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Cracking the Emerging Markets Enigma$

G. Andrew Karolyi

Print publication date: 2015

Print ISBN-13: 9780199336623

Published to Oxford Scholarship Online: June 2015

DOI: 10.1093/acprof:oso/9780199336623.001.0001

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(p.219) Appendix B Measures of Operational Inefficiencies

(p.219) Appendix B Measures of Operational Inefficiencies

Source:
Cracking the Emerging Markets Enigma
Publisher:
Oxford University Press

Category

Variable

Definition and Source

Transaction Costs

Brokerage Commissions

Trading cost measures is a country-level measure of trading costs, expressed in raw form (e.g., 0.0110 is 110 basis points), which includes commissions, transfer and other related fees, and market impact costs in each home market, compiled by Elkins/McSherry LLC. The author is grateful to Dick McSherry for providing this data for 1997. I subsequently purchased access to this summary data through 2011. Now a wholly owned subsidiary of State Street Corporation, some database details are available at www.elkinsmcsherry.com/em/methodology.html. Some data is supplemented with Salomon Smith Barney Guide to World Equity Markets, Euromoney Books.

Transfer/Other Fees

See above.

Market Impact Costs

See above.

Liquidity Measures

Their proxy with the acronym FHT (from the authors’ names) simplifies the existing zero-returns-proportion measure of LOT. These authors show it does well capturing intraday data on effective spreads from Thomson Reuters Tick History global data. The simplification rescales the zero-returns proportion to account for higher volatility of a representative stock; higher volatility implies the transaction cost bounds and spreads must be larger in order to achieve the same proportions of zero returns as an equivalent lower-volatility stock. See Table 2 in Fong, Holden, and Trczinka, “What Are the Best Proxies for Global Liquidity Research?” which gives a proxy for illiquidity. This measure is defined as scaling the zero-returns proportion measure by individual security price volatility.

Zero Return Proportions (Lee, 2011)

Zero return proportions (in percent) represents the number of zero returns over one month scaled by the total number of available trading days averaged across all the months for which the stocks that comprise a country have available data. For each country, the median of the time-series averages of the measure is reported. Table 1 of Kuan-Hui Lee, “The World Price of Liquidity Risk.” Zero-returns proportions are the fraction of trading days within a month with zero returns for the typical stock available 1988–2007; higher proportions of zero returns denote greater illiquidity.

Annual Liquidity (Karolyi, Lee, and van Dijk, 2012)

Amihud, in “Illiquidity and Stock Return,” introduces a measure of the price-impact of a trade defined as the absolute value of stock returns scaled by dollar volume. It draws as its inspiration Pete Kyle’s so-called lambda, or the elasticity of the price change for a trade of a given size. A more liquid market has a lower price impact for a given trade size. I use the time-series average of daily estimates of the Amihud proxy from Karolyi et al. for a large panel of representative stocks in each of the 40 countries the study covers. See data appendix of Karolyi et al., “Understanding Commonality in Liquidity around the World.” Illiquidity is computed as the average daily return volatility per dollar value of trading for the typical stock over 1995–2009.

Annual Turnover (Karolyi, Lee, and van Dijk, 2012)

See above. Turnover is the ratio of the dollar value of trading relative to the market capitalization for the typical stock. I use an annualized measure of daily turnover as the first proxy. It comes from a study by Karolyi et al., “Understanding Commonality in Liquidity around the World,” in which daily turnover rates of representatives stocks (not that of the market as a whole) are computed for a large cross-section of individual stocks from 40 countries around the world over the period from 1988 through 2009.

Short-Selling Restrictions

Median Short-Borrowing Ratio (Jain et al., 2013)

I take the median daily average short-borrowing ratio, which (during 2006 to 2010, their period of analysis) is the daily average outstanding dollar value of shares borrowed summed across all stocks from that country divided by the country’s total stock market capitalization. A higher short borrowing ratio indicates more intense the short-selling activity. From Table 1 of Jain, Jain, McInish, and McKenzie, “The Worldwide Reach of Short Selling Regulations,” the median of the aggregate dollar amount of short-selling-related borrowing of all stocks from each country and whether short-selling is illegal or not.

Short Sales Legality (Jain et al., 2013)

An index that indicates whether, as of 2010 (the ending year of their sample), short-selling activity is legal or illegal. I ignore that there may have been some restrictions in one form or another at a particular time. I flag whether or not there existed a ban on short selling for a large fraction of the equity market. From Table 1 of Jain et al., “Worldwide Reach of Short-Selling Regulations,” which lists the median of the aggregate dollar amount of short-selling-related borrowing of all stocks from each country and a description of short-sale legality and institutional details surrounding restrictions, if any.

