Chapter

Annex IV. Case Studies: Regional Integration

Author(s):
International Monetary Fund
Published Date:
December 2008
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Market Integration in Europe

In Europe, cross-country market access is based on the “single passport” concept. Products and financial intermediaries authorized in one European Union (EU) country have free access to the other EU member countries, based on the authorization given by the home country. For that purpose the European Directives establish minimum common authorization requirements, as well as a certain minimum common approach toward the authorization process by all EU members. Supervision relies mainly on the home country, although under certain circumstances the host country can also exercise supervisory powers.

The Lamfalussy Committee in 2001 proposed a new structure to streamline the preparation of regulations and to foster supervisory convergence between national securities supervisors. This structure has three levels: (1) the Ecofin Council and European Parliament decide on the broad framework principles in Directives and Regulations, (2) regulatory committees (composed of high-level representatives from the ministries of finance) vote on the proposals of the European Commission for implementing technical measures, and (3) supervisory committees (composed of high-level representatives from the relevant supervisory authorities) advise the European Commission on promoting a consistent implementation of EU directives and convergence of supervisory practices.

These institutional and legal arrangements have provided the framework for private-company-led efforts that have deepened securities market integration. Euronext is a cross-border exchange that integrates trading and clearing operations on regulated and non-regulated markets for cash products and derivatives. It was formed in 2000 in response to the globalization of capital markets and, to create a pan-European exchange offering, its participants increased liquidity and lowered transaction costs. Euronext countries’ trading rules have been largely harmonized, under the responsibility of the exchange, but each local market remains subject to its domestic regulation (public law rules), under the supervision of the local authorities. The trading of most securities is done on a unified order-driven platform. Clearing involves a central counterparty—the LCH Clearnet Group—for all exchange-executed trades. In contrast, settlement is partially decentralized, and can be done on the books of several entities.

The Eurolist market operated by the Euronext group brought together the cash markets of France, Belgium, Portugal, and the Netherlands. Up until 2005, the markets used a com mon trading platform, but listing requirements were different. Since 2005, the four markets have shared the same listing requirements, thus facilitating the cross-listing of issuers. Clearance, settlement, and the depository are not fully centralized; rather, each market has its own arrangements. This example of business integration has forced the regulators to take additional steps to ensure proper coordination of their efforts through the signing of memorandums of understanding (MOUs) on the supervision of Euronext and Euroclear.

Notwithstanding all the progress already achieved, there are still concerns regarding the costs of cross-border transactions. On July 11, 2006, the Head of Internal Markets at the European Commission set out a voluntary code of conduct aimed at achieving interoperability between Europe’s many stock exchanges, clearing houses, and settlement firms, as well as a timetable for its implementation. Customers of Europe’s stock exchanges have been critical of the “vertical silo” model, in which a single owner-operator operates one country’s stocks and derivatives markets along with its post-trading services, which in the opinion of many is making trading in Europe more expensive than in the United States. The first phase will include measures aimed at achieving price transparency by the end of the year. Interoperability will come in the second phase; and it will require all stock exchanges, clearing houses, central counterparties, and central securities depositories to be able to send instructions to and from one another. This will allow any customer to choose its own provider of post-trading services. The third phase would encompass complete unbundling of all services and separate accounting for each service provided.

Integration of the Baltic Markets with Nordic Area Markets

The Baltic financial markets have achieved a significant but apparently slowing degree of integration with those of the Nordic area.66 Individually, each of the Baltic equity markets may be too small to be viable—at end-2005, the combined market capitalization of equity markets in the Nordic-Baltic countries was $1.2 trillion. Until the mid- and late 1990s, market integration of these countries was affected by restrictions on selected cross-border equity transactions and by limited foreign ownership of individual companies. After most barriers to cross-border equity transactions were removed in the context of EU integration, foreign ownership of listed companies rose sharply. For example, nonresident investors held 60 percent of market capitalization of the Talinn Stock Exchange in 2006.

Market integration was initiated by Norex, the strategic alliance, originally agreed to between Nordic stock exchanges. The alliance encompasses harmonized membership requirements and trading rules and the removal of cross-country entry fees. The Saxess trading platform, which serves as a single point of entry for the Nordic markets, supports trading in a wide range of cash and derivatives instruments, different trading models, and both order-driven and price-driven market structures.

