V. Secondary Equity Markets

International Monetary Fund
Published Date:
December 2008
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This chapter focuses on secondary market trading in formal equity market exchanges in smaller economies. Formal stock market exchanges are the focus because information is available on them and often governments explicitly aim to develop capital markets. Virtually no data are available for primary markets—which in smaller economies are often dominated by private placements, and by their nature they are less integrated into the financial system. Equity markets are considered after the other financial markets because the infrastructure, liquidity, and institutions that arise from foreign exchange, money, and government securities markets also facilitate the development of stock exchanges. Further, the scope of equity market development policies, which can involve issuing companies and institutional investors (which in smaller economies are often government-owned or controlled), is broader than for the other financial markets. Still, there is some important feedback from developing equity markets for the other financial markets. Case studies for countries referred to below are provided inAnnex III.

Stylized Facts

More cross-country quantitative information is available for secondary equity markets in smaller economies relative to other financial markets. Smaller economy equity markets are much less developed compared to those in other countries:

  • Only 40 percent of smaller economies have formal secondary equity markets, compared with more than 85 percent for emerging market countries.

  • Market capitalization and the stock turnover ratio data for the equity markets that do exist in smaller economies are much lower compared to emerging market countries. Market capitalization and trading volume vary considerably across smaller economies.

  • Stock markets in smaller economies appear to provide a small proportion of financing of companies. Initial public offerings (IPOs) appear to be limited or nonexistent.

  • Importantly, stock market trading, whether measured as a share of GDP or with respect to market capitalization, is much lower in smaller economies.

  • Despite a recent increase in market capitalization (in percentage of GDP) in smaller economies, the gap between market capitalization in smaller economies and emerging economies has widened.

Smaller economy equity market development is not catching up with emerging market countries:

  • The median of market capitalization across smaller economies has increased over the past seven years, but at a much slower rate than that of emerging market countries.

  • The median turnover-to-GDP ratio across smaller economies is stagnant and rapidly falling behind that of emerging market countries.

The lack of development of the vast majority of smaller economy equity markets can be attributed to the following:

  • The number and size of companies and institutional investors in smaller economies are much smaller than in other countries.

  • Companies listed in smaller economy stock markets have a relatively small share of “free float,” or traded shares as a proportion of total shares.

  • A large share of companies in smaller economies are family-owned and reluctant to raise governance and transparency practices to make the issuance of shares on an exchange possible.

Market Development

The discussion of equity market development is also organized into three “stylized” stages, but the strategies are different from the other essential financial markets. Equity markets are somewhat different from the other essential financial markets in that the market players themselves play a bigger leading role and government policies cover a wider spectrum. For these countries, the key policy issue is whether a new market is viable and worth the costs of establishing it. If not, alternative sources of corporate financing may be a better policy objective. Policies to develop markets with a regular but relatively low turnover market are largely aimed at institutions and basic corporate governance. Finally, deep and active secondary market development is led by the market players themselves, with different government agencies improving the provision of information and fostering market stability.

No Market or Inactive Market

Three-quarters of smaller economies either do not have an equity market or have a thin market (less than $20 million in trading volume per year). The main issue here is whether or not to commit to develop an active secondary equity market.

Policy Strategy

When deciding whether to support the creation of a new market or developing an existing one, the authorities must first judge market viability. Viability requires that the country have the number and size of potential issuers and institutional investors to support a market. A necessary condition is that the benefits of market issuance must exceed the costs for a large enough number of companies to sustain the market. Annex III shows that the presence of a market in smaller economies is related to the size and level of development of the economy, which likely correspond to the number and size of potential equity market players.

If a market is deemed not viable, then it is more likely that the fiscal and other costs to the public sector of setting it up exceed the benefits.27 As discussed earlier, the opportunity costs of expending scarce government financial and human resources on market development can be high. The benefits from a less active equity market are likely to be limited, and encompass (1) the reputational improvement that companies get by listing on a stock exchange,28 (2) the asset diversification opportunity, albeit limited, for institutional investors, and (3) positive synergies for developing other financial markets and attracting investors.

