its market traded price.

If liquidity is not brought back to the market soon, the cost of all stocks will look stable only on the portfolio, whereas in reality, these investments will lose actual value over time. Just as the closure of the stock market for two months has called into questions about its credibility, artificial pricing mechanism will eventually do the same for any future investments.

This concludes the first part of this two-part article. In the next article, I shall discuss potential scenarios and solutions about how best to normalise the current predicament.

So, what is the solution for this dilemma – an artificial barrier set to protect investors' investments from market selloff essentially making said investments non-functional?

There are potentially three solutions:

1) Continue with the FPR: Since the rule was created to ensure stocks do not drop below a specific rate and protect asset "prices", continuing with the status quo will avert any selloff and investors can "relax" knowing their investments are "protected".

In the meantime, regulators and market stakeholders can formulate a plan for more institutional investment in the stock market (pumping in more liquidity). When the FPR is taken off, it will ensure enough buyers to position against the impending sellers already available in the market every day. Such a strategy was hinted by the new Chairman of the Bangladesh Securities and Exchange Commission (BSEC). In a recent interview, professor Shibli Rubayat mentioned he will remove the FPR at a moment when the market will not even realise that the FPR is still active, indicating that the next market rally is a good vantage point to execute the withdrawal.

This strategy makes sense only when it can be assured a rally can take place given current economic conditions. While I hope this strategy works, I am sceptical about its feasibility.

Covid-19 and macroeconomic stress are here to stay for the foreseeable future. Most listed companies will experience a drop in earnings. And the recently declared National Budget does not include any favourable policies for the stock market.

For example, allowing undisclosed funds to be invested in the stock market as a way to generate liquidity seems logical until we look into the specifies. Anyone with undisclosed funds can invest by paying a 10 percent tax but will need to hold his/her investments in the stock market for three years.

In an illiquid stock market which can potentially shut down again (BSEC, Ministry of Public Administration nor the Ministry of Finance have declared the stock market as an essential service), these new investors will find it challenging to make any sort of rolling investment or an exit. The perfect scenario of having a strong demand-side ready to meet the impending selloff when the FPR is taken off will be tough to achieve.

2) Take off the FPR now: Recognise that no matter what stakeholders do, the market has to endure more pain as Covid-19 is not like any crisis we have encountered in our lives. The selloff is there waiting and it is not going to go away.

Around 300 stocks out of the 368 stocks cemented at floor price every trading day prove the disproportionate number of sellers versus buyers. When the FPR rule is taken off another selloff will execute, and investors who are planning on holding onto to their investments will witness their equity value for what it is, far different from the artificial portfolio value.

There will be massive market panic and public outcry, but liquidity will come back to the stock market. Markets will function the way it was supposed to, and existing investors will suffer.

The market will eventually find its balance, and this will attract natural buyers who will invest in stocks, many of which are at historic low prices. This will hurt existing investors in the short run, however, in the long run, investors who invested in companies that can survive the Covid-19 economic storm comparatively better can expect positive returns.

3) A hybrid solution: Before introducing this solution, let us fully comprehend the nature of stock markets. A stock market is a liquid market. Necessarily that is the theory.

Buyers and sellers transact, and price discovery occurs every second based on various factors such as company fundamentals, economic outlook, speculation, monetary liquidity, etc. In a perfect liquid market, an investor can easily invest in any stock and exist from that stock after two days (the minimum holding period for most stocks in Bangladesh stock markets). Whenever there is a sudden shift in any significant economic policy, the stock market is the first to react.

Since the financial crisis of 2007, all the Chairs of the Federal Reserve Bank of the United States of America, Ben Bernanke, Janet Yellen and current Chairman Jerome Powell (and their peers) articulate their policies and policy speeches in such a manner so as not to spook stock markets.

The sudden implementation of the FPR has destabilised the market in terms of liquidity and the sudden withdrawal of it will bring back liquidity but will create massive selloff and harm many investors. Hence the removal of the FPR needs to be methodical.

• Hybrid Solution 1: Remove FPR and enact a new (temporary) circuit breaker rule which allows stocks to move up at most 10 percent and move down at most 3 percent (current downside limit is 10 percent).

We can expect in the initial days for many stocks to hit the 3 percent downside limit and essentially be similar to the current situation.

However, it will bring back liquidity into the market. New natural buyers will an opportunity to enter, and existing investors can shift their positions from one stock to another.

Eventually, the market will bottom out, but this long-drawn process will give policymakers enough time to find new ways to inject liquidity to the markets. The quick race to the bottom will turn into a slow downturn, and companies with positive PSI will be made more attractive for investors who will now have the opportunity to shift out of underperforming stocks.

• Hybrid Solution 2: The second version of this hybrid option might work more effectively. Last year a new index was created by the DSE in partnership with its Chinese Strategic Partner's subsidiary Shenzhen Securities Information Company Ltd.

The CDSET Index is a free-float market cap adjusted index. The largest 40 companies with maximum market capitalisation, market liquidity and fundamental stability were selected as the constituents of this index.

This index includes a good variety of companies from sectors such as banks, pharmaceuticals, telecommunication, NBFI's, power and so on. Majority of the liquidity and turnover pre FPR came from these stocks. Since the objective is to ensure a measured step back to normalisation, only the stocks in the CDSET should be allowed beyond FPR with the preceding recommendation (3 percent downside circuit breaker limit). All other remaining stocks (328) will still follow the FPR.

There are certain benefits to this targeted opening. These 40 stocks will bring back a great deal of liquidity to the market. Among all the listed companies, these 40 companies have superior corporate management history and may fare the Covid-19 storm better than their listed peers.

Yes, these companies will see a selloff in their stock prices initially. However, these companies (with the highest historic turnover in the DSE) will be the first to normalise and bring back the much-needed liquidity into the market.

In time, FPR will be removed for the rest of the 328 stocks when natural liquidity comes back in the market, alongside additional policies encouraging stock market investment. In my opinion, based on market experience, this coordinated withdrawal of the FPR has the most realistic chance of success by minimising downside risks for the majority of stocks.

Let us recognise why the FPR was implemented in the first place. It was intended to protect the investment of many retail investors who have suffered for many years investing in a stock market which is mired with inefficiencies and bear markets. Still, these investors took a risk in the hope of a decent return.

Anyone with a generous soul would want to save them during a sudden pandemic selloff. However, even with the best intentions, the rule meant to protect these investors have turned quite contradictory.

I will finish with drawing parallels to a similar situation where good intentions invariably turned into bad policy. During the 2010 stock market crash, a comparable stance was taken by the then BSEC team. To shut off the selloff in the DSE, BSEC unofficially instructed the industry not to enforce any margin call. As we all now know, 10 years later, our stock market is still suffering the consequences of that "well intended and moral" directive.

The author is Managing Director of Midway Securities Ltd.