The Influence of Cross-Border Cooperation on Equity Market Liquidity

In a recent post on this blog, I described how IOSCO’s Multilateral Memorandum of Understanding (MMoU)—an arrangement intended to facilitate cooperation among regulators—improved cross-border enforcement of securities laws. In this post, I summarize a follow-up study showing that this enhanced enforcement significantly increased capital market liquidity by roughly 7 to 13 percent for domestic shares unaffiliated with foreign markets. The study also shows an even greater improvement for shares listed on markets outside an issuer’s home country. Cross-border enforcement is most important in these situations that involve multiple markets, regulators, and jurisdictions, and so it is not surprising that such shares’ liquidity improves by 18 to 25 percent beyond that of purely domestic shares. These results establish strong evidence of stock market liquidity benefits associated with the MMoU for various exchanges across the globe.

Liquidity—measured with bid-ask spreads—refers to the transaction costs in buying and selling securities. Those that provide liquidity in capital markets (such as market makers) are very sensitive to situations in which counterparties have superior information and will widen bid-ask spreads when they perceive a higher probability of informed trading by other market participants, thus compensating for the risk of being on the losing side of a transaction. Increased transactions costs, therefore, get passed along to investors.

The intent of the MMoU is to protect investors by fostering cooperation among regulators and thereby filling gaps in cross-border regulation that historically exposed investors to information asymmetry, agency costs, and expropriation risks. These risks could come in the form of, for example, insufficient disclosure, undisclosed connected transactions, insider trading, or market manipulation. If the MMoU arrangement effectively deters informed trading and exploitation of uninformed shareholders—as it is intended to do—bid-ask spreads should narrow (indicating reduced perceptions of risks and lower transaction costs).

Because the bid-ask spread is widely available across different markets, I include equity shares from across the globe (all shares listed on exchanges that are members of the World Federation of Exchanges, or about 97 percent of world market capitalization). There are 1,128,392 quarterly observations for shares from 59 markets (including cross-listed shares from 70 home countries). Consistent with such a deterrent effect, I find that the MMoU is associated with narrower bid-ask spreads. The magnitude of the effect is roughly 7 to 13 percent for domestic shares (depending on the test)—a result that combines not only the effects of cross-border assistance but also any benefits associated with potential improvements that qualify a regulator as a signatory of the MMoU.

To specifically isolate the effects of cross-border cooperation, I examine firms most affected by cross-border issues—those that are listed in foreign markets. I base my inferences on the connections that the MMoU makes between pairs of regulators that co-supervise cross-border firms. Such links occur when a home country regulator and a host country regulator are both admitted to the MMoU network. The affected shares’ liquidity improves by about 18 to 25 percent for shares listed in foreign markets. This effect is in addition to the 7 to 13 percent improvements that are common to the whole market (i.e., purely domestic shares that serve as benchmarks). The observed effect is stronger when host countries rank high in the strength of their legal systems and disclosure requirements, and when they have common law traditions. This makes sense, because cooperation is particularly difficult when home countries have blocking statutes in place. Using the countries’ ownership stakes in each other’s capital markets, I measure economies of scale and reciprocity considerations and find that both enhance the liquidity benefits associated with the MMoU, indicating that regulators consider economic factors when soliciting and rendering assistance. Firms with poor governance or dispersed ownership also experience greater improvements in liquidity.

Studies that seek to isolate the economic effects of regulation, enforcement, and new laws often suffer from the criticism that changes in these factors usually arise from market-related failures, cycles, or investor preferences. As a result, observed outcomes such as changes in liquidity, cost of capital, or ownership structure may be correlated with regulatory changes, but caused by unobserved variables that are unrelated to regulation, enforcement, or new laws. The links between securities regulators created via the MMoU represent a formation of a network, which has many attributes (described in detail in the paper) that effectively eliminate these and other flaws. Specifically, the creation of the MMoU is an unusual occurrence, because it is a measurable shock to cross-border cooperation that is arguably independent of firms, investors, and, to some extent, even the regulators themselves. It was, for example, prompted by the events of 9/11 (not market cycles) and introduced at different times in different countries. Wide variation in the countries, times, and specific shares affected by these links allows me to exploit these special network properties. Benchmark shares with the same attributes—from the same industry, in the same country, at the same time, with similar fundamentals (size, share turnover, return volatility, etc.)—are employed as a counterfactual that reveals what might have taken place in the absence of the MMoU. To my knowledge, this is the first time that these unique research design properties have been exploited in a large-scale economic study.

In sum, the study empirically establishes the importance of the MMoU in curtailing investment risks and creating substantial economic benefits. These results have important implications as markets become increasingly global and jurisdictions that are currently not signatories to the agreement contemplate entering the MMoU.

This post comes to us from Roger Silvers, a professor at the University of Utah and a former senior economist at the U.S. Securities and Exchange Commission. It is based on his recent paper, “The Influence of Cross-Border Cooperation on Equity Market Liquidity,” available here.

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