Outlook: New Year fix is no long-term solution for Sets

Question: When is a market not a market? Answer: When it is New Year's Eve in London. The Stock Exchange has decided that its new order- driven trading system is just not up to the job of setting closing share prices for the year now that market practitioners have learnt how to abuse the technology. We can be reasonably certain that the boys around at JP Morgan have learnt their lesson - a pounds 350,000 fine generally helps drive the point home.

But the Exchange is still leaving nothing to chance. For one day at least, it has decided to abandon the simple tradition of allowing prices to be set by the number of buyers and sellers in the market and has called in the boffins instead.

Year-end share prices matter to many more people than just chartists since they are widely used by fund managers for acturial valuation purposes. Unfortunately Sets is in the habit of throwing up completely unrepresentative closing prices for Footsie stocks, which then distort the index and play havoc with everyone's pensions. Sometimes the distortion is deliberate - as in the well-documented J P Morgan case - but more often it is a simple, unintended by-product of the system. The Exchange has therefore decided that 31 December is just too important a day to rely on its expensive new piece of kit.

Ordinarily, the closing price of each stock is the price at which the last trade went through. On New Year's Eve, that will change. Over to the rule amendment notice issued by the Exchange last night for a simple explanation of what will happen if a closing price appears to be out of line: "Where that trade price has moved by an exceptional amount compared to three specific (but unpublished) price points in the previous hour, the official closing price will move to that of the previous automatically executed order. The same test referred to above will be applied to that previous automatically executed order until a trade within the defined range is reached. A trade price will be judged to be exceptional if the price movement is above the 99.5 per cent confidence level for the recent historic distribution of price changes over the equivalent time period."

Got all that? Good. Shorn of Exchangese, what the notice means is that a proper market will not be in operation at all on New Year's Eve. Prices will not necessarily be set by what has taken place in the dealing rooms but by a statistician calculating what it ought to have happened based on "recent historic distribution".

The Exchange's member firms have closed ranks and agreed to the rule amendment. However, they are not the ones being hurt most by Sets, partly because two thirds of all trades continue to be executed outside the order book. It is the unwitting private investor who has suffered most through the practice of executing trades at "at best" prices.

The Exchange can fix prices for one day but it cannot do it in perpetuity since the stock market, like all markets, is driven more by fear, greed and emotion than by statistical probabilities. The recent abuse of Sets merely reinforces the point. The longer-term solution being mooted by the Exchange is to fix closing prices by suspending trading each night for a brief period and conducting auctions.

Meanwhile, the Exchange continues to insist cheerfully that there is nothing wrong with the system itself, merely the way it is being used (and abused). Too much money and too many reputations have probably been invested in Sets for it to be abandoned. But there remains a long way to go before it becomes an aid, not an impediment, to a truly even market.