The Market Quality Indicator: A remedy to overcome market illiquidity

Malcolm Galloway Duncan

Introduction

The modernisation of all European marketplaces which followed London’s Big Bang in October 1986 and concerted efforts by the European Commission has undoubtedly led to improved efficiency and transparency, at least as far as the stockmarkets are concerned. Reforms led to the creation of national market centres as opposed to regional or local ones; of screen markets in the place of physical floor markets; the adoption of continuous markets which have replaced call markets; and the introduction of rules, in some market centres, which called for the concentration of all trading on the regulated markets.

This last disposition has now been over-ruled by the EU Directive, which must be inaugurated in all European centres no later than July 1, 2006. This is a change which may have a boomerang effect, with a return to the past and the creation of an oligarchy of a few enormous and stateless market operators. On the contrary, events following the market crash of 2001 would seem to counsel against any such development.

All recent changes and innovations have favoured stock exchange turnover, market depth and the liquidity of the so-called ‘blue chips’ or ‘eurochips’. At the same time, they have clearly illustrated the problem of the scarce liquidity of a large part of the Main List in each and every European stock exchange.

In fact limited market liquidity is a European problem which has become ever more evident with the passage from ‘call markets’ to continuous markets and has been exacerbated by the institutionalisation of investments. The situation has been further aggravated in several marketplaces by an imbalance between retail and wholesale markets in some issues.

The importance of an indicator which accurately and constantly gauges the market quality of each and every security has been illustrated by the growth of institutional investment after the inauguration of the Euro on January 1, 1999. These phenomena call for a major diversification of investment assets and of the capacity to accurately classify international investment alternatives, evaluations which can hardly be limited to mere price performance considerations.

At the same time, in spite of efforts to promote a more democratic corporate management in most countries, many companies still appear to ignore the dimensions and composition of their so-called ‘market float’ for most of the time, even though these factors can effect the market performance of their listed securities. In many cases the companies show little interest in knowing who their shareholders are, apart from those communications in response to regulatory obligations, as well as those few who participate actively in the life of the company and who attend the annual shareholders’ meetings. In fact it may be said, with few exceptions, that there is practically no direct and regular contact between the general shareownership and the management of many listed companies.

Several European stock exchanges have attempted to sensitise company managements to the importance of the ‘public float’ by recalculation of the respective weights of each company within market indices on the basis of an estimate of the ‘public float’, but perhaps the most innovative change was introduced by the Oslo Stock Exchange in October 2004 when the distribution of listed securities within the various market segments was calculated on the basis of the market liquidity in the same securities according to average turnover. This last innovation is very much in line with the concept and objectives of MQI.

I list hereunder some of the motives why, in my opinion, companies would benefit from a reconsideration of their present attitude to their shareownership and to the stock exchange where their shares are listed and traded.

Yesterday’s stock exchanges

Mostly call markets with, in a few cases, continuous markets in a few selected and important equities.
Markets greatly influenced by ‘rumours’ and with only limited market analysis and research.
A prevalence of individual investors.
Forward markets which favoured speculation and short term trading.

Today’s stock exchanges

Screen markets with continuous trading and longer trading hours.
Investment decisions ever more based on research and analysis.
Little or no regulation of firms which limit their activities to mere investment advice.
An ever more important role assigned to institutional investors, with an increase in the average size of market bargains.
New financial instruments: derivatives on individual share and on ‘basket indices’.
Cash markets with rolling settlement (from T+1 to T+5).
An increasing phenomenon of intraday trading (estimated to represent 25% or more of total daily market volume) concentrated in the principal securities inasmuch as it requires very liquid markets.

Tomorrow’s stock exchanges

Global markets
Markets dominated by domestic and international institutional investors and global players.
Major international retail markets thanks to the development of Internet on-line trading facilities.
Direct and increasing competition between stock exchanges, ‘stateless’ intermediaries and proprietary trading encouraged by the MiFID.
A probable ever major proliferation of sophisticated derivative products
Limitations on regulatory restrictions which require the direct membership of Exchanges and the concentration of trading on regulated markets and the possible consequences on the performance of securities.
European regulation of investment advice limited to professional and remunerated advice, thus excluding advice given at bank branches to which most investors address themselves.