“Angel” and Private Equity and Bank Financing

The payoff of policies aimed at fostering angel and private equity financing and bank lending may be higher than that from stock exchange development. “Angel” financing involves informal equity financing of companies by wealthy individuals or families and does not require a systematic regulatory framework or an institutional market infrastructure, but can benefit from a strong contract enforcement legal framework and judiciary, in particular to enforce investor exits (see World Bank, 2001a and 2003). However, in many smaller economies, the legal framework is lacking and the judiciary does not have the expertise or the resources to provide for speedy disposition. In countries where private equity has been successful, the bulk of the limited partners are institutional investors, including mutual funds and pension funds. Thus the lifting of investment restrictions on these institutions can help boost private equity financing. Angel and private equity holdings should have a legal status with clearly defined boundaries to provide legal certainty to all participants (Berger and Gregory, 2004). One approach is to assign legal status to private mechanisms for dispute resolution. In Costa Rica, recent amendments to the Securities Law authorize the creation of venture capital funds, which would be allowed to invest in private equity. At the same time, measures can be taken to develop the banking sector and absorb excess liquidity, as discussed in previous chapters.

Low Turnover Market

At this level, the secondary market is small, with trading taking place on a daily basis. Investors are almost exclusively domestic institutions.

Policy Strategy

The policy goal is to deepen and broaden as much as is feasible in the local circumstances. The extra benefits of this type of market are (1) a degree of market discipline for listed companies, (2) significant portfolio diversification of institutional investors, and (3) extra synergies with other markets, including in infrastructure.

The limited number of players means that the authorities will take the lead, albeit in tandem with market players. Issuers and investors are typically small in number and size and may have been exposed to deep and liquid financial markets. At the same time, the government must work closely with market players to ascertain their infrastructure and other needs, which will differ widely according to the level of market sophistication (Box 5.1). As mentioned before, the government of Botswana formulated and implemented a national financial sector development strategy.

Issuers and Institutional Investors

Privatization of large state companies can boost market capitalization. The sale of government telecom companies in Jordan, Fiji, and Slovenia sharply raised market capitalization. In a similar vein, the cutting back of government financing of state companies can compel them to raise funds from the stock market, as in Botswana.

Pension reform can deepen markets. In Botswana, the introduction of a defined contribution pension scheme for public officers in 2001 shifted pension claims to private funds, which allowed more efficient and diversified investments into both domestic and offshore markets. Botswana’s pension funds at end-2006 held 18 percent of the total assets in the domestic equity markets. Pension funds in Croatia invested 64 percent of their asset growth into the local capital markets in 2005, contributing to a sharp increase the equity prices. The lack of a broad and diversified domestic institutional investor base has held back equity market development in many African countries.

Box 5.1.Stock Exchange Trading Systems in Smaller Economies

The two main trading mechanisms used in smaller economy stock markets are:

  • Auctions—Orders are accumulated in a single place with periodic clearance at a predetermined time, such as a few times a day or several days a week (call system), or continuously. Brokers forward orders to the auction system, but they do not take a position. An auction market requires a formal and institutionalized setting including an information technology infrastructure. Auctions are effi cient and provide transparent price discovery as long as there is enough liquidity. Most smaller economy stock exchanges use auction systems.

  • Market makers—Investors can transact at any time with a market maker, who provides continuous buy and sell quotes. The market maker holds a long/short position until either it or another market maker gets an offsetting order. An effective market-maker mechanism requires that market makers can respond quickly to investors’ orders. Typically, these transactions are executed over the counter (OTC), but in some cases, market-maker and auction mechanisms work in parallel.1

The appropriate trading system evolves in line with the stage of market development:

  • Initial—A market-maker system or a periodic auction system is suitable for markets with a small number of participants and securities. This is the case for the fi rst stage. In Guyana, brokers can match orders in-house before forwarding them to the exchange. The Guyana Stock Exchange, providing only one session a week, supports two types of trading, a single price auction and on-fl oor trading, in the latter of which brokers can view the other brokers’ orders to deal with each other.

  • Intermediate—A periodic call auction system can be used to match buyers and sellers when trading accelerates to the point that buyers and sellers can be matched on a frequent basis. As volume picks up further, the number of calls can be increased. In Fiji, the number of trading sessions increased from three (Mondays, Tuesdays, and Thursdays) to fi ve per week in 2003 in response to an increase in transaction volume.

