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Stock exchanges - Part 3


6. Merger and Stock Liquidity

Following a stock exchange merger, firms gain in terms of stock liquidity. The first reason behind this gain is that the market may widen and become broader such that more participants trade in the listed firms. Every individual firm gets the opportunity to face a bigger pool of potential investors. The second reason is that the market may deepen, which means that, larger quantities are made available at a price that is marginally above and below the prevailing market price. The market, thus, becomes more liquid since the chances of large individual traders to drive price movements are slim. Thirdly, various cost channels exist, through which, the liquidity increases after a stock exchange merger. They include lower information and non-monetary transactions costs like ease of transaction resulting from unification of trading and clearing systems. The merger also has the potentials of lowering direct transaction costs which in turn induces higher trading volume. This is mostly important in Europe since transaction costs here are much higher. The different kinds of pricing schedules affect the trading volume, and the volume shelters where the prices are low. According to The Economist (2006c), 2-5 billion Euros spent on trading, clearing and settlement can be saved by consolidating the exchange infrastructure within Europe, as predicted by the European Commission. In summary, when the transaction costs are lower due to stock exchange mergers, trading volume is most likely to increase.

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Despite the general notion that market liquidity increases after a stock exchange merger, some markets generally experience lower liquidity. The major concern, in such a case, is the potential monopolistic behavior of the newly merged exchange. In The Economist (2006a), such an example exists where a few investment banks became furious after the announcement of Euronext’s decision to return one billion Euros to the shareholders without deducting the trading fees. This was regardless of Euronext’s main aim of offering its participants increased liquidity and low transaction costs. Another argument is that, there is active competition in the current European system e.g. quasi-exchanges like electronic communication networks or automated trading systems. In addition, fees remained fairly stable after the Euronext merger. The study only analyzes the changes in the market shares and examines whether Euronext attracted volume from other European exchanges without taking stand on Euronext merger’s potential monopolistic effects.

Based on these arguments, it is with unreasonable doubt to conclude that, following a stock exchange merger, liquidity is most likely to increase. It is however important to note that not all the markets derive the liquidity benefits: the benefits may be asymmetrically allocated across markets depending on both the market’s characteristics and the individual firms’ characteristics like size, foreign exposure, and listing location or industry. Described hereunder is how these characteristics affect liquidity benefits.

6.1 The Size

The size of the market is a great determinant of its liquidity and performance. If a market is big and salient, most people may be more familiar with it and may opt to trade in its listed firms. Big markets, in terms of size, enjoy publicity and are better covered by market analysts. Such markets avoid informational asymmetries and are most likely to perform better than the small ones. In an event that the markets merge, small firms become relatively tiny and are most likely to disappear. Such firms are prone to get less attention from the investors compared to before the merger. According to Nielsson (2009), it is better to be a small firm in a small market, than being a tiny firm in a big market. The increase in visibility of a small firm has no effect on the big and influential investors who normally trade on big firms. Big firms enjoy relatively increased turnover as compared to the small ones. Dahlquist and Robertsson (2004) also confirm that foreign investors prefer large firms in well-known markets. Such firms realize a great reduction in capital costs due to the greater performance of the market.

It is not obvious, though, that when markets merge, the trading volume and performance increase. A big domestic market does not retain its size image in a newly merged international market. Investors’ attention may therefore shift from such a market to the big ones. Nielsson (2009) postulates that it is better to be a relatively big firm on a small market than being a relatively small firm on a big market. Nielsson further explains that a big firm that qualifies to be included in the domestic market index may fail to qualify for a big-cap market index on the merged market. Less attention is therefore given to such firms as most investors shift their focus to the new market index. The performance of bigger markets may relatively increase or decrease compared to those of smaller ones. Consequently, the turnover for the listed firms may relatively increase or decrease. In some cases, the size of the market does not affect the performance especially for firms of different size categories. It can therefore not be overruled that market size is irrelevant for the realization of merger benefits.

6.2 The Foreign Exposure

A cross-border merger increases the potential investor base since the stock listed on the national stock exchanges are availed to the foreign investors. However, the trading patterns of the foreign investors are focused on certain stock types. A highly visible international market has higher chances of receiving more interest from foreign traders and thus a boost in its performance. An international market enjoys high visibility to the foreign firms and investors. Investors also prefer stocks of recognizable brands to avoid indirect transaction costs and lower information. A cross-border merger exposes the individual domestic firms to the foreign investors. These firms get higher chances of being known better by the foreign investors. Such a firm enjoys more visibility and relatively higher trading thus increasing the performance of the resulting new international market. This confirms that when a firm has foreign exposure, its turnover increases relatively more. Be that as it may, higher visibility due to foreign exposure may result in a relatively worse performance. In most cases, foreign investors trade relatively more in the firms with household names outside the domestic market as compared to the less known firms. In such a case, the effect of the merger on the trading volume may not be recognizable and the performance of the market may not have any significant change.

