Development of equity markets

1
Development ofequity markets

• Jeppe Ladekarl
• Financial Sector Department
• The World Bank

2
Structure of presentation

• Overview of key building blocks for the
  development of an equity market
• What characterizes a good market
• Case the US equity market
• Should equity market development be a public
  policy priority?
• What are the common (mainly regulatory) problems
  we see in emerging equity markets?

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The building blocks of the market

• Issuers
• Investors
• Intermediaries
• Soft infrastructure (legal, regulation
  supervision, accounting, taxation)
• Hard infrastructure (trading, clearing
  settlement, securities depository)
• Instruments

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Overview of the key components
Issuers User of capital
Investors Suppliers of capital
Intermediaries - provides liquidity - access to
investors
Market infrastructure - trading systems -
information systems - brokers - clearing and
settlement - registration
Regulation and supervision. - The Central Bank,-
The Government- Self Regulatory Organizations
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Market cap of NYSE 11.7 trillion
Source SP Emerging Markets Database
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Desirable Market Characteristics

• Transparent
• Timely and accurate information about prices and
  volume, as well as trends in supply and demand
  should be available
• Efficient
• Internally efficient low direct and indirect
  transaction cost (commissions, taxes, market
  impact costs)
• Externally efficient market prices adjust
  quickly to new information (prices are fair).
  Farma efficiency
• Liquid
• Market liquidity is not easily defined. Three
  factors are usually considered tightness, depth
  and resiliency.

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A note on market liquidity

• Tightness is how far transaction prices diverge
  from mid-market prices. (bid-ask spreads).
• Market depth usually refers to the volume of
  trades possible without affecting market prices.
  (Amount of orders on the order book market
  impact fluctuation in quotes or bid-ask spread
  resulting from a trade).
• Market resiliency is the speed with which
  imbalances in the market are absorbed. (The speed
  of the restoration of normal market conditions
  (such as bid-ask spread and order volume) after
  trades).

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Case The U.S. Equity Market - I

• Market venues
• National exchanges NYSE, Amex
• Regional exchanges Boston, Chicago, Cincinnati,
  Philadelphia, and Pacific Stock Exchanges
• Over-the-counter markets (NASDAQ, )
• Brokered institution OTC market (NYSE
  Intermarket, Nasdaq intermarket,)
• Direct institutional trading (ECNs, )

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Case The U.S. Equity Market - II
NYSE Nasdaq Amex
Number of issues 3543 4363 802
Total market cap. (USD) 11.7 trillion 2.9 trillion 103.1 billion
Avg. daily share volume 1.2 billion 1.8 billion 54.1 million
Revenues (USD) 815.3 million 832.7 million 270.4 million
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Case The U.S. Equity Market - III

• The regulatory issue in the US as identified by
  the SEC
• Undermining of market quality by the formation
  of disparate liquidity pools within a fragmented
  structure

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Case The U.S. Equity Market - IV

• Possible remedies
• Greater disclosure by market centers of trade
  execution and order routing
• Restrictions on internalization and payment for
  order flows
• Exposure of market orders to price competition
• Change intermarket trading priorities (prevent
  trading ahead of displayed limit orders, time
  priority to the first order that improves the
  national best bid or offer (NBBO)
• Creation of a central limit order book
• Modification of the Intermarket Trading System
  (ITS)

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Is there a future for equity markets in small
economies?

• Increasing price correlation between US and other
  markets. Are the benefits of international
  diversification shirking?
• Listing of national champions increasingly
  occurring in international centers (direct
  listing, ADR, GDR)
• Network externalities favor larger markets.
  Liquidity disappears in smaller markets?
• Does new technology have an impact?
• Price formation occurs where news is
  disseminated. Is the local monopoly to news
  services evaporating?

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What should the policy response be?

• Use of legal monopolies and/or local listing
  requirements? (infant industry argument and
  market fragmentation)
• Demutualize the exchange in preparation for
  competition?
• Support introduction of technology intensive
  competitors (ACNs, ECNs)?
• Import regulatory functions?
• Introduce regulation light regimes?
• Regional corporation?

