Institutional Design and Liquidity on Stock Exchanges Around the World

Pankaj K. Jain
pankaj.jain@memphis.edu

Paper available at: http://ssrn.com/abstract=869253

Motivation

The Internet and other new technologies are in many ways transforming how our capital markets operate during this time of great innovation and change. There are clear benefits to these changes including lower costs and faster access to the market for investors. -Former SEC Chairman Arthur Levitt

Exchange-Design changing across the board:

Trading Mechanisms: Dealer, Limit Order Book, Hybrid Automation Other Features: Consolidation via Mergers, Transparency, and Decimalization of Tick Size, Demutualized Ownership.

Why is exchange-design important?

Exchange-Design affects:

Investors trading costs & net returns (by 2%/trade)

Trading turnover (Eg. French Stocks on London S.E.) Volatility of stock prices Liquidity / firms cost of equity (Muscarella & Pirowar (2000)) Exchanges competitiveness: Listings, turnover, market

makers profits

Regulatory agencys objectives/ Real economic activity

An example of cross-sectional variation in liquidity

Stock GE Exchange NYSE Mechanism Hybrid Trade 157.375 Bid 157.125 Ask 157.375 Mid-point 157.250 % Roundtrip-Tranaction Cost Effective Spread 0.16% Top-25 NYSE Hybrid Top-25 Top-25 China NASDAQ LOB Dealer

0.10%

0.22%

0.51%

Contributions and preview of results

Wide cross- sectional variety of exchange-designs:

New data to empirically compare spreads, volatility, and turnover on 51 exchanges covering > 90% of worlds market cap.

Integrated framework to test market-design theories. Global benchmarks for liquidity Policy implications for investors, firms, and exchanges

Costs lower with hybrid trading, limit order book than with dealers Emerging markets: Less liquid => More important role for market makers Lower tick sizes, automation, and consolidation are better. Shareholder rights matter.

Outline of this presentation

Motivation/ contribution

Literature review
Description of the data Exchange-design and liquidity: Univariate comparison Multivariate regressions Robustness of results Conclusions and areas of further research

Theory of institutional design and liquidity

Trading mechanism (-) Pure limit order book (LOB): Glosten (1994) Black (1995), Rock
(1995): Adverse/no role for MM vs

(-) Hybridize(LOB+Market Maker): Parlour & Seppi(2001): Positive

role for market maker: Two competing sources of liquidity

Primary null hypothesis tested in the paper:

Spreads on:

Hybrid = LOB = Dealer

Theory of institutional design and liquidity

Trading Mechanism
Dealer
Vishawanathan & Wang (2002) Good for risk averse traders

Pure Limit Order Book

Glosten (94), Black (95), Rock (95) Adverse/ No role for market makers

Hybrid Systems
Parlour & Seppi (2001)

Two Sources of liquidity: (1) Limit orders and (2) positive role for market maker/specialist Cao, Choe & Hatheway (1997)

Primary null hypothesis tested in the paper: Liquidity on: Dealer = Limit order book = Hybrid

More theories: Institutional design & liquidity

Fragmentation? (Biais (1993))

(+) No consolidation of order flow vs. (-) Competition among players

Automation? Domowitz & Stiel (1999), Kumar(2001)

(-) Lower processing costs vs. (+) informational issues

(-) Demutualization (Domowitz and Stiel (1999)) Degree of transparency of order flow
(-) Reduces asymmetry: Pagano & Roell(1996) vs. (+) endogenous information acquisition: Madhavan(1996), Rindi (2001)

(-) Lower tick size but not zero (Seppi (1997))

Empirical studies on worldwide liquidity

USA: NYSE versus NASDAQ:

Muscarella & LaPlante (1997): bloc trades Bessembinder & Kaufman (1997): smaller stocks Huang & Stoll (1996): large stocks

International pair-wise comparisons:

