author : Clem Chambers

level 2 Articles

by Clem Chembers



Level 2, Small Caps & SETSmm

Small caps get in on the action

The introduction of SETSmm was a dark day for market makers. A hybrid of the big cap SETS market and the small cap SEAQ market; SETSmm signaled a shift of power away from the 'jobbers' to the market as a whole. Last week, without fanfare, the top 200 small caps also moved onto SETSmm. Now anyone can make the bid and offer on approximately 400 companies. With the remaining small caps due to move to SETSmm this December, the initial 200 from the top of the FTSE 250 were the thin edge of the wedge.

Market makers were the exclusive wholesalers of the stock market. They'd buy and sell to a broker, who would come onto the floor of the stock exchange to buy or sell shares for their customer. The modern stock exchange still reflects this basic system. SEAQ is a simple electronic version of the old system and had dominated the small and mid caps. The FTSE 100 uses the SETS system which allows anyone to enter their orders into a centralised system and compete with all comers via Level 2. SETS is for big liquid stocks, while SEAQ supports an exclusive market maker environment where the 'jobbers' share a monopoly of quoting bid and offer prices.

Sadly the market maker monopoly that is SEAQ has fat spreads and this costs investors dearly when buying and selling. SETS on the other hand, has tiny spreads, so while SEAQ stocks often have a 5% spread, SETS stocks will have a 0.1% or 0.2% spread. Fat spreads not only cost investors money but lowers the general activity of a share.

SETSmm on the other hand has stimulated share trading. The London Stock Exchange has just reported that in 2005 there have been roughly 200,000 shares deals per day on SETS, which includes SETSmm, up from around 150,000 last year. Tight spreads are good news for the market and investors and bad news for market makers used to fat profit margins.

SETSmm was introduced in 2003 with the idea of bringing tight spreads to the market while giving jobbers an opportunity to change their spots and get competitive. SETSmm has been a great success, but not for the market makers, who are seldom seen on the bid and offer, and are instead guzumped by other traders.

SETSmm stocks have thrived and the strength of the FTSE 250 over the last couple of years has been underpinned by the new regime where anyone can play market maker and thus create a more efficient and benign market. Volumes this June were up 119%on last year, which is a significant increase in liquidity; it is often the case that day traders have actually turned into private jobbers who are driving this valuable liquidity.

Now the 200 largest small cap companies have been introduced to the SETSmm market and anyone with 'direct market access' can put their bids and offers, it seems inevitable that eventually SETSmm will cover the whole market and trading will look much like the Nasdaq market with its huge order volumes. This is good news for the market and it's good news for the private investor. Now that's a rarity.