  • Advanced—A continuous auction system is common in the more developed smaller economy markets. In addition, a market-maker mechanism may serve sophisticated investors that demand fl exible trade size, timing, and composition. These customer-made transactions are facilitated both OTC and by exchanges.2 Nordic and Baltic exchanges allow off-exchange registration, where buyers and sellers agree to terms over the telephone rather than via automatic matching. The Colombo Stock Exchange also provides special procedures for block trades so that they are executed based on already-negotiated terms.

1 The market-maker approach also can be well suited for securities such as government bonds with trades concentrated in a small number of benchmark issues and participants limited to institutional investors and dealers, as well as smaller economy interbank money markets and foreign exchange markets. In some cases, market makers can be provided incentives by the authorities like those of primary dealers.2 Information on OTC transactions may be required to be reported to the exchange to ensure an efficient and transparent price discovery process.

The gradual relaxation of restrictions on holdings of institutional investors in private equity can boost market development. The shift of assets of the Social Security Corporation of Jordan from bank deposits and fixed-income instruments to equity products reached $851 million in 2004 (46 percent of its total assets), comprising 11 percent of the ownership in the local exchange.

Attracting foreign investors can be effective as long as new capital inflows are consistent with external stability. Jordan has a success case. Botswana continues to provide positive signals to international investors by getting sovereign ratings and preparing the offshore center, although this has yet to bear fruit for the stock exchange. The lifting of limits on foreign ownership of domestic companies in Kenya boosted market capitalization.

Regulation Should Balance Development and Stability

Regulation should balance costs to issuers against the need for information for market development and investor protection. For most companies in smaller economies, the costs of adhering to market regulations will exceed the benefits of market issuance. Thus, a balance must be struck so that the costs of regulations are right for market-worthy companies.

A regulatory framework will be needed for market intermediaries. Governments should consider whether to allow banks or other existing financial intermediaries to carry out these activities or whether a new type of specialized financial intermediary is needed (investment banks, fund managers).

Secondary equity market trading should be limited to sophisticated investors. Only shares issued on the market should be traded freely, because other shares (venture capital and private placements) are not supported by a regulatory framework that obliges issuers to provide information to the public.

Policy Capacity and Implementation

Small countries often face challenges in implementing market-supporting legal and regulatory changes.29 In Guyana, the Securities Industry Act was enacted in 1998, but was not put into operation until 2002 upon issuance of the regulations. In Mauritius, staffing needs have slowed implementation of key market supporting laws.

Infrastructure Need Not Be Sophisticated

Low trading volume usually implies that sophisticated systems are probably not needed and resources could be spent elsewhere. The sophistication of infrastructure varies considerably across smaller economies and is not always related to the very wide spectrum of market volume. Sixteen smaller economy markets have less than $20 million annual turnover and another nine are in the $20 million to $100 million range (Annex III). The fixed costs of setting up the basic components of a sophisticated secondary market infrastructure (trading platform and a CSD) are in the range of $2 million to $3 million, while maintenance costs can be $200,000 to $1 million.30 These infrastructure costs likely exceed the efficiencies gained for the low-volume smaller economy markets. Thus, for these countries the infrastructure can be kept simple and the lack of a sophisticated infrastructure should not be viewed as a constraint to market development.

Thus, a fixing session can be appropriate for thin markets. Under this approach, trading is on a periodic basis, at predetermined points in time—for example, once or twice a day or even once a week.31 The frequency would depend on the trading volume of the market. This approach is quite inexpensive and fully supportive of low-volume trading. In Fiji, the number of trading sessions increased from three to five per week in 2003.

Investor Education

Improving awareness on the role of the stock exchange can prompt potential issuers to tap equity markets. A lack of knowledge regarding equity financing enhances firms’ reluctance to be listed on the exchange. In Sri Lanka, the stock exchange upgrades marketing activities toward companies and assists their listing processes. The stock exchange in Fiji also initiated seminars to educate potential investors.

Deep and Active Secondary Markets

These secondary equity markets are active and formal. Equity financing in the form of initial public offerings (IPOs) is available for a wide variety of companies from a wide variety of investors, including small investors. The secondary market is a formal stock exchange with transactions facilitated by market makers and custodians. In Jordan and Sri Lanka, the primary markets are benefiting from active secondary markets.

