Development of equity markets Jeppe Ladekarl Financial Sector Department The World Bank

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?

The building blocks of the market Issuers Investors Intermediaries “Soft” infrastructure (legal, regulation & supervision, accounting, taxation) “Hard” infrastructure (trading, clearing & settlement, securities depository) Instruments

Overview of the key components Issuers User of capital Investors Suppliers of capital Intermediaries - provides liquidity - access to investors Regulation and supervision. - The Central Bank, - The Government - Self Regulatory Organizations Market infrastructure - trading systems - information systems - brokers - clearing and settlement - registration

Market cap of NYSE: 11.7 trillion Source: S&P Emerging Markets Database

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.

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).

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, …)

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

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”

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)

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?

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?

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

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

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.

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?

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.

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

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.

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)

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”

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.

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

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.

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

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 investor’s 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.

Common Problems Weak eligibility criteria “fit and proper” CIS’s 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

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.

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

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.

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.

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

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

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

Questions/comments/suggestions to: Thank you ! Questions/comments/suggestions to: Jeppe Ladekarl jladekarl@worldbank.org (202) 473-4718