The merger is primarily meant to benefit the markets with relatively highest increase in visibility to foreign traders. Such markets experience a greater boost in attention as compared to already well-known markets by the foreign investors (Nielsson 2009). Markets lacking foreign exposure previous to the merger are those which the investors are not familiar with. These are the very markets that experience the greatest fall in the indirect transaction cost and greater increase in trading volume, which in turn boosts the market performance. This means that the liquidity of the markets with little or no foreign exposure have higher chances of increasing following a cross-border merger.

For the merger considered herein, identifying the change in turnover dictates that the data on the level of foreign trading be looked at before and after the merger. The cross-listing data is important in identifying the markets where foreigners are already trading in. Due to the fact that all the cross-listed firms are large international firms, their high number is an indication that big firms with foreign exposure have little gain from the merger as compared to the small domestic ones. Aggregate foreign ownership data is also important in identifying whether foreigners already trade in well-known markets before the merger.

It cannot be overruled that foreign exposure is irrelevant for the realization of merger benefits like performance boost. The investors might be trading on financially relevant information like the dividend payments, profits per share and the expected future prospects. In such a case, foreign assets or sales may most likely fail to determine the increase in post merger turnover.

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6.3 The listing location or industry

It is normally not easy to predict the market whose performance increases due to gains in liquidity. However, the general opinions are presented hereunder. If a market has a bigger increase in the potential investor base, it is expected to enjoy a greater increase in liquidity. Also, if the merger breaks down on restrictions and red-tape, then, the market with the least favorable business environment and the most strict pre-merger regulations are most likely to enjoy greater rise in trading volume. Nielsson (2009) explains that the market where the foreign access was relatively difficult before the merger is most likely to experience a large rise in trading volume and market participants. The turnover is most likely to increase for the firms that are listed in exchanges that originally are small and restrictive. In contrast, the firms listed on the most attractive exchanges prior to the merger may attract the highest number of foreign investors. Liquidity may rise as the trading concentrates on one market, especially the one with the highest pre-merger liquidity. In summary, when the transaction costs are limited, the liquidity concentrates on a few markets (Danielsson and Payne 2002). According to Portes and Rey (2005), the main determinant of liquidity is the market size, which is measured as the equity market capitalization. It can be stated therefore, without any reasonable doubt, that trading concentrates on the biggest market. Turnover increases for firms listed in large, liquid, and less regulated exchanges.

Home bias also play another important role in liquidity. Investors normally prefer to invest domestically. They, therefore forego the potentially large gains associated with international diversification. Investors also prefer investing in their home markets so that they can support the domestic business. Stock exchange mergers may thus, facilitate cross border transactions; however, it may not be able to significantly induce the cross-border transactions. It can therefore not be overruled that post-merger turnover may not be different from the pre-merger turnover.

7. The benefits of liquidity

Liquidity is important and beneficial for various market players including stock exchanges, listed firms, and the traders. When liquidity is high, investors have higher chances of buying and selling stock more easily, quickly, and at low costs, thus more participation. Because of the increased participation, the price impact of trade is limited and the market stability increases. Authorities should therefore enhance liquidity at all costs. Benefits of liquidity are rooted in the market microstructure considering the forces that affect trade, the prices, and quotes. The forces can either be economic motives of agents or the organization of the markets where trading occurs.

For traders, liquidity benefit is that more assets can be bought and sold at lower costs as the portfolio strategy is also affected. Pastor and Stambaugh (2003) view liquidity as a risk factor priced in the market. In this view, liquidity is seen to be risk-reducing and most investors prefer to hold the assets that have greater liquidity.

For stock exchanges, liquidity greatly attracts firms to cross-list. Firms have greater likelihood of cross-listing in the liquid markets (Pagano et al. 2001). In the competition with other exchanges, liquidity is a very important variable. Liquidity also determines the asset returns. Based on this, it influences the firm’s decisions on the optimal capital structure. Financing of investments through the issuance of bonds, shares, debt, internal finance, depend greatly on the liquidity of the markets. According to Ellul and Pagano (2005), liquidity risk is a major determinant of the underpricing of the IPO. When the liquidity of a firm is high, it tends to have lower leverage and equity financing is preferred to debt (Lipson and Mortal 2006). However, it cannot be completely overruled that global financial instability can still occur when the liquidity of different assets move together, a phenomenon called commonality in liquidity.