Policy Strategy

The increased sophistication and dynamism of markets means that market players are best suited to drive market deepening. The extra benefits are considerable: (1) the alternative source of financing for corporations provided by IPOs, (2) the continuous market discipline exerted on corporate management, (3) an exit for investors, (4) better portfolio performance for institutional and individual investors, (5) better systemic financial stability provided by the “spare tire” of equity financing, (6) synergies with other markets, and (7) greater capital inflows. Rather than trying to drive the reform of sophisticated markets, the most useful role of the authorities is to remove impediments and foster systemic stability. Often, the stock exchange itself can instigate market development, as in Kenya and Sri Lanka. Similarly, intermediaries can drive reform, as was the case in Jamaica.

At the same time, the authorities must take the lead to maintain systemic financial stability. In most cases, government intervention is not needed in the event that nonbank market players become insolvent, because their failure would not have systemic implications. However, broad market failures can have systemic implications, including through linkages with the banking system (Carvajal, 2006). Thus, the authorities should aim to ensure that the decisions of market players do not threaten systemic stability.

For many smaller economies, innovative approaches may be needed to foster equity financing. As discussed below, equity markets that are not developed enough to attract the capital of local large companies may serve the public interest better by targeting SMEs.

Information Disclosure and Corporate Governance

Information disclosure will rest on balancing investor needs for information and the costs to issuers of regulatory requirements. A basic degree of transparency is required, whereas more sophisticated issues can be dealt with over time (for example, regulation of tender offers). The regulatory framework requires issuers to disclose key financial information, updated periodically. However, mandatory disclosure requirements for SMEs should be simpler, to reduce their costs of issuance. Publication of issuer financial information by the exchange itself, as in Jordan, can improve transparency. In Mauritius, the new Corporate Governance Code is seen as improving the governance of private companies. A “comply or explain” regime, under which companies are obliged to justify any deviation from corporate governance codes, is a possible alternative to a sophisticated corporate governance framework. The stock exchange in Kenya has also promoted improvements in corporate governance through the award program.

Individual Investors

The involvement of individual investors in the stock market can boost market development. Sri Lanka promotes participation of individuals thorough various marketing activities via its unique branch network. In Jamaica, securities dealers have encouraged the participation of retail investors. More generally, an education program for potential investors, including the young generation, may be effective for expanding individual participants.

Pension Reform

Pension fund reform poses tradeoffs for market development. A mandatory private pension system can vastly strengthen the institutional investor base for equity and other markets, and has proved to help boost market development. At the same time, these pension funds can dominate the demand side and hinder secondary market liquidity with a buy and hold strategy, as was the case in Botswana, Chile, and Croatia. Further, for most smaller economies, restricting pension fund assets to be invested domestically may limit the portfolio performance with respect to investors, and potentially create asset bubbles. Hence, easing restrictions on the overseas investment of pension funds32 helps promote domestic stability, as well as diversification of the fund’s portfolio.

Market Synergies

Equity markets can benefit from the development of markets for bonds and other securities. The stock exchanges of Botswana, Croatia, Jamaica, Mauritius, and Sri Lanka trade bonds and government securities, thus allowing investors to diversify their investments in a single marketplace.33 This would be assisted further through a common CSD that facilitates efficient settlement operations.34 In Sri Lanka, other instruments, such as securities lending and derivatives, are also recognized as necessary ingredients to equity markets.

Market Associations

Associations of market players can help set up a stock exchange and improve efficiency and stability as markets become more sophisticated.35 Market associations established the forerunners of the stock exchanges in Kenya and Sri Lanka. The market association in Guyana runs the stock exchange.

Demutualization and Merger of Exchanges

Demutualization of the stock exchange can help develop the market. Demutualization converts member-owned, nonprofit exchanges into profit-driven investor-owned corporations with a view to increasing access to capital, which can be invested in new technology and can strengthen corporate governance (Aggarwal and Dahiya, 2006; Elliott, 2002). The stock exchanges of Jamaica, Kenya, and Sri Lanka are considering demutualizing or are planning to do so. Issues raised by demutualization include the regulation of the new exchange, the distribution of shares, and the new governance structure. Differently, in Croatia, two domestic stock exchanges were merged into one in 2007, in order to achieve greater liquidity in equity markets.