NYSE versus Paris Bourse: Venkataraman (2001) London Stock Exchange: Hansch, Naik, Viswanathan (1999) NYSE vs. Australian Exchange: Frino & McCorry (1995)

Global comparisons:

Domowitz, Glen & Madhavan (2000): 42 countries Perold & Sirri (1997): 35 countries

Data

Institutional features: of 51 exchanges from fact books, trading rules documentations, web-pages, and correspondence Limit order book 47%, Dealer emphasis 24%, Hybrid 29% Fragmented order flow 37% or consolidated 63% Automatic Execution of Trades or manual matching Mutually Owned 63% or Incorporated 37% Transparency of order flow or opaqueness Better Shareholders Rights (La Porta 96), Enforcement of insider trading laws: Bhattacharya & Daouk 2001), Higher Relative Tick Size (% of Price) , Designated Market Maker, developed, age, size

Performance/liquidity measures: Dependent variables

Sample: 25 biggest stocks from 51 exchanges with >90% of worlds marketcap

1263 firms; 4871 firm months or 89,460 firm days No ADRs/GDRs/foreign stocks. Only primary listings Daily closing bid, ask and transaction prices, volumes Jan-Apr 2000 from TAQ & Bloomberg

Quoted % spread = (Ask - Bid)/Quote Midpoint

Effective % spread = (|Trade price midpoint|)/ midpoint*2

Realized spread = {(Trade price MPt+1)/MPt*2}* Direction Daily volatility of returns Trading turnover = $ volume/market capitalization

Explanatory variables

Exchange-design features:

Order book, designated market maker, fragmentation of order, automatic execution of trades or manual matching, mutually owned or incorporated, transparency of order flow, tick size

Exchange-specific control variables:

Age of exchange, size (market cap), number of listings

Firm-specific control variables: Datastream, worldScope, bloomberg

Size, price, trading turnover, volatility, cross-listed

Country-specific control variables:

Shareholders rights (La Porta 96), accounting practices (CIFAR 1995) Enforcement of insider trading laws: Bhattacharya & Daouk 2001), Ownership concentration (WorldScope) Developed or emerging, total market capitalization, GDP, population, area

a.) Presence or absence of designated market maker

Appendix 1.a Market Maker

Discrete Classification

No Designated Market Maker

Designated MM =1

Continuum

Dealers can only act as agents for client orders. Don't trade as principal by law or custom.

Dealers can make market voluntarily but have no such obligation

Each stock is assigned to designated dealer(s) who is contractually obligated to continuosly post binding bidask quotes within certain parameters

Examples

Latvia, Tokyo (Japan)

Australia, Denmark, Norway Toronto , Italy, Ireland Paris Bourse (France) NYSE, NASDAQ New Zealand, Taiwan Netherlands, NASDAQ South Africa, Singapore AMEX, Czech, Poland

b.) Trading Mechanisms

Discrete Pure Limit Order Book Classification

Appendix 1 B: Trading Mechanisms

Hybrid Markets (LOB+MM)

Continuum

Consolidated Limit Order book within the exchange and No market makers

Consolidated Limit Order Book within the exchange and Designated Market Makers

Examples

Paris Bourse (France), Norway Australian, Denmark, Latvia New Zealand, Sweden, China German stocks in DAX index Taiwan, South Africa, Singapore

New York Stock Excahnge Toronto (canada), Ireland, Italy, Czech, Poland German Stocks not in DAX

Dealer Emphasis Market

Dealer Quote driven market Dealer Quote Driven with some Markets/ Open-Outcry on exposure to Floor with some provision for customer limit electronic order book trading orders

Pure Quote Driven Markets

Brazil, London, Spain Indonesia

Nasdaq

Historical NASDAQ Easdaq Russian

Appendix 1 c. : Centralization of Order Flow

c.) Centralized vs Fragmented Markets
Discrete Classification Centralized Fragemented

