DD Support Board and Research Team

[BigBake1]

MMs and trading Penny stock.

No matter how many times I see the posts and replies about MMs buying, selling or banking penny stock I cringe at the thought of how out of whack this thought process is. In a normal exchange this is how things work because there is plenty of liquidity and there is transparency. But the OTC is known as the “Illiquid Security Market” and as such has different rules involved when clearing, settlement and deposits. The basic idea that any MM would buy 10million shares of WXYZ stock for example means that money is being placed into that security, how liquid is the environment to have money sitting on the table?

With that process why would any financial institution place large chunks of money in the most illiquid market known? Especially when the cost of business is thrown on top just to maintain a deposit on hand. So back to the example, 10 million shares are bought at say .008 or $80,000, that is $80,000 that must sit there and hope for liquidation at a later date, in some cases that could take years and the OTC has over 10,000 securities currently listed. I do not know of any accountant out there that would recommend buying an illiquid stock and placing it on the books in hopes of selling at a later date.

The amount of interest being lost alone on just the principle amount is ridiculous, but now throw into account that if you want to deposit these shares in the market to be able to sell them when the opportunity comes you must come out of pocket for a “Illiquid Deposit” fee to guarantee your settlement at T+3. Here is the a snipit of the Notice increasing that deposit requirement:

Today, positions in OTC Bulletin Board and Pink Sheet issues as well as issues with insufficient pricing history1 are excluded from the volatility, or “VaR”, component of NSCC’s Clearing Fund formula, and are margined instead according to a haircut. This haircut, currently at 10%, will be increased to 20%, in order to achieve 99% coverage levels.

http://www.dtcc.com/downloads/legal/imp_notices/2011/nscc/a7281.pdf

That is a huge piece of change to hang out there on a penny stock, increase the amount of cash sitting there to $96,000. They are called “illiquid” for a reason as we all know the OTC is a fickle market and is mostly a popularity contest. Get a rejection and it causes a “Short Position” and you can be debited 130% of the current market value until that rejection is resolved. Rejections are common in the OTC as we all know the amount of bad or poorly documented shares floating around out there. If that is not bad enough then you are assessed a fee for the rejection by the DTCC.

Now did I mention illiquid? I have read this and yet I cannot find the supporting document to verify the accuracy of this, but here is a quote with an example:

the NSCC illiquid deposit requirement is calculated for stocks selling at $0.01 and below as (($0.01*number_of_shares)-trade_value).
The NSCC imposes that deposit requirement to clearing firms when a trade size exceeds 25% of 20-day ADV, "as a way to limit settlement risks" (whaaaat?), however the NSCC itself doesn't limit tradeable order sizes.
The deposit is then wired by clearing firms to the NSCC and the money is returned back to the clearing firm when the trade settles at T+3.

The amount of the requirement on subbies pretty much gets out of whack: here are a couple examples:

120,000 share trade @ $0.008 => NSCC deposit requirement of (($0.01x120,000)-($0.008x120_000)) => $1200-$960 = $240. Not much at all, right? Here comes the funny stuff...

10,000,000 share trade @ $0.0001 => NSCC deposit requirement of (($0.01x10,000,000)-($0.0001*10,000,000)) => $100,000-$1,000 = $99,000. The pain!!!

That is, $99,000 has to be wired by the clearing firm to be able to settle a trade worth $1,000! Since those funds are tied for 3 days (T+3) the chunk the brokerage misses on interest revenue of the funds they wire can be considerable. In the above example, at a 10% interest rate, they'd miss (3/365)*0.1*$99,000 = $81.

Ouch, talk about the pain there, so we all know how quickly the volume can dry up and leave people hanging onto worthless shares. But the same can be said for MMs banking shares to sell another day. I cannot think of one CFO even recommending to buy shares of a non reporting pinky let alone a fully reporting pinky below .01 at one of these firms for selling at a later date. Volume goes away and you want to sell millions of shares and it exceeds the ADV because of a spike in volume and that is a whole lot of cash sitting there for T+3.

This has all been discussed on a very small scale and when you think about the hundreds of millions of shares that can be traded on just one bad security and there are over 10,000 securities listed on the OTC you can begin to understand the scope of the amount of money that would be wasted sitting around in this illiquid market. There is just no way a MM would waste their precious resources on making a market with the majority of the OTC market place.

Now enter the DTCC and it’s Chill and Global Lock process, there is a reason the DTCC is taking this under their control at this point. See nobody wants to make a market or clear and settle on their own behalf, they would rather the DTCC do it all and take the risk along with the costs. Nobody is doing their job when it comes to vetting these securities, they all just figure it is not their problem since they are not the ones that are going to get hung out to dry. You can argue that it is market that is causing this, well yes and no. These brokers, dealers and clients all have a responsibility in bringing these securities to the DTCC to get them eligible for them to be entered into CNS.

Strangely enough as the security gains their eligibility nobody is doing their part and just relies upon the DTCC to do everything from that point forward. So now you have the certificate printing machine that is dumping billions of certs onto the market from various parties and sometimes only one party and well now all of that risk is on the DTCC. Then the chill gets slapped down and this security goes trade for trade and clearing and settlement is strictly left to those who will do their own.

Unlike the exchanges where everyone has a part in a security and wants to be a part in that security for making money, the OTC Market however is the exact opposite. Nobody wants to put their neck out on the line for these and has left it all to the DTCC to deal with the messes that are created and also holding the tab. The OTC Market is a huge drain and cuts into profits for the DTCC, it is like a public program, a huge cost burden with no benefit of doing it.

The bottom line is that the only people buying and selling shares in the OTC market save those rare less than 1% top tier OTC stocks that are actual companies that have been in successful business for years, are just retail investors large and small. No MM wants to make a market here, they will just treat them all as unsolicited quote stock and match trades all day long, because it is profitable business and has no overhead like it would if they made a market.