PDF Ebook Financial Market Design and Equity Premium: Electronic versus Floor Trading
We assemble the dates of announcement and actual introduction of electronic trading by the leading exchange of 120 countries to examine the long term and medium term impact of automation. Estimates from dividend growth model as well as international CAPM suggest a significant decline in expected returns after the introduction of electronic trading in the world’s equity markets, especially in the developing nations. Consistent with this reduction in equity premium in the long run, there is a positive short-term price reaction to the switch. These findings are sustained even after controlling for risk factors, economic growth, financial integration, and economic liberalization. Further analysis of trading turnover supports the notion that electronic trading enhances the liquidity and informativeness of stock markets leading to a reduction in cost of capital.
Rapid technological advancements in telecommunications and the Internet are transforming the basic business model of a stock exchange. In an increasingly competitive world with low barriers to entry, exchange-owners are rapidly recognizing that efficient market design and trading mechanism are keys to winning higher market shares for both trading volume and number of listings. Scores of stock exchanges around the world have abolished their trading floors on which brokers manually matched orders using an open-outcry system. Fully automated and transparent electronic systems have replaced those outcry mechanisms.1 This paper empirically examines whether this major change in market-microstructure has helped the listed firms lower their cost of equity because of improvements in liquidity and the informational environment in the secondary market.
Computerization of trading can improve liquidity in secondary markets through several means. Electronic trading systems can significantly lower investors’ trading costs (spreads, fees, brokerage, and commissions) and increase the amount of publicly available information about a stock’s demand and supply. In addition, electronic systems are capable of attracting new pools of liquidity by providing affordable remote access to investors and by retaining unexecuted orders in a consolidated order book for possible matching with future orders. Liquidity begets liquidity and creates network externalities. It certainly reduces barriers to market-making activity, allowing individual investors to compete with brokers having exchange seats. On automated electronic trading systems, profit-seeking value traders can closely monitor the market and become suppliers of liquidity even without their presence on the trading floor. This phenomenon is further facilitated by the manifestly higher speed of execution and settlement of trades on electronic systems.
Electronic systems are also more transparent than trading floors in displaying detailed order-flow information such as quotes, depths, and recent transactions from the limit order book to the market participants in real time. Higher ex-ante transparency reduces the adverse selection problem (Pagano and Roell (1996)). This information can also be archived more efficiently in electronic formats and then used ex-post by regulators in audit trails to penalize abusive practices such as insider trading and front running customers’ orders. Chung and Postelnicu (2003) attribute a lack of automation as the key reason for the suspicions of front-running by specialists recently investigated by the NYSE. Exchange officials in both developed and emerging markets such as Germany, Italy, and Pakistan have commonly cited cost reduction and investor protection as the main reasons cited for switching from floor to electronic trading.
Several articles in the academic literature (See Domowitz and Steil (1999) and Jain (2001) for a detailed review and international evidence) and the financial press have documented these merits of electronic systems in day-to-day trading.2 However, there is relatively little research on the long-term effects of electronic trading on the equity premium. Improvements in liquidity and informativeness of stock markets can have far reaching effects on the equity premium. Amihud and Mendelson (1986) show that investors expect lower returns for stocks with higher liquidity.3 This is possible because a lower gross return can still yield them the same net return if they face lower transaction costs. O’Hara and Easley (2002) show that investor demand a higher return to hold stocks with greater private information. Although their focus is on private versus public information about cash flows of the stock, greater public information about the order-flow is likely to have similar effects too. For example, Franke and Hess (2000) examine the role of order-flow transparency in the information diffusion process. Better order-flow information can enhance the traders’ ability to react quickly to any new cash-flow information and protect them against adverse trading with insiders. Ohara (2003) argues that particular trading systems may provide more information or better information (pp 1342). This can facilitate price discovery, lowers traders’ risks and therefore affect asset returns. Therefore, one can expect lower equity premium on the electronic exchanges if they offer better liquidity, lower trading costs and better information to traders than do the floor based exchanges.
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PDF Ebook Financial Market Design and Equity Premium: Electronic versus Floor Trading
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