Continuum

Stocks trade on only 1 exchange/ system in the world

Stocks trade on only 1 exchange/ system within the country but may trade elsewhere in the world

Stocks trade on more than 1 exchange/ system within the country

Examples

France, Australia, Greece Canada,

NYSE Stocks

Appendix 1 d. : Transparency of Order Flow

Appendix 1 e. : Automation
e.) Automatic Execution vs Human Intervention
Discrete Classification Automatic Human Intervention

Continuum

Orders are matched on price time priority automatically by a computer

Investors can hit dealers quotes for automatic execution

Orders are routed automatically, but human intervention takes place for execution

Completely manual matching

Examples

Paris Bourse NASDAQ-SOES Australia, Finland EASDAQ Germany, HongKong Ireland, Italy, Singapore

NYSE Super-Dot AMEX

Open-Outcry like Zimbabwe

Appendix 1 f. : Ownership
f.) Ownership of the Exchange
Discrete Classification Mutual Ownership =0 Mutual Ownership =1

Continuum

Incorporated

A Government Department

Owned by Brokermembers and Financial Institutions

Owned Solely by Broker-Members

Examples

Australia, Italy Belgium, Bermuda Denmark, Finland

Greece Poland

Easdaq Latvia

NYSE, Israel, Korea New Zealand, S. Africa Argentina, India Malaysia, Mexico

Average quoted spreads across exchanges sorted by size

16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

UN UQ JP UK GR FR SW CN NA HK IT TA AU SP SS BZ SA MX BG IN UA CH SG DK MK FH RU NO AR IR BR IS KO ES PO AV LX GA PH NZ IJ TH PE CO HU VE CZ PW ET LR UR

Comparison with other empirical studies: Quoted spreads on top 10-20 securities
Exchange USA-NYSE USA-NASDAQ UK-LSE France-Paris Bourse Japan-TSE Sweden-Stockholm Study Stoll (2000) Stoll (2000) Hansch et.al. (1998) Biais et.al. (1995) Lehmann et.al. (1994) Sandas (1999) Spreads This Paper $0.13 $0.14 $0.25 $0.34 1.04% 0.88% 0.30% 0.40% 0.82% 0.80% 0.77% 0.68%

Average quoted spreads by trading mechanism, MM and LOB

5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Dealer LOB Hybrid . MM No MM . No LOB LOB

Quoted Spreads: 3-Way Classification by Trading Mechanism, Economic Development, and Fragmentation

9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

Quoted Spreads

Dealer LOB
Emerging Centralized Developed Centralized

Hybrid
Emerging Fragmented Developed Fragmented

Fig 2 b. Effective Spreads: 3-way Classification by Trading Mechanism, Economic Development, and Fragmentation

0.1 0.09 0.08

Effective Spreads

0.07 0.06 0.05 0.04 0.03 0.02 0.01 0

Dealer Emphasis Systems Pure Limit order Books Emerging Centralized Developed Centralized Hybrid (LOB+MM) Systems Emerging Fragmented Developed Fragmented

Regression methodology

Following simultaneous system-of-equations model is estimated using two-stage least squares (2SLS):

Spread*= f(institutional + controls** + volatility + turnover)

Volatility= f(institutional features + controls**)

Turnover= f(institutional + controls + endogenous)

* Three systems are estimated with: Quoted, effective, and realized spreads
** Controls Include firm, exchange and country-specific variables

Table 4. 2SLS Regressions

Dependent Variable % Quoted Effective Adjusted R-Square 0.32 0.31 Intercept 0.066 0.053 Institutional Design Variables Relative Tick Size 0.007 ** 0.006 ** Market Maker -0.003 * -0.005 ** Limit order book -0.020 ** -0.014 ** Fragmentation 0.005 * 0.008 ** Transparency 0.007 ** 0.006 * Automatic Execution -0.007 * -0.003 Mutual Ownership -0.003 * -0.006 ** Control Variables Market Capitalization -0.003 ** -0.002 Developed market -0.014 ** -0.011 ** Number of firms listed Age of Exchange Shareholder rights -0.001 * -0.002 ** Interrelated Liquidity measures Quoted Spread % Volatility % 0.003 ** 0.004 ** Trading Turnover -0.017 ** -0.021 **
* = 1% ** = p<.0001