Integration has been facilitated by the purchase of all but one of the regional stock exchanges by the OMX Group of Sweden.67 Integration has been furthered by harmonization of share indices, a common “Nordic List” organized by market capitalization and industry, new corporate governance codes for issuers, and harmonized listing requirements among the OMX Nordic exchanges.

Regional market intermediaries and remote membership are also enhancing integration. In 2002, banking groups from Denmark, Sweden, Norway, and Finland agreed to offer clearing, settlement, and custody to international and domestic customers. Ten brokers account for about 42 percent of global equity turnover in the region, with six belonging to global investment banking groups.

In 2004, the three Baltic stock exchanges jointly established the Baltic Market by integrating trading and settlement systems. This is part of the larger OMX group of exchanges, and it offers ease of access to more than 80 percent of the exchange trading in the Nordic and Baltic countries. However, the Baltic Market and the Nordic Market adopted separate operation frameworks for the moment, because they are at different stages of development. The Baltic Market offers for the three exchanges the advantages of easy cross-membership, a common trading system, harmonized market practices and rules, efficient cross-border trading and settlement services, one market information source such as a common securities list, harmonized corporate information, a common index, and a common data website. A Baltic Fund Center, which was established in 2006, allows investors to more easily compare investment funds and fund-management companies. Further, the Baltic Market introduced an Alternative Securities Market targeting small and medium-sized companies (First North Baltic) in 2007.

Further integration of the Nordic and Baltic markets as one entity is envisaged. The plans call for investors to have full access to all trading both in the Nordic and Baltic exchanges. This would be made possible by full integration of membership applications, trading systems, practices and rules, and information sources.

Supervision is taking the form of arrangements among regulators rather than institutional consolidation. Several Nordic market regulators have concluded an MOU on cooperation in the supervision of the OMX group, and Nordic central banks have signed cross-border MOUs on the oversight of stock exchanges and payment and settlement systems. Further, MOUs are being signed covering cross-border central securities depositories (CSD) groups.

Trading is well integrated for the Nordic-Baltic exchanges, but integration has slowed for clearing and settlement. Clearing and settlement systems use different technologies and are tailored for domestic markets. Upgrading and integrating these systems will be costly. Further, banks are in many cases shareholders of the CSDs and members of the exchange, and also provide other services to investors. Because integration of post-trading infrastructures can alter the profitability of various services, these different products can create conflicts and make it in their interest to slow integration.

The Baltic markets seem to be evolving as an integrated entity unto themselves rather than as part of the Nordic Market. For example, the Baltic exchanges are not part of a CSD created in 2004 by the Nordic exchanges. The divergence of the Baltic exchanges may reflect their smaller economic sizes, different corporate structures, and less-developed country markets.68 The separate path suggests that the Baltics are not fully integrated with their more developed Nordic neighbors, and that it is likely to take time for the Baltics to benefit from the full-fledged regional integration enough to attract global investors’ interests.

Central America69

The setting for market integration in Central America is mixed. On the plus side, financial groups own subsidiaries in almost every country in Central America, and the key shareholders of the most important financial groups are from the region. However, capital market integration is impeded by different currencies, restrictions on domestic institutional investors, the presence of as many as eight exchanges and custodians, the mutual structure of most exchanges, the presence of competing exchanges and custodians, and regulatory conflicts.

Steps toward regional integration have been mainly with respect to the regulators and stock exchanges of Costa Rica, El Salvador, and Panama. In 2003, El Salvador and Panama signed an MOU committing to a fast-track registration of primary issues and mutual funds, Panama granted El Salvador the status of recognized jurisdiction, and El Salvador and Costa Rica signed another MOU agreeing to streamline the registration process, but the impact of this cooperation has been limited. The stock exchanges of Costa Rica, El Salvador, and Panama signed an MOU in September of 2006 for the development of a common trading platform, but progress in implementation has been slow. Further, the exchanges agreed to seek the technical support from OMX.

The slow pace of integration reflects perceived differences in regulation and the challenge of passing new legislation in support of harmonization. There is a perception that the quality of supervision is uneven across countries, and countries that believe they have higher standards of regulation and supervision are not willing to compromise those standards. Other efforts to achieve broader harmonization in Central America have yet to bear fruit because the differences in the regulatory requirements are perceived as significant, and therefore efforts to harmonize them would require legislative amendments, for which it would be difficult to gain political support.