All the above innovations have generally led to a notable increment in market volume but, at the same time, have tended to increase the concentration of turnover in leading equities. The problem is further aggravated by the increasing importance and dimensions of institutional investors, destined to grow even further, and of the augmented professional management of individual and collective assets which tend, for obvious reasons, to privilege securities which offer guarantees of market liquidity whatever may be the humour of the market, above all at the moment of disinvestment. The diminished interest for the second tier equities has been partly caused by the birth of new financial products: basket indices and other derivative instruments which, indirectly, tend to penalise minor securities which have been excluded from such market instruments.

In some markets the situation is somewhat aggravated by the scarce diffusion of a stockmarket culture among the management of listed companies, who often interpret rules which call for a guaranteed minimum transparency as an obligation which also amounts to a considerable cost, instead of considering it as a manner in which to give added value to their securities. This reluctance vis-à-vis market disclosure has been one of the causes which has kept many excellent companies with all their numbers in order away from the stock exchange. Consequently, contact with the stockmarket community is frequently limited to the quarterly, six-monthly and annual reports: communications which frequently have a much reduced significance due to their tardy distribution.

Nevertheless, I must admit that the greater part of the newcomers who have crossed the threshold of the stock exchanges during the last three or four years have shown a notable change of attitude and a major attention to the market and have been duly rewarded by the stockmarket community. A lot of merit is due to the national market authorities and to the stock exchanges which have reviewed corporate governance rules in the wake of the 2000/2001 market debacle and of the scandals which surfaced on that occasion.

It is indispensable that, once quoted, companies realise that, in order to exploit to the full the benefits of ‘value added’ which they may derive from a stock exchange listing, they must not limit their attention to the demands of the stock exchange authorities, or of the financial press and market operators and merely communicate their quarterly, six-monthly and annual results. In fact their effective or potential public is composed of many other categories. Furthermore it is a public destined to grow immensely in the coming years with the changes in the Welfare State and the rise of private pension funds in most European economies, as well as of closed end and property investment funds. The rapid development of ‘on-line trading’ thanks to the Internet also promises well for a better future equilibrium at European level, between retail and wholesale markets in securities.

I strongly believe that the Market Quality Indicator (MQI) could help to sensitise corporate managements to the benefits which may accrue from a major and more timely market disclosure, and the possible dangers of a lack of regard for market disclosure demands.

The raison d’être for MQI

All stockmarkets suffer from a problem of limited liquidity in most listed securities, that is, excluding their so-called ‘blue chip’ securities. However, even these equities may suffer a liquidity risk in times of major market stress, as occurred in autumn 1987 and 1989. Some experts fear that the début of the MiFID, programmed for mid 2006, may prove detrimental for market transparency and liquidity even in major equities, following the forced abandonment of the concentration rule previously imposed by some national authorities.

A survey commissioned by the Federation of European Stock Exchanges (FESE) in 1990, which the author directed, confirmed that limited liquidity was a pathology common to all European marketplaces. In fact, trading in all European markets tends to be concentrated in a handful of leading equities. Concentration was at that time particularly marked in the case of the Amsterdam Stock Exchange, now part of Euronext. A similar study carried out by the London Stock Exchange in 1992 showed that, on average, a third of the number of listed equities recorded not even one transaction in the course of a whole month. A third survey carried out more recently by the Italian Stock Exchange Council (now Borsa Italiana) noted that there was a close correlation between the degree of market liquidity and the transparency and quality of corporate disclosure. The same study confirmed that, during 1996, the 100 less liquid Italian listed equities, out of a total of a little over 300, had represented less than 1% of aggregate annual volume.

