Internationalization of Securities Markets

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Internationalization of Securities Markets

• Learning Objectives
• Globalization trends.
• Globalization implications.
• American depositary receipts.

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Outline

• Globalization
• Some history
• Moving from segmented to integrated markets
• The forces of globalization the good and the bad
• American depositary receipts
• ADR programs
• Listing requirements
• Raising equity

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Globalization brief history

• End of World War II national financial and
  capital markets are in chaos
• Regulators devised policies to restore order and
  generate forced savings to finance reconstruction
• Strict controls on foreign exchange
• Restricted use of national capital markets by
  foreign firms and investors
• Restricted cross-border lending by banks
• Introduced high tariff barriers
• Limited opportunities for international portfolio
  investment (i.e. foreign ownership limits,
  limited voting rights)
• Host of other less formal barriers

I. Globalization trends.
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Globalization brief history

• WWII reconstruction completed in the 1950s
• Gradual deregulation of financial and capital
  markets
• Conversion of foreign exchange restored end of
  1950s
• 1960s and 70s
• Tariffs reducedtrade
• Cross-border lending
• Eurobond market
• Equity markets were laststarting in mid-1980s
• De-regulated more gradually started with
  developed markets
• Major changes in the past 10-15 years
• Emerging markets only recently opened to foreign
  investors

I. Globalization trends.
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Equity markets

• Equity marketsmore country specific factors
  involved
• Different market structures around the world
  (i.e. bank centered models in Japan and Germany
  vs. market centered models in the US and UK)
• Information barriers
• Transaction costs
• Foreign exchange risk
• Political risk
• Many privately held firms
• Local firms protected

I. Globalization trends.
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Segmented equity markets

• Policies / regulations led to segmented equity
  markets
• Each national market is its own island
• Investors can only diversify domesticallyhave to
  bear all the risk of the economic activities of
  that country
• Implications
• The same future cash flows are likely to be
  priced differently across countriesfuture
  cash-flows are viewed as having different market
  (nondiversifiable) risks by investors from
  different countries
• There can be systematic differences in the cost
  of capital among countriesfirms in countries
  with lower cost of capital have an advantage

I. Globalization trends.
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Integrated equity markets

• Integrated equity markets
• There is a global equity market where investors
  can invest and firms can raise capital
• Investors can diversify their home country risk
• Implications
• The same future cash flows are likely to be
  priced the same across countries
• Investors lower the risk of their portfolios
• Firms have lower cost of capital

I. Globalization trends.
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Equity marketsthe transition

• 1980s and 90s Transition from segmented to
  more integrated equity markets
• Not defined by any single event
• Gradual processa series of events
• Facilitated by advances in computer and
  telecommunications technology
• Transmission of information
• Order processing and settlement

I. Globalization trends.
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Equity marketsthe transition

• De-regulation
• De-regulation on LSE in 1986 (BIG BANG) London
  became one of the most open and competitive
  markets in the world
• To keep up with London, other markets were forced
  to make similar changes
• U.S repealed the Glass-Steagall act
• More competition in financial services industry
• De-regulation and increased competition led to
  financial innovations that facilitated
  integration
• Currency futures and options
• International mutual funds, etc.

I. Globalization trends.
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Equity marketsthe transition

• Privatization a national government divests
  itself of a state-run business
• Started in the UK in the 1980sBritish Telecom
• Governments across Europe have sold many
  state-owned companies
• Trend spread through Asia and Latin America in
  early 1990s
• Fall of Soviet bloc
• 1988-1993 2700 state-owned companies sold to the
  private sector in 95 different countries raising
  271 billion (IFC)
• Often the largest companies in the
  countrytelecommunications, oil, steel, etc.
• Privatizations are often too large for domestic
  markets to absorbforeign investors are needed to
  buy up the issue