Policy measures are available to help set the stage for integration. Indeed, market participants seem to be positioning themselves through partnerships with regional counterparts to take advantage of regionaliza-tion. A decisive signal by the authorities to harmonize varying regulations could provide an effective signal to align issuers, investors, and intermediaries toward such a goal. Equity market integration could piggyback off of the already fairly liquid government securities markets by government efforts to foster listing and trading in a shared or linked marketplace.

Other Examples of Smaller Economy Regional Equity Market Integration

The first steps toward equity market integration are under way in several groups of smaller economies, in addition to the Baltics and Central America. The stock exchanges of Kenya, Uganda, and Tanzania offer a cross-listing service that enables firms to list their shares on all three exchanges simultaneously. Jamaica has also facilitated trading and transferring shares with Trinidad and Tobago and Barbados through a network of CSDs. These are examples of regional integration among countries at a similar stage of market development, rather than a merger of smaller markets with a larger neighbor. In Maghreb countries, measures fostering information and technology sharing, cross-listing, and cross-border investment would boost equity markets and ultimately lead to broad financial integration.

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1Other markets—such as corporate bonds and commercial paper—are not the subject of this paper because they have a minimal role in most smaller economies or do not exist at all. There is already a large literature on bank financial intermediation and small-scale access (for bank reform, see Calvo, 2004, and DemirgüçKunt and Levine, 2002; and for access, see Claessens, 2006).
2Of the 185 IMF member countries plus Taiwan Province of China and Hong Kong SAR, clearly the 29 advanced countries should not be counted as smaller economies, leaving 157 countries. Seven of the smallest countries were dropped owing to a lack of the most basic data (Antigua and Barbuda, Liberia, Marshall Islands, Federated States of Micronesia, Palau, San Marino, and Somalia).
3Critical thresholds for financial globalization are presented by Kose and others (2006), and evidence for the low level of integration of smaller economy markets with world financial markets is reported in Chapter II. See also Hanson, Honohan, and Majnoni (2003).
4West African Economic and Monetary Union and Central African Economic and Monetary Community integration is addressed in Gulde and others (2006); the Common Monetary Area is discussed in Wang and others (2007); Maghreb countries are covered in IMF (2007a); and Shah and others (2007) assesses integration in Central America.
5Honohan and Beck (2007) discuss the impediments to financial sector development in Africa.
6Chinn and Ito (2005) find that banking sector development is a precondition for equity market development.
7One estimate of the minimum level of outstanding government debt for a very liquid (in terms of tightness, depth, immediacy, and resilience) government bond market is provided by McCauley and Remolona (2000), who propose a minimum threshold of $100 billion, which is far larger than any of the smaller economies’ government domestic debt.
8Bossone and Lee (2004), based on a sample of 875 banks in 75 countries, found that intermediaries operating in systems with large markets and infrastructures have lower production costs and lower costs of risk absorption and reputation signaling than banks operating in small systems. Malkamäki (1999) find evidence for economies of scale for relatively small stock exchanges. Schmie-del, Malkamäki, and Tarkka (2002) find significant economies of scale in depository and settlement systems especially for smaller systems.
9Because banking systems are more important for smaller countries, the use of broad money will overestimate the relative size of smaller economy financial systems.
10For example, in Zambia the 13 companies listed on the Lusaka Stock Exchange as of early 2006 may not be sufficient to allow the market to develop, notwithstanding the recent favorable macroeco-nomic performance.
11Stulz (2005) argues that agency problems posed by cooperating sovereign states and corporate insiders with respect to outside investors limits financial development.
12IMF (2008) assesses capital flows and financial market development in Africa.
13This index takes on higher values the more open the country is to cross-border capital transactions. It is based on four binary dummy variables (covering the presence of multiple exchange rates, restrictions on current account transactions, restrictions on capital account transactions, and the requirement of the surrender of export proceeds) reported in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).
14The only papers that address foreign exchange markets in emerging market countries and smaller economies appear to be Kovanen (1996) and Gray and Talbot (2006).
15This paper does not address the issue of the appropriate exchange rate regime for smaller economies (see Mussa and others, 2000).
16The lack of data for smaller economy foreign exchange markets can itself be seen as a sign of lack of development.
