An Introduction The Microstructure Emerging Markets

I. IntroductionInterest in the emerging markets as a source of high returns and diversificationbenefits hasincreased in recent years. One result of this interest is that estimatedgross portfolio equity flows toemergingmarket countriesdoubledfrom 3.5 billion in 1989to about 7.6 billion by year-end 1991,andreached 13.2 billion in 1993.1 Unless conditions change dramatically, one can expect to see evengreater interest in these markets in the future as experienceleads to a better understandingof how themarketsbehave and who the market participantsare.One fundamentalfactor leadingthe wave of emergingmarket investmentis an increasingvolumeof research on the markets,the listed companiesand the countries. Once thesemarkets were discovered,Wall Street analysts and investmentbanking firms have devoted significant amounts of resources toprovidinginvestorswith ever-more-detailedreports and forecastson where to invest. Hardly a day passesnow withoutreference in one of the major financialpublicationsto some emergingmarket development,somethingunheardof just a few years ago.Despitethis flurry of activity, however, much remains relatively obscure about these markets.One aspect of the markets that has been neglectedin most of the availableliterature is a discussionoftheir trading structures,now commonlycalledmarketmicrostructure. Probablyall institutionalinvestorsknowthat the New YorkStock exchangeuses a market specialistsystem, what types of trades are allowedand how the market functions,but that level of knowledgeis largely missingfor the emergingmarkets.This paper provides an introductionto market microstructurein the emergingmarkets. Its goalis to sensitizereadersto the importanceof microstructurein achievingmarket successand to the amountof variation in microstructure that is possible. The importance of microstructure is explored bydescribing the role it can play in promoting market liquidity, somethingcritical for market success.Microstructurevariationis illustratedby examininga sampleof seven marketsfrom six emergingmarketcountries. Those marketsprovideevidenceof how muchleewaymarket administratorshave in designinga market.The paper is descriptivein nature, not prescriptive. While theory suggeststhat market structurecan have importanteffects on price and trading behavior, the modelsused by economistsare much toosimple to allow one to draw firm conclusionsabout which market structure is optimal. Still, one canlearn muchfrom the economicliteraturethat exists and from understandingbetter how different marketsare designed. With that in mind, the paper describes some of the important features of marketmicrostructureand illustratesmicrostructurediversitythrough market descriptions.The remainder of the paper is organized as follows. First, a general discussionof financialmarkets is presented,followedby an overviewof microstructurewhich describesmajor market attributesand the importanceof market microstructureto those attributes. Following that is an overviewof theseven emergingmarkets and how they differ in their microstructures. A summaryis followedby detaileddescriptionsof each of the marketsin the market annexes.' World Bank (1994).