Intermediaries that agree to continuously quote buy and sell prices can enhance market liquidity. The separation of banking from nonbanking activities in Jamaica led to the transfer of funds under management to securities dealers, which intermediated these funds into the stock market. Effective intermediation requires a sufficient degree of competition, which can be problematic in some of the smaller economies. High brokerage fees are cited as an obstacle to greater liquidity in some countries.


Upgrading of infrastructure should be market-led. A very basic automated-floor-based system can work well for a simple market. Advances in technology have also made it more affordable for countries to begin with fully dematerialized systems. In Croatia, brokerages and members of the exchange are connected by special telecommunications links with exchange headquarters, facilitating dematerialized trading. The stock exchange in Jamaica has benefited from the book entry services of the central securities depository. The role of the government should be only to remove impediments or address potential systemic risk issues.

Equity Market Regulation

A clear assignment of regulatory responsibility is important. A variety of equity market regulatory arrangements are in place in smaller economies. The stock exchanges of Guyana and Fiji are regulated independent entities whose members are appointed by the minister of finance. In Jordan, the institutional separation of the supervisory, legislative, and executive roles in 1997 facilitated market development. By contrast, the regulatory arrangements in some smaller economies are complex and ambiguous.37 Harmonization of the work of different regulatory bodies helps eliminate regulatory arbitrage.

An incremental approach tailored to local circumstances is the best way for policies to help develop equity markets. For most countries there is no need to jump to a high degree of market sophistication. Rather, policies should be guided by the needs of issuers and investors, with progress on different fronts.

Supervision must be tailored to ensure that market players do not threaten systemic stability. Nevertheless, smaller economy markets can be large enough to cause systemic problems, as in Costa Rica (Carvajal, 2006). Regulatory restrictions should be carefully considered, and removed if the benefits for market development outweigh the potential risks. These restrictions can apply to investment, portfolio allocation, and trading by market participants or limits to assume or hedge risks.

Targeting Small and Medium-Sized Enterprises

Smaller economy stock exchanges face the risk that larger companies may cross-list with large exchanges in other countries. The cross-listing of firms is increasing around the world (Claessens and Schmukler, 2007). Cross-listing of corporations from emerging market countries tends to reduce liquidity in their home country stock market (Levine and Schmukler, 2006). Although cross-listing data are not available for smaller economy countries, the stagnant number of companies listed on most smaller economy exchanges, and the growing gap between capitalization and turnover of smaller economy stock markets with those of advanced and emerging market countries, suggests that there is a risk of significant cross-listing of large domestic companies.38

If this is the case, then smaller economy stock markets should consider focusing on local SMEs with a view to enhancing their access to financing by domestic institutional investors. Switching from large companies to SMEs may be the best way for smaller economy stock exchanges to maintain their viability and maximize their positive economic impact. This would require lowering the cost of issuance to attract SMEs by lightening the regulatory touch on information disclosure and corporate governance (Honohan and Beck, 2007).

Indeed, many smaller economies have set up second-tier markets with less-stringent listing requirements, but these have met with mixed success. Second-tier markets have less-costly listing requirements (a minimal degree of market capitalization, profits, governance, and information disclosure) to make them attractive to small and newer companies. Botswana, Ghana, Kenya, and Mauritius are examples of smaller economies with second-tier markets targeted at different types of companies, including SMEs, technology companies, and start-ups. In some cases, only sophisticated investors that do not require the same level of protection as the average investor are allowed to purchase shares. Some of these markets have grown quickly, such as that of Mauritius, but others have not attracted many listing companies. Notwithstanding lighter listing requirements, establishing active second-tier markets for SMEs requires that the disclosure and governance practices of these listed companies be sufficiently robust to gain local investors. This requires a strong legal and regulatory infrastructure for issuers, which will be a challenge for many smaller economies.

It may be possible to involve stock exchanges in an innovative way with existing government-supported efforts to enhance financing for SMEs.39 Botswana established the Citizens Entrepreneurial Development Agency, aimed at supporting SMEs with subsidized loans. Sri Lanka created a new specialized bank to finance SMEs, and the Central Bank of Sri Lanka continues to assist commercial banks to expand the micro credit programs to rural regions. Several European governments are working with banks to make possible securitization of SME loans (European Commission, 2007).40 An open question is whether there may be a role here for stock exchanges, for example in facilitating the trading of securitized loans, or explicit government involvement in individual SME issuance.

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