I. Globalization trends.
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Equity marketsthe transition

• Stock market liberalization decision by a
  countrys government to allow foreigners to
  purchase shares in that countrys market
• Remove legal restrictions barring foreign
  investors from the country
• Establishment of country funds
• Allow local firms to establish ADR programs
• Examples Philippines 1986 Chile 1987 Korea
  1987 Malaysia 1987 Mexico 1989 Venezuela 1990
  Colombia 1991

I. Globalization trends.
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Equity marketsthe transition

• Cross-listing firms list their shares on foreign
  stock exchanges in addition to the home country
  exchange
• London and New York (to a lesser extent) Tokyo
  are the major marketschoice depends on motive
  for cross-listing
• Direct listings
• ADRs
• Global capital raising
• Shares of local firms become easily accessible to
  foreign investors

I. Globalization trends.
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Equity marketsthe transition

• Summary
• De-regulation
• Privatizations
• Liberalizations
• Cross-listing
• All of these have contributed to the transition
  from segmented to more integrated markets
• Not mutually exclusive
• The pace of integration is increasing

I. Globalization trends.
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Equity markets 1987 - 1997

• 1987
• Many barriers
• US residents held 94.7 billion, or 3.5 of their
  portfolios in non-US stocks
• Volume of trading of non-US stocks in the US
  213 billion
• Volume of trading of US stocks by foreign
  residents 483 billion

• 1997
• Fewer barriers
• US residents held 876 billion, or 10 of their
  portfolios in non-US stocks
• Volume of trading of non-US stocks in the US 1
  trillion
• Volume of trading of US stocks by foreign
  residents 1.2 trillion

I. Globalization trends.
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Equity markets 1987 - 1997

• Transaction costs of trading foreign equities
  have fallen
• 1 in 5 equity transactions now involve either a
  foreign resident or foreign stock
• Global cross-border trading has doubled in this
  period
• Foreign investors now have large equity stakes,
  i.e. 38 in Argentina, 17 in Chile, 25 in
  Mexico (IFC)
• Foreign ownership in developed markets is less
  dramatic
• Foreign investors have influence on equity prices

I. Globalization trends.
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Equity markets 1987 - 1997

• Summary
• Global expansion in cross-border and
  cross-exchange trading
• Impact on investment positions and the extent of
  home bias is relatively small
• Global investors have been slow in adjusting
  their portfolios after capital market
  liberalization
• The process of integration is well under way, but
  is still near the beginning

I. Globalization trends.
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Integration of equity markets the good side ?

• Globalization can decrease the risk for the the
  world equity market as a whole
• Investors in each country are better offmore
  diversified portfolios ? lower risk for a given
  return
• Firms in each country are better offlower cost
  of capital
• Firms have global sources of equity beyond
  domestic markets
• Increased liquidity and lower transaction costs
  for trading securities

II. Globalization implications.
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Integration of equity markets the good side ?

• More competition in global financial markets,
  i.e. investment banking services
• Allowed developing countries to obtain financing
  for the growth of private enterprises and
  development of basic infrastructure
• Accelerated development of capital markets in
  developing countries

II. Globalization implications.
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Integration of equity markets the bad side ?

• In emerging markets
• Concerns about the reliability and sustainability
  of foreign private capital flows
• Are foreign flows short-term in naturehot money?
• Could increase the volatility of stock market
  market prices
• If rates of return in developed markets increase,
  will investors leave emerging markets?
• Foreign investors are prone to herding
• Unwarranted drops in stock prices and a
  deterioration of liquidity
• In sum, vulnerable to foreign capital inflows
  are foreign investors destabilizing?

II. Globalization implications.
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Integration of equity markets the bad side ?