8. The dangers of liquidity

Liquidity has been viewed as a source of destabilization in markets. Liquid markets are mainly focused on the short-term achievements. Investors, on the other hand, fail to consider the fundamentals when making the investment decisions. An instability results, which has high chances of affecting other markets, thus, the whole financial system becomes instable. Liquidity is also associated with the corporate governance problems. According to Butler, Grullon, and Weston (2002), liquidity impairs the corporate governance by discouraging active investing and encouraging diffuse stockholding. The diffuse stockholders are faced with more serious collective action problems. Those in agreement with Coffee’s view recommend that liquidity should be restricted. There should be an increase in the cost of trading so that traders are forced to internalize the social cost of liquidity.

9. Earnings and Returns

There are various theories that attempt to explain the value effects of stock exchange mergers. According to Thorwartl (2005), the advantage for investors today is the possibility of choosing between markets on the basis of different infrastructure criteria. They can select networks with the highest liquidity, adequate transparency and low transaction costs. Some studies depict that the earnings and returns are most likely to increase as a result of the economies of scale and the reduction in costs, the adoption of more efficient technologies that enhance market performance, and the combination of the administrative and R&D facilities that enhance market efficiency (Arnold et al. 1999). The Resource Based View postulates that a merger between markets enhances the capturing of complementary resources which enhances market performance. On the other hand, the risk diversification theory shows that market mergers improve the investors’ risk-return opportunities (Anshuman, Chordia, & Subrahmanyam, 2001). Market mergers, however, can result in additional costs and higher operating risks that adversely affect the market performance, lowering the earnings and returns. The literature on price pressure effect depict that there may be abnormal returns generated by a sudden market demand or supply shock instead of the informational effect of the event (Mitchell, Pulvino and Stafford 2004). According to the efficient market hypothesis, the security price instantly absorbs all the information and reflects it in the current market price. The assumption in this hypothesis is that investors can always get perfect substitute securities based on risk and return preferences. Therefore, the stock market is able to absorb the excess demand shocks without changing the stock price.

The analysis of Stock exchange mergers can be considered in terms of the operating gains and the effects on the earnings. The returns and earnings are most likely to improve following a merger between stock exchange markets. The two main factors that facilitate an increase in earnings or returns are the increase in revenues and the decrease in operating costs. Revenues normally increase due to the fact that after a merger, the resulting market has better and more efficient marketing efforts and increased market power. There are also strategic benefits associated with the entry into the new markets. The operating costs decrease following a market merger due to the economies of scale, the complementary resources, and the elimination of market inefficiencies. The earnings also increase as a result of the reduction of taxes. This is achieved through the transfer of net operating losses to profitable market, the utilization of the unused debt capacity, and the reinvestment of the surplus funds in non-taxable acquisitions. Also responsible for the earnings growth is the decrease in financing costs which may result from the large economies of scale in issuing debt and equity securities. The merged markets may also have greater access to the capital markets at a lower cost.

In the current financial market, strategically competitive exchanges have largely been formed through mergers. Sofia Ramos (2003) identifies the likely contributing factors as existence of larger economies, freedom from taxes, and favorable regulations and banking. All these factors directly contribute towards substantial growth in earnings. A merger puts the markets at strategic positions of exploiting the technological advances. This, together with the new wave of economic communications network and absence of regulatory barriers, results in greater earnings for the stock exchange markets.

According to Chordia and Swaminathan (2000), the value of equity decreases as the value of debt increases when there is a merger between two firms with less-than-perfect correlation in terms of rates of return. In the absence of synergistic economic effects, the relative variability of the resulting returns is most likely to decrease. In such a case, the variability of the rate of return on the firm’s asset is greatly influenced by the value of the equity, which is the increasing function. It can therefore be stated, without any reasonable doubt, that there will be no change in the market values of equity and debt in a merger where a change in the variance of the firm’s rate of return is experienced. According to the conventional theory with regard to a divestiture, the divestiture increases the variability in earnings and causes the value of the firm to rise when the return of the firm is held constant (Anshuman, Chordia & Subrahmanyam 2001). As the legislative and economic environments change, divestiture becomes an option that gains in prominence in a firm’s decision-making process. When stocks have low price-earnings multiples, higher rates of return are provided. Also, stocks with high price-to-earnings ratios provide relatively lower returns (Danielsson & Payne 2002; Anshuman, Chordia & Subrahmanyam 2001).

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For a clear understanding of the effects of merger on returns and earnings, it is important to know that the ultimate role of such a market provides a range of investment and financing tools. Such markets operate with either equity securities like shares of the individual firms (either by means of initial public offering or subsequent purchases and sales in the secondary markets) or debt securities like bonds or other debt instruments. It can therefore not be stated without any doubt or exemptions that earnings and returns increase when the markets merge. The exchange prices always influence the shareholders' value through the profitability of the exchange.

Due to the improved liquidity, bonds are most likely to be traded in merged markets. ECB Report states that the key element behind the development of the bond market is the impetus for a better integrated and more liquid market. Liquid markets bring transaction costs down for investors, who in turn achieve greater returns and minimize the cost of funds to firms.

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