Efficiency and Fairness: How Australia's Securities Market Measures UpPublished: July 09, 2012 in Knowledge@Australian School of Business
With lacklustre investor confidence and falling trading volumes, regulators around the world are under more pressure than ever to reassure the public that securities markets are fair and efficient.
Safe mechanisms are required to stabilise markets, but controversial new evidence – the first of its kind – reveals Australia is one of the world's most expensive markets in which to trade. And, in Australia, there appears to be more instances of market participants engaging in aberrant trading behaviour, such as insider trading and market manipulation, than in other major markets.
A new quarterly market quality report (to be published through web forum www.q2forum.com) compares securities markets worldwide on efficiency and integrity. The study, released by Michael J Aitken, chair of Capital Market Technologies at the University of New South Wales and chief scientist at the Capital Markets Cooperative Research Centre, puts Australia's stock market roughly on par with counterparts in the Asia-Pacific region in terms of integrity, but raises questions about its performance against peers in Europe and North American markets.
On one measure of integrity – information leakage – the Australian equities market has five times as many instances requiring some form of investigation as Europe and twice as many as the US markets. On the efficiency front, the costs of trading on the Australian market are twice as high as they are in Europe and four times higher than North America.
Information leakage identifies statistically unexplained price and volume movements in the lead-up to public announcements by public companies. "Based on these numbers, the Australian Securities Exchange ranks 12th overall in the world in terms of integrity. It's a leading market in the Asia-Pacific region, but behind the major markets of North America and Europe," Aitken reports.
An unexpected finding in Aitken's research is the seemingly very low number of insider trading cases in Australia. It's less than 1%. The numbers still suggest that the regulator, the Australian Securities and Investments Commission (ASIC), has its work cut out as it takes over the responsibility for market surveillance from the Australian Securities Exchange (ASX). "While the absolute dollar numbers are still quite large, the relative numbers (as a percentage of overall trading) are surprisingly small," Aitken says. In Australia information leakage is only 5/100ths of 1%.
Crunching the Numbers on Insider Traders
Global figures for insider trading show the average European market at 0.0271% compared to the Asia-Pacific markets (0.0799%) and North America (0.0394%). The results suggest that Asian markets are generally considered less fair than their international counterparts though it remains to be seen whether this is at the expense of efficiency, or whether the results stand up when other elements of fairness such as market manipulation and front-running are taken into account.
While insider trading numbers are small, Aitken says his new report provides the first real estimate of integrity in global markets. "The point is that insider trading could be increasing or decreasing and no-one knows," he suggests.
Research measuring market fairness is scant globally. ASIC has announced the measurement of market quality (which includes estimates of fairness and efficiency) as a top strategic research priority. However, the lack of insight to date is odd as the fairness of markets is pivotal for optimal market design, observes Aitken. "At best, this has meant that regulators [have] had only half the evidence to determine whether the changes they are approving actually improve the market or not," he emphasises. "As this is the first time they've ever had these particular integrity estimates, how can they know the extent of the problem?"
Australian regulators face particular difficulties identifying insider trading because the trading records of the Australian Securities Exchange do not show who's trading. "If we had that information in the trading records, insider trading would be easy to identify and eradicate. The regulator has recently asked for that information to be supplied, but there's a lot of resistance from industry," notes Aitken.
Market manipulation is less of a problem than insider trading, according to Aitken's report. As a percentage of trading it is 0.0391% of total turnover. This looks small, yet the Australian figure is still unacceptably high when compared to North America (0.0051% of total trade for the 2012 first quarter), Europe (0.0164%) and Asia-Pacific (0.0171%).
Aitken draws the distinction between market manipulation and insider trading: insider trading is essentially where someone has access to information, whereas with market manipulation there's no information, but people act as though there is after seeing unusual activity on the market.
Aitken is unimpressed by the supposedly better figures offshore. "While offshore markets appear to be fairer and cheaper for trading, we don't know why that is since there has been no systematic study of the market designs of these various markets," he says.