Volatility 0.11 4.712 0.404 0.417 -0.973 0.842 -0.119 -0.451 0.034 ** ** ** ** *

Turnover 0.22 0.289 -0.003 -0.051 0.085 0.201 0.273 0.364 -0.143

* ** ** ** **

-0.221 -0.003 **

-0.130 ** 0.0002 ** -0.003 -0.031 ** 0.015 **

2SLS Regressions with Top 15% market cap from each market
Dependent Variable % Quoted Effective Adjusted R-Square 0.51 0.57 Intercept 0.042 0.056 Institutional Design Variables Relative Tick Size 0.019 ** 0.017 ** Market Maker -0.001 -0.004 Limit order book -0.018 ** -0.019 ** Fragmentation 0.002 0.004 Transparency -0.003 -0.002 Automatic Execution 0.000 -0.009 Mutual Ownership -0.004 -0.006 * Control Variables Market Capitalization -0.004 ** -0.005 ** Developed market -0.001 0.000 Number of firms listed Age of Exchange Shareholder rights 0.001 0.001 Interrelated Liquidity measures Quoted Spread % Volatility % 0.001 ** 0.001 ** Trading Turnover -0.003 -0.002
* = 1% ** = p<.0001

Volatility 0.12 7.983 0.461 -0.820 -2.608 ** 1.715 ** 0.107 -1.771 * -0.932

Turnover 0.38 0.581 0.098 0.058 -0.085 0.482 ** -0.081 0.684 ** -0.330 *

-0.730 -0.001

-0.028 0.000 * -0.068 * -0.100 ** -0.005

Regressions with 51 observations based on exchange-wide averages

Dependent Variable % Quoted Effective Adjusted R-Square 0.50 0.48 Intercept 0.075 0.065 Institutional Design Variables Relative Tick Size 0.013 ** 0.012 ** Market Maker -0.002 -0.003 Limit order book -0.026 ** -0.021 * Fragmentation 0.000 0.004 Transparency 0.008 0.005 Automatic Execution -0.025 * -0.023 * Mutual Ownership -0.003 -0.003 Developed -0.027 ** -0.021 **
* = 5% ** = p<.01

Volatility 0.41 7.525 0.013 -0.158 -2.613 * 0.025 0.804 -2.527 * -0.312 -2.677

Turnover 0.15 0.177 -0.157 -0.067 0.134 0.336 0.209 0.481 -0.104 0.024

Results of the pooled regressions

Spreads lower with LOB, MM, automation, lower tick size, centralization, transparency, better shareholder rights and mutual ownership Spreads lower for larger markets, developed markets, less volatile stocks and high turnover stocks Volatility lower for LOB

Trading turnover higher with automated execution, LOB, fragmentation, transparency, and lower trading costs

Results of the pooled regressions

Liquidity Measure Spreads Volatility

Features with biggest economic impact: Limit Order Book; 2% Limit Order Book; 0.97

Turnover

Automation; 0.36 times

Table 4. B. Role of Markets Maker: Developed vs. Emerging Markets Specification Pooled Interactive R-square 0.3208 0.3220 Institutional Design Variables Relative Tick Size 0.0073 0.0072 Market Maker -0.0032 Market maker * Developed -0.0005 Market maker * Emerging -0.0070 Limit order book -0.0201 -0.0199 Fragmentation 0.0045 0.0045 Transparency 0.0068 0.0076 Automatic Execution -0.0066 -0.0069 Mutual Ownership -0.0035 -0.0030