17Calvo (2004) provides an overview of bank development policies.
18The number of market makers in Iceland was at most six, but this number has declined owing to, among other issues, mergers.
19See Canales Kriljenko, Guimarães, and Karacadag (2003).
20In developed markets, codes of conduct are formed by professional dealer associations such as the Financial Markets Association. Market committees such as the Joint Standing Committee in the London market and the Foreign Exchange Committee in New York relay the views of market participants to the authorities.
21In developed markets, however, the traditional segmentation between the inter-dealer and the dealer-to-customer market is undergoing a transformation by new types of electronic trading platforms that provide nonbank customers direct access to the interbank market.
22Although the rules guiding interbank market trading and codes of conduct are typically based on self-regulation, government or central bank regulation may restrict access to the foreign exchange market for specific purposes.
23Price discovery is also possible under a currency board arrangement. For example, the Hong Kong Monetary Authority maintains a “Convertibility Zone” of US$7.75–$7.85 to HK$1 within which the exchange rate varies and market operations are conducted.
24Government securities market development in emerging market countries is covered in Árvai and Heenan (2008) and IMF and World Bank (2001); Gray and Talbot (2006) address money and government securities market development generally. The discussion and country references in this chapter draw on these papers, as well as IMF (2005a,2007c,2007d).
25This is the approach taken in IMF (2005a) with respect to money markets, and Árvai and Heenan (2008) on government securities markets.
26Abbas and Christensen (2007), using a database of 93 emerging market and developing countries, found that moderate levels of domestic government debt are associated with a positive impact on economic growth and financial development.
27Equity markets can be developed by private sectors themselves as well. But here we focus on the government policy because it plays an important role in establishing an institutional market framework such as a stock exchange.
28Reputation and status are cited as key reasons for listing in Fiji and Guyana.
29Carvajal and Elliott (2007) find a high correlation between the level of income of a jurisdiction and the level of implementation of the International Organization of Securities Commission’s (IOSCO) “Objectives and Principles of Securities Regulation.”
30According to IMF experts, the costs for the components of a capital market infrastructure are (1) trading platform, including IT equipment for eight to 10 trading houses, $1.9 million; (2) CSD, including a securities settlement system, $1.4 million; (3) real-time gross settlement system, $1.2 million; (4) automated clearing house, $1 million; and (5) maintenance costs (consultancy and training of the involved staff at the capital market and the central bank), which can be about $1 million, depending on transaction volume and the salary of qualified staff.
31This approach can be applied to other institutional markets such as those for commodities and metals.
32This should be accompanied by proper prudential guidelines for such investments to avoid excessive risk taking and potential adverse social consequences.
33A single trading platform for equities and fixed-income securities is not necessarily common in developed markets. However, stock exchanges in developing countries often aim at the synergy effects, with government securities given underdeveloped OTC bond markets.
34For experiences in European exchanges in the context of regional integration, see Annex IV.
35See the discussion of market associations in the previous chapter.
37Carvajal and Elliott (2007) find that weakness in implementation of IOSCO principles for low-income jurisdictions is observed particularly in the areas of cooperation (with domestic and foreign counterparts) and market intermediaries.
38Although median market capitalization and turnover across smaller economies have been growing, the median number of listed companies has barely increased (Annex IV).
39For Slovenia, Andritzky (2007) advocates preserving a local capital market segment tailored to the needs of domestic issuers.
40In Spain, banks can package SME loans and pass them on to special-purpose vehicles, which are eligible for treasury guarantees for specific tranches.
41WAEMU and CEMAC integration is addressed in Gulde and others (2006); CMA is discussed in Wang and others (2007); Maghreb countries are covered in IMF (2007a); and Shah and others (2007) assesses integration in Central America.
42Even the most developed markets do not appear to be efficient and, at least at high frequencies, do not reflect information on the underlying fundamentals (Sager and Taylor, 2006; and Lyons, 2005).
43A systematic examination of smaller economy central bank websites and Financial Sector Assessment Program (FSAP) reports showed that official foreign exchange market turnover data are not available for most of these countries.
44These case studies are based on, in addition to specified references, various information sources including central bank websites, IMF Staff Reports, and unpublished papers at the IMF.
