Brian Gaynor: NZX starting to find its way... finally

New price structure should help encourage on-market trading. Photo / File

COMMENT:The NZX pricing structure announcement this week shows the stock exchange is finally travelling down the right road.

After decades of going down blind alleys and cul-de-sacs, chief executive Mark Peterson has steered the exchange in the right direction, although the bourse has a long way to go before it achieves its full potential.

The main problem with the domestic sharemarket is that it has been run for the benefit of brokers, rather than investors and companies wishing to raise equity.

This is demonstrated by several statistics, including the small number of stockbrokers trading on the NZX, the huge concentration of broking power, and the enormous amount of off-market trading.

New Zealand has only seven brokers trading on the NZX, with the three largest — First NZ, Craigs Investment Partners and Forsyth Barr — accounting for 78.3 per cent of market trading, in value terms, in the first half of 2018. By contrast, the ASX has 71 brokers with the largest three accounting for 31.3 per cent of turnover over the same period.

The small number of NZ brokers, and the conspicuous concentration of market power, means there is a limited choice for investors wishing to invest in the sharemarket, and companies wanting to raise capital.

Only five trading brokers publish company analysis, a major drawback as far as attracting new NZX listings is concerned.

The concentration of broking power is particularly evident compared with other areas of the financial sector. The 78.3 per cent market share of the largest three brokers compares with a 63.7 per cent market share by the three largest registered banks, ANZ, BNZ and ASB.

The latest FundSource report on wholesale and retail managed funds shows the country's three largest investment managers, ANZ Investments, AMP Capital and ASB, have a 43.3 per cent market share.

Notably, New Zealand has 35 investment managers, 26 registered banks but only seven brokers trading on the NZX.

The substantial amount of off-market trading has been a major contributor to the concentration of broking power in New Zealand. Traditionally, only two-thirds of trading value has been executed on-market as demonstrated in the accompanying table. This is out of line with the rest of the world.

For example, 37.8 per cent of NZX trading went through the electronic market in 2017 compared with 87.9 per cent on the ASX, and 71.6 per cent of all trades on global sharemarkets monitored by the World Federation of Exchanges.

These figures demonstrate that the NZX is effectively controlled by a small number of brokers negotiating large off-market trades for their preferred clients.

The domestic stock exchange lacks transparency because these off-market buy and sell orders are not disclosed, or made available, to all market participants.

Consequently, the New Zealand stockbroking sector has strong oligopolistic characteristics that make it difficult for new entrants to challenge the dominant incumbents.

But the good news is that there has been an increase in on-market trading as illustrated in the table.

In the first half of the current year, 48.2 per cent of trades by value have been on-market compared with 36.1 per cent in the first half of 2017, and 37.8 per cent for the 12 months to December 2017.

However, the NZX is behind the ASX, where 87.2 per cent of trades by value were on-market during the first six months of 2018.

Another pleasing development has been the sharp reduction in the NZX's value per trade, from $10,950 in 2017 to $6610 in the first half of the current year.

This is usually a sign of increased retail participation although the latest reduction in the value per trade figure is probably due to increased algorithmic trading by large overseas investors.

Algorithmic trading is a way of sending large orders to the market through computerised pre-programmed trading instructions that break these orders into smaller parcels and spread them over a day or longer period.

On Wednesday, the NZX announced several changes, from October 1, that should encourage more on-market trading:
• Transactions of $50,000 or less must go through the market whereas at present tiny transactions, often as low as $100 worth, can be executed by brokers without these shares being offered through the market
• The current $1.31 per trade fixed fee will be removed with the NZX moving to a fully variable or value-based fee structure
• An additional fee will be charged for trades executed off-market.

These changes are a welcome development, although there is an argument that they should have been more radical, that the $50,000 minimum threshold should have been higher.

However, it was encouraging to note the NZX media release contained the following statement: "The minimum crossing size ($50,000) will be reviewed regularly to ensure it remains fit for purpose as NZX's markets develop further."

The new fee structure, and $50,000 minimum off-market rule, will be scrutinised although there is little to suggest they will encourage the establishment of new stockbroking firms.

This is disappointing because the NZX won't make substantial progress until the oligopolistic characteristics of the broking sector are eroded.

Global sharemarkets, including the NZX, are facing challenges as demonstrated by Elon Musk's twitter announcement that he was looking to take Tesla private.

In a letter to employees he wrote that "wild swings in our share price can be a major distraction for everyone working at Tesla, all of whom are shareholders".

He was also critical of short sellers as Tesla's market listing gave these investors "the incentive to attack the company".

According to S3 Analytics, short sellers have a US$10.5 billion ($15.9b) position in Tesla, the largest of any US listed company. This is followed by a $8.5b short interest in Apple and a $7.5b short interest in Amazon.

These short-selling positions have been facilitated by passive funds lending shares to short sellers for a fee. The income from this share-lending activity has partially compensated passive funds for the low fees charged to investors.

The ability of short sellers to borrow stock is expected to increase with the announcement that US-based Fidelity Investments is launching two new passive funds, covering international and US sharemarkets, with no fees payable by investors. US based Fidelity has 30 million clients and US$7 trillion under management.

A Fidelity spokeswoman said the new funds would help build "long-term relationships with clients and we benefit from clients having a relationship of 30 to 40 years with us".

But US media reports suggest Fidelity will use stock lending to partially compensate for its no-fee structure.

The problem facing global sharemarkets is that increased short-selling activity, and extreme price volatility, will encourage companies to look for equity finance elsewhere and there seems to be plenty available.

World Federation of Exchanges figures show global sharemarkets are worth US$84.2t at present while Preqin estimates global foreign sovereign funds, which include the NZ Superannuation Fund, are worth US$7.5t and private equity funds US$3.1t.

The latter two figures, which don't include investable funds held by wealthy individuals or other sources, are increasing rapidly.

Accordingly, Musk should be able to raise funds if he wishes to take Tesla private.

Private equity funds are also expanding in New Zealand and Australia and they offer an alternative source of equity for growth-oriented companies compared with a stock exchange listing.

Peterson and his NZX management team are heading down on the right road but they will have to move much faster to avoid being overtaken by global trends, particularly the increasing ability of companies to raise equity without having to list on a stock exchange.

- Brian Gaynor is an executive director of Milford Asset Management.