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Regulation

• Objectives of regulation
• Ensure fair, efficient and transparent markets
• Minimize systemic risk
• Ensure investor protection
• With regulation the devil is in the detail

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The IOSCO Principles

• Objectives and Principles of Securities
  Regulation from 1998 (http//www.iosco.org/library
  _docs-public.html)
• Subjects covered by the 30 principles
• The regulator
• Self Regulatory Organizations
• Enforcement
• Corporation
• Issuers
• Collective investment schemes
• Market Intermediaries
• Secondary market

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Principles Relating to the Regulator

• The responsibilities of the regulator should be
  clear and objectively stated
• The regulator should be operationally independent
  and accountable in the exercise of its functions
  and powers
• The regulator should have adequate powers, proper
  resources and the capacity to perform its
  functions and exercise its powers.
• The regulator should adopt clear and consistent
  regulatory processes.
• The staff of the regulator should observe the
  highest professional standards including
  appropriate standards of confidentiality.

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Common problems

• Unclear mandate
• Responsibilities divided between different
  agencies (loopholes and overlaps
• No independence (the ministry dominates)
• Lack of human, monetary and IT resources
• Lack of consistency in application of policy
• Corruption?

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Principles for Self-Regulation

• The regulatory regime should make appropriate use
  of Self-Regulatory Organizations (SROs) that
  exercise some direct oversight responsibility for
  their respective areas of competence, to the
  extent appropriate to the size and complexity of
  the markets.
• SROs should be subject to the oversight of the
  regulator and should observe standards of
  fairness and confidentiality when exercising
  powers and delegated responsibilities.

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Common problems

• No use of SROs or SRAs
• Over reliance on SROs (more powerful and capable
  than the regulator)
• No oversight of the SRO
• No clear definition of SRO responsibilities
• Regulatory capture of the SRO by market
  participants
• A governance/ownership structure of the SRO,
  which creates conflict of interest and adverse
  incentives
• Unclear design of SRO functions after
  demutualization

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Principles for the Enforcement of Securities
Regulation

• The regulator should have comprehensive
  inspection, investigation and surveillance
  powers.
• The regulator should have comprehensive
  enforcement powers.
• The regulatory system should ensure an effective
  and credible use of inspection, investigation,
  surveillance and enforcement powers and
  implementation of an effective compliance program.

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Common Problems - I

• Unclear division of labor in enforcement and
  investigation between e.g. regulator, police, and
  prosecutors
• Lack of investigative powers (supeena documents
  and information from industry as well as others,
  right to interrogate, access to premises)
• Lack of enforcement powers (administrative,
  criminal, and civil tools)

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Common Problems - II

• Lack of desire, skills and practical tools to
  make use of existing investigative and
  enforcement powers
• Inconsistent application of powers
• Wrong focus no use of risk based supervision
  focus more on formal compliance, filing
  requirements etc. check box approach

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Principles for Cooperation in Regulation

• The regulator should have authority to share both
  public and non-public information with domestic
  and foreign counterparts.
• Regulators should establish information sharing
  mechanisms that set out when and how they will
  share both public and non-public information with
  their domestic and foreign counterparts.
• The regulatory system should allow for assistance
  to be provided to foreign regulators who need to
  make inquiries in the discharge of their
  functions and exercise of their powers.

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Common Problems

• Overlap and underlap in regulation and
  supervision
• No domestic MoUs (banking and securities
  regulator, accounting board, corporate
  registration)
• No international MoUs
• Only high level and not day to day
  corporation
• Problems with exchange of information due to
  secrecy laws

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Principles for Issuers

• There should be full, timely and accurate
  disclosure of financial results and other
  information that is material to investors
  decisions.
• Holders of securities in a company should be
  treated in a fair and equitable manner.
• Accounting and auditing standards should be of a
  high and internationally acceptable quality.

