Stock exchanges around the world place a great importance on market efficiency and integrity, and they invest considerable resources in providing the ideal regulatory environment to support trading activities. Exchanges based in jurisdictions with superior regulation and surveillance benefit from greater market participation and more active trading. Exchanges play a crucial role in designing trading rules to promote trading.
Trading rules include restrictions on insider trading, market manipulation and front running. The policy underlying trading rules is that they increase the integrity of market prices, which gives investors confidence to rely on market prices and encourages them to trade. There are numerous studies showing that trading rules affect trading behavior. Whilst strict exchange trading rules can enhance market integrity, compliance can also be costly, and excessively stringent rules might deter trading. The impact of trading rules will increase with the strength of the country’s regulatory institutions, as strong rules that are not enforced will simply be ineffective.
Cross-listed stocks provide a unique opportunity to examine investors’ preferences to trade the same firm’s shares in different locations. In analyzing a large sample of firms from 26 countries outside of North America cross-listed on a U.S. stock exchange up to the recent international financial crisis, we observe that a larger proportion of the firms’ stock trades will take place in the firms’ home markets as compared to the U.S. when stock exchange rules and regulations are relatively stronger at home. This seems at odds with the frequently used explanation that non-U.S. companies sometimes list in the U.S. in order to ameliorate the effects of market segmentation and to increase liquidity. Hence, our analysis highlights that there is in fact a joint importance of the quality of both exchange trading rules and regulatory institutions.
Provided countries and exchanges around the world focus on improving rules to support trading, the playing field can be leveled with even the larger and more financially developed markets around the world. This is an important finding when there are increasingly greater numbers of sophisticated investors who are choosing where they wish to trade around the world. Our findings suggest that local trading rules can and do matter but not on their own, they need to be supported by strong regulatory institutions within the local jurisdiction. The design of good exchange trading rules is economically important as we estimate that a 10 percent increase in a composite measure of all the trading rules from the means increases relative trading volume by approximately 13 percent. This result holds strongly even in the presence of controlling for measures for liquidity/ transactions costs, tax differentials, foreign ownership restrictions, financial development, information sharing and other usual drivers of trading volume.
To examine their impact on the location of trade for cross-listed foreign stocks in the U.S., we include 452 firms from 26 countries outside North America between 1999 and 2008.
There is a reduction of cross-listings over time. To measure the relative trading volume, we use the ratio of non-U.S. trading volume to U.S. trading volume. In our analysis we comprehensively examine the rules of stock exchanges across seven dimensions: price manipulation, volume manipulation, spoofing, false disclosure, market manipulation, insider trading and broker-agent conflict rules. In addition to complying with these aspects of exchange trading rules we also consider cross-listed firm’s exposure to sovereign risk, corruption and poor regulation within their home markets, as these measures will affect the extent to which the local trading rules may be enforced within the home market jurisdiction.
Stronger market rules alleviate investors’ concern on ambiguity and market-malfeasance and therefore initially increases the proportion of trade in the market. Strong rules, however, are not costless: too much compliance and disclosure in legally-stringent countries may deter investors from trading. We document that the impact of trading rules on the relative amount of trade on the exchange is non-monotonic. The results suggest that exchanges can obtain a greater share of trade if they strengthen stock exchanges by tightening trading rules, but excessively onerous rules should be avoided. In our study we find that the effects are mainly concentrated on price manipulation rules, false disclosure rules and market manipulation rules.
We also consider the role of sovereign governance in that stronger trading rules are only effective in countries with strong institutions where regulations are well enforced. We rely on the following reports to measure sovereign governance quality: 1) World Bank’s governance rank variable for political stability, government effectiveness, corruption, rule of all, regulation and accountability; 2) S&P sovereign credit ratings; 3) the composite governance index in the International Country Risk Guide report; 4) anti-director rights. Although these four measures do not always promote trading volume directly, we find that they magnify the impact of stock exchange rules on trading activities. The results imply that improving legal institutions in countries with strong trading rules would help to attract more investors.
The promulgation of the Directive on Markets in Financial Instruments (MiFID) in May 2005 provided a natural experiment setting to examine the impact of strengthened trading rules on trading volume. Aiming at creating an integrated economic market in Europe, MiFID harmonizes trading rules, strengthens disclosure obligations and imposes a best-execution obligation on firms. Meanwhile, MiFID’s provisions are flexible. Some degree of vagueness make rules account for evolving circumstances. As a result, MiFID is expected to shift trade from U.S. markets to EU markets.
Our findings are most prominent in the European Union after the adoption of the Markets in Financial Instruments Directive (MiFiD) from 2005. Countries in the EU largely strengthened and harmonized stock exchange trading rules under MiFiD. Some exchanges, such as those in France, experienced significant increases in rules covering areas such as price manipulation and market manipulation. MiFID also made disclosure requirements more onerous across the EU. Increased disclosure works to discourage informed traders from trading on private information and increases trading activity by other traders. This increased transparency has worked to make EU-based exchanges more attractive and has shifted more trading of the stocks that are cross listed in the U.S. back to the EU. The results suggest that MiFID has at least partially succeeded in its goal.
In summary, our study lends support to the view that stock exchanges around the world can do much to encourage active market participation and trading of financial securities, and in doing so deepen financial development. However on a final note, there does appear to be a tradeoff (as with all good things in life). The benefit of additional exchange trading rules to strengthen stock exchanges diminishes as trading and compliance becomes more costly and competing markets start to lose their “cheap compliance” competitive advantage over the “big boys” in the world of capital markets.