Tuesday, January 25, 2011

Electronic Inflation

What a difference a rule change makes! In 2002, FINRA (back then known as the National Association of Securities Dealers or NASD) permitted ECNs (Electronic Communications Networks) and ATSs (Alternative Trading Systems) participation in the Over-the-Counter Bulletin Board. Of course ECNs eliminate the role of a third party in the execution of orders entered by market makers. Most of the ATSs serve high volume professional traders. Such ATSs have become the platform of choice for institutions looking for a counterparty to a large volume trade.

True that is history, but the 2002 rule change has implications for what we are observing in trading patterns on the OTC/BB today. The year 2010 appeared to be a tough year for micro-caps in the last year. The number of securities quoted on the OTC/BB declined to 2,896 at the end of December 2010 - a 15% drop from the year before. Of course, since the OTC/BB is a quotation services for member broker dealers, the decline can be traced to the number of market makers with active positions. Market makers declined to 119 at the end of December 2010, compared to 147 a year earlier. That was a 19% drop.

Average Daily Securities by Month - December 2009 – December 2010
Source: OTC Bulletin Board

Of course, this is not the first time the OTC/BB has experienced shrinkage. Between July 1999 and June 2000, the OTC/BB removed over 3,000 securities that were not compliant with eligibility requirements. The OTC/BB was created under a mandate of The Penny Stock Reform Act of 1990, which required the SEC to establish an electronic system to report trades in all domestic securities traded “over the counter.” The idea was to create price transparency. However, it was not until April 1997 that the SEC approved the operation of the OTC/BB on a permanent basis. Then in January 1999 the SEC took action to limit quotation of securities to those for companies with current SEC financial files.

Average Daily Securities 1995 – 2010
Source: OTC Bulletin Board

Trends in share and dollar volumes are also illuminate some interesting trends in trading. Average daily share volumes posted by market makers increased steadily through 2000. After the burst of the dot.com bubble and the September 11 disaster in 2001, share volumes dropped slightly and then skyrocketed through 2006. It took the financial industry crisis to bring average daily share volumes back down to pre-housing bubble levels. The chart below also shows that share volumes have very little to do with the number of securities that are quoted. Indeed, dollar volumes appear to be more closely liked to the number of securities quoted, at least up through the year 2001. As shown in the third chart below, after 2001 dollar volume rebounded even as the number of securities quoted continued to decline.

Average Daily Dollar and Share Volume Against Securities Quoted - 1995 – 2009
Source: OTC Bulletin Board

Average Daily Share Volume Against Securities Quoted - 1995 – 2009
Source: OTC Bulletin Board

Average Daily Dollar Volume Against Securities Quoted - 1995 – 2009
Source: OTC Bulletin Board


There is merit in the adoption of electronic platforms at least in terms of creating reducing costs and creating efficiency. Yet in the case of the OTC/BB it appears as if fewer market makers are trading fewer different securities for fewer dollars. They are just making it up on volume.


Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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