Developed versus emerging markets: Quoted spreads

Specification Only developed (D) Only emerging (E) R-Square 0.4378 D>E 0.29194 Intercept 0.0203 D < E (Same direction) 0.1002 Institutional Design Variables Relative Tick Size 0.0056 Similar effect in D and E 0.0070 Market Maker 0.0042 D>E -0.0036 Limit order book -0.0079 D > E (Same Direction) -0.0430 Fragmentation 0.0062 D>E -0.0017 Transparency 0.0034 D>E -0.0029 Automatic vs. Manual 0.0043 Similar effect in D and E 0.0081 Mutual Ownership 0.0026 D>E -0.0129 Control Variables Market Capitalization -0.0037 Similar effect in D and E -0.0051 Shareholder rights -0.0002 D > E (Same Direction) -0.0057 Volatility % 0.0025 Similar effect in D and E 0.0027 Trading Turnover -0.0034 D > E (Same Direction) -0.0122

Key results

Exchange characteristics associated with higher liquidity:

Hybrid trading mechanism, or LOB versus dealer mechanism Lower tick size versus higher Automated trade execution versus broker intervened

Spreads much higher in emerging markets.

Greater role of market maker in emerging markets. Centralization of order flow lowers spread in developed markets Higher degree of transparency more important in emerging markets

Endogeniety of the choice of exchange-design

Are the results being driven by an endogenous choice of exchangedesign based on liquidity?

Are the less liquid exchanges choosing the dealer mechanism? If this is true, there should be a predominance of dealer markets in emerging markets (where spread are high and liquidity is poor)
Average Quoted Spreads Emerging Markets = 3.81% Developed Markets = 1.16%

Robustness of results

Institutional features cross checked from 3 or more sources in 75% cases

MSCI handbook, Smith Barney handbook, Websites of exchanges, Email/snail mail/literature directly from exchanges By sub-samples like month-wise regressions Top 10 stocks only, top 15 stocks only Regression with 51 observations (exchange-averages) Globally cross-listed versus single listed stocks Correction for heteroskedasticity Exclusion of exchanges such as the NYSE Exclusion of endogenous variables Inclusion of accounting standards Inclusion of Ownership Structure Variable Statistically insignificant correlation Condition number < 4 in all regressions (30-100 indicates problem)

Results are Robust to additional analysis

Multicollinearity check for institutional measures

Correlation between spread measures is high

Cross-listing issue

No ADRs included. Only primary-listed stocks

Home market dominates ADR in volume and low trading cost (Pirowar (1997))

Globally cross-listed vs. single-listed

For each countrys home market: spreads are not statistically different for globally cross-listed vs. single listed on a country by country basis Indicator variable for global cross-listing is not significant in the regression analysis

Specification

D r o p N Y S E

Original Drop NYSE Transparent 0.3208 0.3199 0.3219 Institutional Design Variables Relative Tick Size 0.0073 0.0072 0.0072 Market Maker -0.0032 -0.0034 -0.0033 Limit order book -0.0201 -0.0214 -0.0210 Fragmentation 0.0045 0.0040 0.0043 Transparency 0.0068 0.0064 0.0069 Automatic Execution -0.0066 -0.0045 -0.0052 Mutual Ownership -0.0035 -0.0038 -0.0037 Control Variables Market Capitalization -0.0025 -0.0030 -0.0028 Developed market -0.0135 -0.0129 -0.0133 Number of firms listed Age of Exchange Shareholder rights -0.0015 -0.0016 -0.0015 Interrelated Liquidity measures Volatility % 0.0029 0.0029 0.0029 Trading Turnover -0.0167 -0.0157 -0.0163

Conclusion and agenda for further research

Exchange-design matters!

Investors gain liquidity by routing market orders to exchanges with better exchange-design. Further research: identify best exchangedesign for limit orders, large orders, smaller stocks etc

Integrated theoretical modeling of complex exchange-designs

Does exchange-design affect cost of equity via liquidity and information?