Market Manipulation

Market Manipulation Index (Cumming, Johan, and Li, 2011)

Cumming, Johan, and Li, in “Exchange Trading Rules and Stock Market Liquidity,” create a series of indices for trading rules that pertain to market manipulation and insider trading for 42 exchanges in both developed and emerging markets. Market manipulation rules refer to “trading practices that distort prices and enable market manipulators to profit at the expense of other market participants” (p. 652). Brokers, for example, could take actions while acting on behalf of a client that benefits the broker or some other affiliated party at the expense of a client or the market more generally. Insider trading rules refer to “acting on material nonpublic information” (also, p. 652). The market manipulation index is the tally of “yes” responses to 14 questions concerning the presence of price manipulation, such as ramping or gouging, in which a series of trades over a short time period generate unusual price movement given the security’s history; volume manipulation, such as the explicit prohibition on wash sales (same client referenced on both sides of a trade); what they call “spoofing,” such as rules preventing brokers from staggering orders from the same client at different price and volume levels to give a false appearance of market activity; and false disclosure, such as rules prohibiting the hiding of the true ownership of securities with fictitious trades. The insider trading rules index represents a tally of 10 yes/no questions that might preclude front-running (in which brokers buy or sell ahead of a client) and trading ahead of research reports, and that impose a separation of trading and research, restrictions on affiliations between exchange members, and member companies. From Table 2 of Cumming et al., “Exchange Trading Rules and Stock Market Liquidity,” count up to five market manipulation rules for brokers on trade-through, improper execution, fair dealing with customers and up to seven exchange rules on insider trading.

Insider Trading Index (Cumming et al., 2011)

See above. The insider trading rules index represents a series of 10 yes/no questions that might preclude front-running (in which brokers buy or sell ahead of a client) and trading ahead of research reports, and that impose a separation of trading and research, restrictions on affiliations between exchange members, and member companies. From Table 2 of Cumming et al., “Exchange Trading Rules and Stock Market Liquidity.”

Clearance & Settlement Procedures

  • Settlement Cycles:

  • World Bank T+3 Cycle or Better

From the World Bank’s Global Payments Survey 2010. A risk in settlement can be capital risk where only one side of a transaction settles, credit risk where a transaction has to be replaced due to default of one party or operational risk when it is not completed on the due date due to failure of one party to settle. Shorter settlement cycles can help minimize credit risk. ISSA recommends a rolling settlement cycle of T+3 (trade date plus three days) or shorter, which means that the funds are transferred within three business days after the trade is executed. One point is given if cycle exceeds T+3 days.

Settlement Methods: World Bank CSD Integrated with RTGS

RTGS (real time gross settlement) systems are funds transfer systems where transfer of money or securities takes place from one bank to another on a real-time basis (no waiting period) and as a gross settlement, or one transaction at a time without bunching or netting with other transactions. The World Bank survey indicates that 90 out of 179 CSDs (Central Securities Depositories) have a real-time interface with the RTGS system. One point is given if a country has this interface.

  • Delivery vs. Payment

  • (DvP): World Bank Model 1 DvP

A risk in settlement can be capital risk where only one side of a transaction settles, credit risk where a transaction has to be replaced due to default of one party, or operational risk when it is not completed on the due date due to failure of one party to settle. A DVP mechanism in a settlement system minimizes credit risk by ensuring that the final transfer of one asset (security) occurs if and only if the final transfer of another asset (monetary, e.g., foreign exchange) occurs. Only 8% of CSDs do not use a DvP model at all. However, more sophisticated models allow for simultaneous settlement (DvP Model 1), on a net basis (DvP Model 2) or at the end of the processing cycle (DvP Model 3). One point is given for those countries that have at least one form of upgrade (denoted Model 1+) on the basic DvP model.

Participation: World Bank CSD Participants

CSDs and securities settlement systems, in general, also attempt to control the risks in their systems by defining access criteria for participants. According to the World Bank survey, 86% of CSDs indicated that commercial banks are direct participants, whereas corresponding figures for broker-dealers and other financial institutions (like central banks, stock exchanges, treasury departments) is only 66%. Direct participation by nonbanks is higher in more developed countries, they find. I arbitrarily compile a score out of 3 points to the yes/no questions as to whether these three groups participate directly (commercial banks, broker-dealers, other financial institutions).

Risk Management; World Bank Risk Management Systems

See above. An investment in risk management systems in CSDs and securities settlement systems is more likely to ensure the integrity of the process. The World Bank survey captures a number of assessments of the resilience and business continuity features of CSDs. They ask seven questions about whether they have routine procedures in place for periodic data backups, whether backup tapes are kept in sites other than the main processing site, whether backup servers are deployed, and even whether business continuity arrangements include procedures for crisis management and information dissemination. Up to seven points are possible, with one point for each positive answer.

(p.220) (p.221) (p.222)