An important question is how the aspects of efficiency and fairness interact. For example, if fairness (as measured by the instances of bad behaviour) rises as efficiency drops, then clearly there is a problem no matter how low the cost of trading, Aitken suggests. There is evidence of a correlation between markets that are less fair and markets that cost a lot more to trade in. "If people think a market can be manipulated, prices will blow out and transaction costs will be higher. One could argue then it's dearer to trade because people feel that the market is more 'rig-able', so people will price-protect themselves in such markets." This may be why the cost of trading is higher in Australia than in other markets, hypothesises Aitken.
Using relative effective spread (between the bid and the offer price) as a measure of trading costs, Aitken shows that trading costs are 23.38 basis points in Australia, compared to 6.37 and 12.41 respectively for the US and Europe, with Asian markets trading costs sitting at 27.90 basis points.
What drives these differences? Aitken believes Australian regulators have made choices that have led to a less desirable market design than others around the world as evidenced by higher transaction costs and lower fairness scores. "We need to go back and look at how other markets that are more efficient and fair are structured before restructuring ourselves to ensure these figures come down over time," he says. To eliminate the problem and improve market quality, regulators everywhere need to define and measure fairness and efficiency before and after major design changes in their trading systems to ensure the proposed changes reap the desired effects on market fairness and efficiency. "By measuring every market in the world quarterly, we can establish differences and then seek to explain those differences through the design choices made for the market place over the previous quarter," Aitken says.
Facing Up to Australia's Challenges
High transaction costs are an issue in Australia, concurs Jerry Parwada, head of Banking and Finance at the Australian School of Business. Questions about transaction costs and fairness should definitely be asked of policymakers charged with promoting market integrity and monitoring for potential abuse. "If the market is so sophisticated and innovative, why are we paying such high transaction costs?" he asks.
Parwada believes Australia's comparatively small size, which prevents it locking in economies of scale, is the reason it lags the major markets. The recent arrival of a competitor, Chi-X, which now offers an alternative trading platform in Australia, might provide lower trading costs, Parwada suggests. "The problem is that we had only one main market and all the competition was at the broker level," he says. "Now, with the arrival of Chi-X we have competition at the market level as well."
Until the Capital Markets Cooperative Research Centre (CMCRC) produced its latest market quality report showing the advantage of one market over another, no figures for forecasting have been available to market designers. Accurate numbers will help the Australian market resolve problems. Challenges are in the composition of the Australian securities market with a dominance of small companies that are difficult and mostly uneconomical to research. Prime drivers of activity are the large stocks and information is scarcer for all but the high-turnover companies. The potential trading costs of having Australia's dominant stocks cross-listed in markets such as London, New Zealand and New York also need to be considered.
Australia is often used as a surrogate for Asia by some hedge funds and that can introduce some temporary dislocation. As Parwada observes: "In aggregate these capital flows are quite benign in nature and aid price discovery, sometimes Australian securities are a surrogate for investing in China, say, and investors looking at economic fundamentals could easily get confused since they are seeing the affect of what could be interpreted as noise. This can confound integrity analysis."
Relative to similar Asian markets, attention will always be drawn to the fact that the ASX removed the ability of market participants to observe the identities of brokers behind transactions. The Korean market has instead moved from opacity to transparency in relation to broker identities.
Finally, the quality of information might be compromised by a simple lag in technology keeping up with the demands for highly frequent information updates, claims Parwada. For instance information announcements made by ASX companies are still labelled as being price-sensitive manually, introducing the possibility of human coding error. "I understand research being carried out at the CMCRC to automate the identification of price-sensitive news releases may ameliorate this problem," notes Parwada.
The ASX has declined to respond to the CMCRC findings, but says making direct comparisons between markets is fraught due to, among other factors, the different regulatory regimes, number of market operators and levels of liquidity. "Moreover, Australia is currently undergoing significant structural change and increased complexity," concludes a spokesperson.