45The AREAER notes that the regime operating de facto is different from its de jure regime.
46At most, the number of interbank market makers reached six but has since declined to four.
47The status as a counterpart to the central bank tends to be highly valued by banks for several reasons: (1) it has a positive impact on the reputation of a bank and is used as a marketing tool for attracting other client flows, (2) they can earn a premium on the intermediation business, and (3) it provides private information about central bank flows. For a discussion on the value of private information see Lyons (2005).
48Since 1999, the central bank has operated exclusively within the policy objectives set by the inflation targeting regime or for purposes of strengthening its net foreign position. Transparency is a key aspect in the implementation of any operations (see Ísberg and Pétursson, 2003).
49The horizontal bands were widened from +/−2.25 percent to +/−6 percent in 1995 and to +/−9 percent in 2000 before fully floating the exchange rate in 2001.
50The AREAER notes that the regime operating de facto is different from its de jure regime.
51The exclusion of foreign exchange bureaus at the early stages of market development initially led to a significant reduction in the degree of competition in the foreign exchange market. The more sophisticated foreign exchange bureaus were thus encouraged to develop into nonbank financial institutions or even banks, possibly through mergers.
52Market participants perceived that exchange rate variations were subject to daily limits of +/–2 percent from the previous day’s weighted average rate and that deviations from what was perceived as a “desirable” level would result in less support for covering their foreign exchange position with the central bank.
53Foreign exchange sales form part of central bank operations to sterilize the inflows under the Poverty Alleviation Fund expenditures financed by donor flows.
54Spot foreign exchange sales withdraw domestic liquidity and may be resorted to as an instrument to reduce (or remove) a structural surplus of liquidity (as opposed to foreign exchange swaps, which only have a temporary impact on liquidity).
55The reported data encompass instruments issued by the national government, regional and municipal governments, agencies, and local corporations.
56The data source with the broadest international coverage appears to be the Standard & Poor’s Emerging Markets Database, which is reported by the World Bank.
57These case studies are based on, in addition to specified references, various sources including annual reports of central banks and stock exchanges, other information on their websites, and IMF Staff Reports.
58The government has partly made up for shortfalls in bank lending in some areas, ranging from small enterprises to parastatal corporations. The Citizens Entrepreneurial Development Agency (CEDA) implements such programs aimed at supporting small and medium-sized enterprises by providing subsidized loans. Lending by the CEDA through August 2004 amounted to P 674 million (1½ percent of GDP) for use in more than 1,000 projects.
59In addition, new bonds were issued in 2004 by Debt Participation Capital Funding, a vehicle to securitize the government’s loan book, and they are now listed on the BSE. This is also consistent with the strategy of developing capital markets, as well as of reducing government financial arrangements.
60OMX is a private firm that is expert in the exchange industry, operating the exchanges in the Nordic and Baltic region. It develops and provides technology and services to companies in the securities industry around the world.
61This was due to the buyback of Hansabank shares, one of the largest listed companies in the Tallinn Stock Exchange.
62In 2006, the Olympic Entertainment Group’s stocks began to be traded simultaneously in Estonia, Latvia, and Lithuania. This is the first case in the Baltic Market.
63In 2005, the average market capitalization for emerging Asia was 39.8 percent of GDP, emerging Europe was 54.7 percent, and Latin America was 49.5 percent.
64The ATS is sourced from Millennium Information Technologies (MIT) of Colombo, Sri Lanka. MIT has also supplied similar solutions to the Colombo Stock Exchange and the Stock Exchange of Mauritius.
65Separately, the government has made efforts to enhance access to finance for micro, small, and medium-sized companies. A new specialized bank, “Lankaputhra,” was established in 2005 to cater to the SME sector in the country. The Central Bank of Sri Lanka has continued to assist these programs.
66The Baltic Markets refer to stock exchanges in Estonia, Latvia, and Lithuania. The reference to the Nordic area means exchanges in Denmark, Sweden, Norway, Finland, and Iceland.
67The Norex alliance remains valid even after the OMX group of exchanges was established.
68The Baltic exchanges have much lower capitalization-to-GDP ratios compared to those of the Nordic countries, and they are dominated by equity issues, whereas bonds make up a significant share of the Nordic exchange capitalization.
69This section draws on Shah and others (2007).

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