• International linkages have caused greater
  international correlations in asset prices,
  particularly during downturns
• Crises in one country (or region) can affect
  markets of different structures and sizes around
  the globe
• Contagion the Mexican Tequila crisis, Asian
  flu, Russian virus
• East Asian crisis the Brazilian stock market
  fell by 31, the South African market fell by 14
  and so did the Australian market
• Massive bailouts
• Events are outside the control of domestic policy
  makers and regulators

II. Globalization implications.
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Integration of equity markets summary

• Study by Tesar and Werner
• The long-run benefits outweigh the costs
• Increase in international correlations is not
  badsecurities are increasingly priced in the
  international marketplace
• Global events and global risk factors
  automatically play a role.
• Most crises are the result of domestic
  macroeconomic events and policies
• Foreign investors are not the cause of crises
• Crises are not transmitted by excessive capital
  movements

II. Globalization implications.
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American depositary receipts

• American depositary receipt a negotiable
  certificate representing ownership of a number of
  foreign shares that are deposited with a US bank
• Legal US securities
• Sponsoring firm must register with SEC
• Trade freely on organized exchanges or OTC
• Priced in and pay dividends in
• Effective vehicles for constructing
  internationally diversified equity portfolios

III. ADRs.
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American depositary receipts

• Benefits
• Expands its potential investor base ? higher
  stock price and lower cost of capital.
• Creates a secondary market for the companys
  shares, which facilitates raising new capital in
  foreign markets.
• Enhances the liquidity of the companys stock.
• Enhances the visibility of the companys name and
  its products in foreign marketplaces
• Capital raising
• Facilitates cross-border acquisitions

III. ADRs.
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American depositary receipts

• Costs
• Disclosure and listing requirements
• US GAAP requires more disclosure than many
  companies are accustomed to
• Onerous and costly prevents many foreign firms
  from listing in the US
• Volatility spillover
• Foreigners might acquire controlling interest
• A firm that is large in local markets might not
  be large in global markets

III. ADRs.
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American depositary receipts

• Statistics 2000
• 1,534 foreign firms are listed in the US
• 608 firms trade on organized exchanges
• Trading volume 28.7 billion shares
• Dollar volume 1,185 billion
• Companies from 69 countries around the world

• Statistics 1990
• 836 foreign firms are listed in the US
• 176 foreign firms trade on organized exchanges
• Trading volume 3.8 billion shares
• Dollar volume 75 billion

III. ADRs.
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American depositary receipts

• ADR trading reached record levels in 2000crossed
  the 1 trillion milestone
• Nokia (Finland) 166 billion traded
• Ericsson (Sweden) 94 billion traded
• BP Amoco (UK) 45 billion traded
• ADRs 56 of international mutual fund assets
• 182 new ADR programs established in 2000
• Some recent ADR programs
• United Heavy Machinery Uralmash-Izhorz Group
  (OTC-Russia)
• Vivendi Universal (NYSE-France)
• Telekom Austria (NYSE-Austria)

III. ADRs.
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American depositary receipts

• Examples
• Ashton Mining Ltd (OTC-Australia)
• Driefontein Consolidated (Nasdaq-South Africa)
• Cementos Paz Del Rio (144a-Colombia)
• Amsteel Corporation Berhad (OTC-Malaysia)
• Sony Corporation (NYSE-Japan)
• British Airways (NYSE-UK)
• Samsung Electronics (144a-Korea)
• YPF Sociedad Anonima (NYSE-Argentina)
• Qingling Motor Company (144a-China)

III. ADRs.
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American depositary receipts

• Issuance
• US investor instructs broker to purchase DRs
• Broker may purchase existing DRs or have
  depositary issue new DRs
• To issue new DRs, the US broker contacts a non-US
  broker to purchase ordinary shares through an
  exchange in the local market
• Ordinary shares are deposited with a local
  custodian
• Custodian instructs depositary to issue DRs that
  represent the ordinary shares received
• Depositary issues DRs and delivers them to the
  broker
• Broker delivers DRs to customer or credits the
  customers account