The problem is at times aggravated by a misinterpretation of the term ‘public float’ – the percentage of listed securities in public hands and therefore theoretically available for trading. It is becoming more and more difficult to define the effective dimensions of the ‘public float’ on which the stockmarket may count in order to assure regular trading at fair prices at all times, as it does not depend merely on its dimensions but also on its composition. In several international markets a limited liquidity has been noted owing to the ‘loyalty’ of the funds which may hold the greater part of the so-called ‘public float’ – holdings which the market may have difficulty to absorb without penalising market prices in the same securities. This can also affect leading equities in times of market stress as occurred in October 1987 and 1989.

However, the problem occurs more frequently in the case of minor or growth securities, even though their business prospects may be excellent. This phenomenon frequently arises when institutional investors take a considerable stake in a minor stock, which often leads to the freezing of a consistent part of the securities in public hands. An imbalanced public float renders it difficult for the stockmarket to accurately evaluate the effective value of the company’s equities. A 1% holding in a leading equity probably presents no problem on disinvestment, but it may represent an obstacle in the case of a second tier stock.

This may lead to the abandoning of the security by market operators and investors, even if the role of ‘market maker’ exists in the same marketplace. The security therefore enters into a kind of ‘deep coma’, penalising the performance of the security, flattening market prices and in no way rewarding positive managerial conduct of the underlying company. In the wake of the market upset which occurred in 2001, many minor but promising companies have in fact delisted and others, previously intending to list on their national exchange, later opted for a private equity alternative. I believe that the liquidity risk is destined to increase in future for the motives outlined under the sub-section Tomorrow’s stock exchanges.

The MQI indicator

All modern and developed stock exchanges abound in indices which trace the price performance of listed shares either at sectoral or market levels, according to the interest of the market inquirer. On the other hand, indicators are scarce or imprecise on other important market aspects such as market volume. Few are capable of going beyond the simple crude figure of the number of shares traded and their monetary value, and no indicator at present exists which enables accurate comparisons among securities listed in the same or different market centres.

Of those factors not usually covered by indices, liquidity is important for investors, especially of an institutional nature, as they need to know at each and every moment the market’s capability to absorb buy and sell orders of a certain size. Issuers also need to have the same knowledge when they evaluate strategically how and when to make additional capital issues.

While market intermediaries may appear at first sight not particularly worried about the fluctuation of market prices, nor of a momentary illiquidity of a security, as they are often able to increase their own return on such transactions by an ample spread between bid and ask prices, in the long term they are also negatively affected by the same market illiquidity.

By means of MQI I expect to sensitise all market players (issuers, intermediaries, analysts, fund managers, investors, research bureaux, the mass media and even the bourse authorities) to the importance of the ‘market quality’ of each listed equity and, in particular, to the importance of the depth and continuity of market turnover. The programme and preliminary software developed in order to test the validity of the indicator nevertheless do not exclude the contemporary illustration of price performance and the volatility of the same equities in the course of time.

Market indications provided by MQI

It must be borne in mind that MQI is proposed as an international and global indicator of the comparative value and ‘market quality’ of equities of companies active in identical business sectors but listed and traded on different international marketplaces. For this reason all terminology in the software programme is expressed in English, even though the indicator has been studied and developed by a number of experts located in Italy. On the basis of tests carried out in the course of eighteen months or so, MQI is able to provide the following indications to operators in the various marketplaces:

Measure the quality and ‘market feeling’ of each and every share to encourage the adoption of benchmarks by both enterprises and market operators. In other words, to act as a kind of ‘barometer’.
Confirm an excellent or poor placing and distribution of shares among the investing public.
Indicate the possible predominance of a wholesale or retail market in the securities.
Illustrate market appreciation of the company’s communication policy relative to the stock exchange and the investing public (the communication of company results, roadshows and presentations, important corporate news such as acquisitions, new products or markets and important business agreements).
Point out an unstable market, possibly owing to an imperfect or insufficient distribution of the equities amongst the public.
Enable the companies as well as the stock exchanges to monitor continuously the performance of the shares in the stockmarket and their market width and depth, and note any possible improvements or, just as important, any eventual deterioration.
Indicate when and how to proceed in order to improve the impact of the security the stockmarket.
Improve the image and rating of the company in the eyes of the market.
Influence positively the opinion of the security among market operators and investors.
Give an early warning of an unusual interest in the equities such as in the early phases of a hostile takeover bid or of a disinvestment by an important shareholder such as an investment or pension fund.
Evaluate market reaction to important company innovations such as mergers, takeovers, capital increases etc.
Indicate, at times, the probable forthcoming volume in the securities.
Enable portfolio managers and market operators to evaluate the variability of the market quality of each and every share and, as a result, its relative riskiness, which tends to worsen whenever disclosure is lacking or tardy. In such cases, the securities are often exposed to an uncontrollable wave of sale orders.
Provide the possibility to make international comparisons, of particular interest for institutional investors.
Furnish the possibility to make comparisons between MQI, stock prices and market volatility, aspects which draw the attention of short term market speculators which, in turn, can contribute to the degree of market liquidity in the same securities.
Confirm improvements or deteriorations in the MQI of a security over a period of time, possibly the result of corporate policy, business prospects, changes in shareownership and so on.