II. Financial MarketsFinancial markets play an importantrole in capitalist economiesby facilitating intermediationbetweensavers and investors. The better they performthat service, the more likely it is that savers willbe motivatedto supply capital, thereby reducing its cost to investors, who themselveswill be motivatedto seek capitalfrom the public rather than through their own savings. By facilitatingintermediation,wellfunctioning financial markets increase investment/savingsrates, which translates into higher rates ofeconomicgrowth. For that reason, it is importantthat financialmarketsbe well organizedand regulated.Participantsdependon financial marketsto provide four basic functions. On both the investorand issuer side, markets are expected to provide information signalling on the value of financialinstruments, which provides the basis for the emphasis in finance on market efficiencyin processinginformation. This informationrole is critical as it provides the basis for investmentand issuancedecisionsby indicatingto participantsthe value (or cost) of individualinstruments.Investors also rely upon marketsto providesavings instruments,which provide the second andthird functions: storage of wealth and risk sharing through diversification.The fourth function relates directly to the supply side of the market and the role of financialmarkets as a source of capital. The ability of markets to provide this fourth function, capital raising,makes them particularly attractiveto developing countries where capital can be in short supply. Ineconomieswhere markets have not developed,capital shortagesinhibit development.Economistsrecognizethe importanceof financial markets and separate fields of specializationhave emerged in order to study the markets, their participants and their ability to provide the fourfunctionsjust described. Corporatefinance studiesthe issuers of securities and how the choicebetweendifferent financialinstrumentsis made. Capital market theory investigatesthe pricing of securitiesandthe role of financialintermediaries.Marketmicrostructuretheory examineshow securitiesare traded andthe influencethat trading systemshave on market behavior and success.Economictheory indicatesthat the ability of financialmarketsto attract private capital dependsvery much on the institutional nature of those markets, which is itself a function of the regulatorystructure under which the market functions, as well as the market's microstructure. Regulationhasobvious importanceby dictatingwho can participatein the markets, what instrumentscan be traded and,to some extent, how much trading costs. Despite this obvious importance, regulation is taken asexogenousin this paper in order to concentrateexclusivelyon market microstructure.A growing body of theory and empirical work shows the influencemicrostructurecan have onmarket behavior. While much of that influence arrives through the effect of microstructure oninformation processing and transaction costs, the impact carries over to each of the other functionsmentionedaboveas well, somethingdescribedin more detailbelow. Given the importanceof financialmarkets more generallyand the impactthat microstructurecanhave on their success, it behoovesmarketparticipants, regulators and administratorsalike to understandbetter at least the basic tenets of marketmicrostructure. The next sectiondescribes in more detailthe influencethat microstructurecan have onmarket behavior and attractiveness.2

M. Market Microstructure TheoryAccordingto economictheory, markets achieveoptimalcapital allocationsthrough the classicalrisk/return tradeoff that is the keystoneof modernfinance. But this theory takes the market as a blackbox where information goes in and an efficiently determined price comes out. Increasingly,microstructure theory highlights the importance of stock market institutional features and tradingmechanisms as important determinantsof market behavior. These new theories suggest that policymakersand market administrators,throughtheir choiceof tradingsystemsand other institutionalfeatures,can influence trading and price behavior. To the extent this also translates into more efficientdeterminationof prices and lower transactioncosts, then all concerned-both investors and securitiesissuers-are better off.The idea that market microstructureinfluencesprice behaviormay surprisemanyreadersbecausemarkets are often taken for granted and assumedto be essentiallythe same everywherewith supply anddemandalone determiningprices. At a very generallevel that is true, but at another level microstructurecan influenceboth supply and demandby making trading easier or harder, more or less costly, and byproviding informationto potential traders that influencestheir trading decisions and induces them toparticipatein the market. In short, microstructurecan make markets more attractive.Marketmicrostructuresare complicatedand involvea numberof importantaspectsof the tradingprocess. They vary in the way transactionsare handled-discrete versus continuousauctions, marketmaker versusjobber markets,manualversusautomatedsystems,on- and off-exchangetransactions2 -andin the types of transactionsthat are permitted-for example,limit orders and short sales.' Importantly,market structure determinesthe type of informationavailable to market participants. Some marketsprovidenearly completeinformationnot only on past transactions,but also on the outstandingsupplyanddemand curves; in other cases minimal informationis available. Also importantly, especiallyin thenewer automatedsystems, microstructuredictatesthe manner in which incomingorders to buy and sellare matched, which determines,to some extent at least, the price at which trades occur.The importanceof microstructurearises from the role it plays in eachof four fundamentalmarketattributes: liquidity, efficiency, trading costs and volatility. Though closely related, each of theseattributes is different and can be influencedby microstructure,the regulatory regime under which themarket operates, as well as by the economicfundamentalswhich drive securityprices. The remainderof this section definesthese attributes and discussesthe manner in which microstructurecan enhancemarket success through its effect on them. Of course, markets are driven in large part by economicfundamentals which, regardless of the microstructure, play an important role in price and volume

market microstructure has revealed the significant role that it can play in both market success and individual security pricing. Through its effects on market liquidity and the cost of trading in particular, microstructure can make a market more or less attractive, t