III. ADRs.
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American depositary receipts

• Cancellation
• US investor instructs broker to sell DRs
• Broker may sell DRs to another investor in the US
  market or sell the underlying shares back to the
  home market
• To sell the underlying shares, the US broker
  delivers the DRs to the depositary for
  cancellation
• The depositary instructs the local custodian to
  release ordinary shares to the brokers
  counterparty (non-US or local broker)
• The local custodian delivers the shares to the
  local broker
• Local broker sells the ordinary shares through an
  exchange in the local market

III. ADRs.
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American depositary receipts

• Pricing
• DR price the ordinary share price converted to
  at the current spot rate, adjusted for the
  appropriate ratio plus any transaction costs
• Deviations between ordinary share price and the
  DR price?
• Small
• Short periods of time
• Arbitrage between the home market and the US
  ensures the DR price and ordinary share price are
  consistent

III. ADRs.
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American depositary receipts

• Trading
• DRs trade in the US the same way US common
  equities tradesame settlement and clearing
  procedures
• In addition to the usual trading costs
• Pay DR conversion (issue / cancel) fees to the
  depositary bankoften paid by the broker
• Custodian safekeeping fee
• Depositary fee
• Cost effective way to invest internationally

III. ADRs.
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American depositary receipts

• Trading
• The extra costs associated with DRs are less than
  the extra costs associated with buying the
  underlying shares
• Custodian safekeeping fee
• Custodian settlement fee
• Stamp duty tax
• FX conversion fee
• Miscellaneous service charges
• Indirect expenses
• Broker fees tend to be higher in local markets

III. ADRs.
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ADR programs

• Level 1 ADR program
• Trade over-the-counter as OTCBB or Pink Sheet
  issues
• Register with the SEC
• Minimal SEC disclosure required
• No GAAP compliancehome country accounting with
  adequate English translation
• Offer limited liquidity
• Costs are low ? benefits are low

III. ADRs.
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ADR programs

• Level 2 and 3 ADR programs
• Trade on the NYSE, Nasdaq, or AMEX
• Must meet the exchanges listing requirements
• Register with the SEC
• Full SEC disclosure required
• Reconcile accounting statements according to US
  GAAP
• Offer increased liquidity
• Level 3 programs include a capital raising
  element (most prestigious)
• Costs are higher ? benefits are potentially higher

III. ADRs.
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Level 3 ADRs Public equity issues

• Statistics 1990
• 11 foreign firms issued public equity in the US
• Raised 1,742 million
• Average issue 158 million

• Statistics 2000
• 90 foreign firms issued public equity in the US
• Raised 28,033 million
• Average issue 311 million

• These firms are under the full scrutiny of US
  regulators and investors
• Increases monitoring of management

III. ADRs.
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Rule 144a Private equity issues

• Statistics 2000
• 28 foreign firms issued private equity in the US
  (peak in 94 at 102)
• Raised 2,091 million (peak in 94 at 8,254
  million)
• Average issue 74.7 million

• Statistics 1990
• 19 foreign firms issued private equity in the US
• Raised 840 million
• Average issue 44.2 million

• Rule 144a or RADRs
• No SEC registration or GAAP compliance speed
• Issued to qualified institution buyers (QIBs)
  only
• Trade on Portal among QIBs very limited liquidity

III. ADRs.
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ADRs Raising equity capital

• What steps have to be taken?
• Decision to raise equity in the US
• Costs / benefits
• Timing
• Other sources of capital
• Arrange for depositary and underwriter
• Satisfy US disclosure and listing requirements
• Varies Level 3 vs. Rule 144a
• Set the price!!!
• Maximize proceeds
• Sell the entire issue

III. ADRs.
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ADRs Summary

• Firms from countries around the world
• Convenient and efficient way to invest
  internationally
• Process of issuance and cancellation
• Increasing popularity in the last 10 years
• 4 different ADR programs Levels 1-3 and Rule
  144a
• Costs and benefits depend on the program chosen
• Public and private equity issues

III. ADRs.