AIM market and ISA's, what effect will it have on spreads?

At the last budget a mention was made that consideration was being given to allowing AIM listed shares to be allowed into ISA's (UK tax free individual savings accounts). Currently most AIM shares are not eligible as AIM does not qualify as it is not listed as a "recognised stock exchange". A few that are also listed on a recognised exchange overseas do qualify, but most don't. It is hoped that after the consultation period AIM stocks will be allowed into ISA's, if not from this year than in 2014.

One question that this will raise is the issue of the spread on AIM stocks. Smaller companies, especially those listed on AIM, can have the most ridiculous spreads, 5-10% not being uncommon and often more, which can be quite off-putting especially for smaller investors. One of the main reasons given for these wide spreads is the lack of a market, lack of liquidity.

Unlike the FTSE 100, which uses an order book to create a marketplace where buyers and sellers are matched up depending on the price they are bidding or offering, smaller companies rely upon market makers. Market makers do exactly as their name suggests; they make a market for smaller company shares. Unlike FTSE 100 companies, smaller companies attract very few buyers and sellers and thus need an artificial stimulus to enable investors to buy and sell shares. Market makers are firms which provide this service and there are normally a handful of them per listed company, with the investor being matched up with the best price available.

Market makers do not only make markets, they also make money. They do this by charging buyers a higher price than they pay sellers; this difference is called the spread. For bigger companies the spread is very small (for example the spread on Vodafone is around 0.1%) but since smaller companies attract minimal interest and trading activity, the spread needs to be very, very wide in order for market makers to make a nice little earner. Indeed double digit spreads are par for the course, which means you need the share price to increase by 10%+ just to break even

http://citywire.co.uk/money/smart-investor-scary-facts-about-smaller-companies/a462550

So, one of the main arguments for the wide spreads is this lack of investor and trader interest. In theory, adding AIM stocks to ISA's should potentially lead to greater interest from investors and therefore the excuse for such wide spreads will be difficult to justify, although one suspects that those companies with a small number of shares in issue may find the spreads remain wider. It will be interesting to see if and when AIM stocks are included if it has any effect on the spread.

Links:

Recognised stock exchanges http://www.hmrc.gov.uk/fid/rse.htm