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Common problems

• Inadequate ongoing and initial disclosure of
  information from listed companies
• Where information is given the administrative
  burdens overwhelm the regulator (lack of
  prioritization and inadequate access to use of IT
  edgar type filing)
• Lack of minority shareholder protection
• Weak corporate governance (and no corporate
  governance code)
• Low accounting and auditing standards. No
  enforcement of standards in place

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Principles for Collective Investment Schemes

• The regulatory system should set standards for
  the eligibility and the regulation of those who
  wish to market or operate a collective investment
  scheme.
• The regulatory system should provide for rules
  governing the legal form and structure of
  collective investment schemes and the segregation
  and protection of client assets.
• Regulation should require disclosure, as set
  forth under the principles for issuers, which is
  necessary to evaluate the suitability of a
  collective investment scheme for a particular
  investor and the value of the investors interest
  in the scheme.
• Regulation should ensure that there is a proper
  and disclosed basis for asset valuation and the
  pricing and the redemption of units in a
  collective investment scheme.

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Common Problems

• Weak eligibility criteria fit and proper
• CISs used as dumping ground for banks
• Weak asset management capability
• Lack of asset segregation
• Role of (independent) custodians unclear
• Asset valuation in illiquid markets
• High direct and indirect costs
• Lack of disclosure of costs

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Principles for Market Intermediaries

• Regulation should provide for minimum entry
  standards for market intermediaries.
• There should be initial and ongoing capital and
  other prudential requirements for market
  intermediaries that reflect the risks that the
  intermediaries undertake.
• Market intermediaries should be required to
  comply with standards for internal organization
  and operational conduct that aim to protect the
  interests of clients, ensure proper management of
  risk, and under which management of the
  intermediary accepts primary responsibility for
  these matters.
• There should be procedures for dealing with the
  failure of a market intermediary in order to
  minimize damage and loss to investors and to
  contain systemic risk.

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Common Problems

• Very low minimum entry standards. fit and
  proper
• Unregulated brokers active in the market
• Capital not adequate for the business exposure
• Know you client rules not implemented
• best execution not ensured. Client order
  handling rules mechanic.
• Segregation of assets unclear
• Conduct of business rules, if in place, not
  enforced
• Lack of funding tools for market intermediaries

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Principles for the Secondary Market - I

• The establishment of trading systems including
  securities exchanges should be subject to
  regulatory authorization and oversight.
• There should be ongoing regulatory supervision of
  exchanges and trading systems which should aim to
  ensure that the integrity of trading is
  maintained through fair and equitable rules that
  strike an appropriate balance between the demands
  of different market participants.
• Regulation should promote transparency of trading.

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Principles for the Secondary Market - II

• Regulation should be designed to detect and deter
  manipulation and other unfair trading practices.
• Regulation should aim to ensure the proper
  management of large exposures, default risk and
  market disruption.
• Systems for clearing and settlement of securities
  transactions should be subject to regulatory
  oversight, and designed to ensure that they are
  fair, effective and efficient and that they
  reduce systemic risk.

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Common problems - I

• No definitions of exchange (ATS, ECNs,
  Interdealer brokers)
• Weak regulatory oversight of the exchange and its
  SRO functions
• Opaque trading environment pre- and post trade
  information only available to select market
  participants
• Minimum commissions
• once size fits all approach to market regulation

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Common problems - II

• Unclear definitions of market manipulation.
• Market abuse no deterrence or preventive
  measures
• Tainted script in the market
• Dematerialization / immobilization of script not
  in place. No central securities depository.
• No Electronic Fund Transfer System (I.e. no DVP)
• T ?. Use of account period settlement system.
• No central clearing counterparty
• Inadequate risk management of open positions

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Sequencing ?

• Start top down with a securities law
• Provide market structure owned by the government
  but run as a company
• Ensure concentration of liquidity (monopoly or at
  least reporting and trade consolidation)
• Build and rely on a paperless depository system
• Start with a few stocks relying on local investor
  interest for liquidity
• Use a non-continues auction market

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Thank you !

• Questions/comments/suggestions to
• Jeppe Ladekarl
• jladekarl_at_worldbank.org
• [phone]