MQI is in fact an indicator of market liquidity which does not limit itself to a simple recording of stockmarket turnover but also takes into consideration its consistence as well as the dimensions of the relative issuer and therefore facilitates comparisons between securities issued by companies of different dimensions and listed in different market centres. An MQI score of 0 indicates a total lack of liquidity, while 100 represents the highest liquidity value. It is also irrespective of the importance of the security. In conformity with market logic, the higher the liquidity the lower is the liquidity risk and vice versa. This is equally true for both investment and disinvestment in the same securities. In the case of Alitalia, for example, its market quality improved after July 1997 following the merger of its ordinary and preference shares which notably improved market liqiudity. It also experienced a consequent improved performance of its stock price.

As concerns the relation between MQI and price volatility on a specific date, it may be said that price volatility is generally and normally higher where the equity MQI is low and vice versa. However, this is not always the case: in days of low volume both MQI and price volatility may be low. Vice versa, when a security is under pressure, a rise in its MQI is normally accompanied by considerable price upturns and a higher volatility.

Moreover MQI, in line with the new rules on corporate governance, aims to alert listed companies to the need for a qualified officer who is always available to respond to inquiries by the financial community.

MQI could also prove useful to stock exchange authorities and could enable them to evaluate the importance and consequences of a deconcentration of trading, which is a likely consequence of the MiFID in 2006, and of the effect of the phenomenon known as ‘cross orders’. As in the case of the Oslo Stock Exchange it could also encourage them to allocate securities in the various market segments on the basis of market turnover and estimated liquidity.

Conclusions

The initial testing period for MQI lasted about eighteen months and included data covering well over four stockmarket years. This enabled the authors and programmers to test the effectiveness of the MQI indicator under varying market and company conditions. Confidential opinions were also sought from a cross-section group of market experts including market operators, analysts, asset managers, investor relations officers of leading companies, journalists and university professors, who kindly provided invaluable advice and contributions. Most of them expressed themselves in a positive manner, above all in consideration of the new and future requirements of the new global stockmarket.

MQI should favour a notable improvement in the regularity and timeliness of disclosure; enable market operators to establish opportune domestic and intermarket benchmarks in order to evaluate performance; sensitise issuers to the benefits which accrue as a result of improved transparency and corporate communications; and facilitate the management of portfolios, especially for international asset allocators who are probably less conversant with the reality of local stockmarkets.

The originators of the MQI (Market Quality Indicator), Giovanni Bottazzi and Malcolm Galloway Duncan, have been actively involved for many years in initiatives to improve transparency and favour market development. Mr Bottazzi is well known in Italy as an expert in market statistics and has been the author of several well known Italian market indices. Mr Duncan was co-author of the first European securities markets’ report commissioned by the European Community; author of the first strategic development plans for the FIBV (International Stock Exchange Federation), now WFE, and FESE (Federation of European Stock Exchanges) which included a project called ‘Euroquote’ which aimed to connect the various European Stock Exchange price information networks in real time; and played an important role in the early stages of the reform of the Italian Stock Exchange. He has also been the author of numerous technical handbooks, financial newsletters and an important Italian financial award.