In its 2004 annual report, the Federation Internationale des Bourses de Valeurs (FIBV) pointed out that "the market quality plays an important role in securities trading given the globalized competition." Following its first "Market Quality Report" in 2006, the Shanghai Stock Exchange (SSE) issued today the much-anticipated "Market Quality Report (2007)", which probes into last year's market quality on the Shanghai securities market. In line with the development trend of the international securities market, it provides valuable reference information for decision-making of all market participants.
Attention to the market quality marks maturity of a securities market.
With the accelerated informatization and globalization of the securities market over the last decade, the international securities industry has paid unprecedented attention to the market quality and microstructure. Many securities markets and intermediaries start to disclose the market quality data. It has become a common practice for major securities markets to disclose periodical market quality reports.
In the United States, the information disclosure of market quality has become a legal obligation of the securities market. Since November 2000, the U.S. Securities and Exchange Commission (SEC) has asked the exchanges and trading centers to publish the monthly quality reports on order match. Besides the quality report of order match required by the SEC, the New York Stock Exchange (NYSE) also discloses on its website special market quality reports on order execution, market depth, spread, institutional trading cost and volatility in comparison with other markets including the NASDAQ Stock Market (NASDAQ). The Deutsche Börse releases and offers paid services of market impact cost of the auction market to measure the liquidity of its electronic trading platform Xetra. Besides, it also publishes free stock data with best liquidity on a regular basis. The London Stock Exchange (LSE), which also calculates indexes of market quality, provides brokers with paid information services of order match quality. Every month, the National Stock Exchange of India (NSE) releases the impact cost data of its major index S&P CNX Nifty, including the impact cost of each constituent and the whole index. The monthly data since 2001 can be found on its website. Besides, some intermediary agencies also provide paid services for market participants by estimating the liquidity cost and institutional trading cost on the major securities markets.
Since the SSE issued China's first securities market quality report in 2006, the market quality has attracted attention on the domestic market. At present, China's securities market is stepping on a new stage of innovation and development. Therefore, the market quality index will, undoubtedly, be widely applied to the following cases.- The market quality index can help investors not only to estimate the trading cost more accurately but also to judge the risks and proceeds in their decision-making of investment in arbitrage, risk hedging and program trading. So, it is a good reference for investors, especially institutional investors, in decision-making.
- The index can facilitate fundraisers in their decision-making of financing. A market of high liquidity can fully play its function in resource allocation optimization and financing, thus allowing the enterprises to raise capital on the issuance market at a lower price. In addition, upon analysis and comparison of the market quality index, the raisers can choose the best time to raise funds in a most beneficial way on the most favorable market.
- It can act as guidelines for market organizers (stock exchanges) to improve the market quality that is a core sign of competitiveness of a stock exchange. Upon analysis of some indicators of market quality (such as the liquidity and volatility), the exchanges can review their own market structures and trading mechanism designs, thus continuously improving their market quality and competitiveness. In addition, the exchanges should also take the market quality index into account upon customizing different trading mechanisms for different products.
- It can also be referred by market supervision of regulatory authorities. For example, regulators can work out investment guide for funds and financial plans. According to the index, the market frontline supervision agents can reinforce their supervision over a certain kind of securities trading.
- The index can also support other market participants and market innovations. For example, indexes can be compiled and basic securities portfolios can be created by reference of market quality index. Based on it, financial derivatives can be developed.
SSE market quality improves year by year
Indexes related to liquidity, volatility and pricing efficiency, released by the "Market Quality Report", showed that the SSE's market quality has been improving over the last decade.
Firstly, the SSE's liquidity has been enhanced. The price impact index for trading of RMB100 thousands stocks in 1995 was as high as 199 base points. But it plummeted to 67 points in 2005 and further dropped to 31 points in 2006. The liquidity index is RMB2.81 million, up 105% and 115% from 2005 and 1995, respectively. The absolute bid-ask spread is RMB0.016, falling by 24%, 72% and 80% compared with 2005, 2000 and 1995, respectively. The relative bid-ask spread, dropping by 24%, 48% and 80% compared with 2005, 2000 and 1995, respectively, is 31 base points. The absolute effective spread falls by 7%, 82% and 58% from 2005, 2000 and 1995, respectively to RMB0.028. The relative effective spread, decreasing by 1.5%, 59% and 59% compared with 2005, 2000 and 1995, respectively, is 53 base points.
Secondly, the volatility index sees a dwindling volatility rate on the Shanghai securities market. The report calculates the relative volatility rate, excess volatility rate and return volatility rate of all stocks on the Shanghai securities market in 5 intraday minutes. According to the statistics, they experienced a fall by 47.5%, 17.5% and 6%, respectively, from 1995 to 2006.
Thirdly, a look at the market efficiency coefficient and the pricing error coefficient shows a marked improvement in recent years in the pricing efficiency of the Shanghai securities market. In 1995, the two coefficients were 0.76 and 234.39. But in 2006, they were 1.04 and 10.29. The intraday market efficiency coefficients in 2005 and 2006 were very close to 1. All this indicates the enhanced capacity, speed and accuracy of securities prices in response to information on the Shanghai securities market.
Compared with the international market, the Shanghai securities market enjoys better indexes such as the bid-ask spread and the effective spread, a dramatic improvement of the market quality over the last decade. Nevertheless, in terms of the market depth and the liquidity cost, it still legs behind some major international securities markets. Its liquidity cost, not only higher than that on the mature markets including the Deutsche Börse, the Tokyo Stock Exchange, the NYSE, the Euronext, the LSE and the NASDAQ, but also higher than that on some emerging markets such as the NSE and the Mexico Stock Exchange. Moreover, its market quality differs a lot on each board. The quality of the SSE 50 and 180 Indices' constituents is the best, with the spread indexes of the SSE 50 Index's constituents close to international standard. But the quality of the B shares and ST shares is poor.
Market quality soars thanks to new products, trading mechanisms
The "Market Quality Report" analyzes the influence of SSE's new mechanisms and products of 2006 on the market quality. The results show that the new products such as the warrant and the ETF as well as the new trading mechanisms, including the open call auction, the market order, the primary dealer mechanism and the warrant creation, are of great significance to the improvement of SSE's market efficiency.
The ETF provides investors with chances for arbitrage between the primary market and the secondary market. Due to the 50ETF arbitrage, the trading volume of SSE 50 Index's constituents reached to RMB39.6 billion in 2006. The subscription, redemption and arbitrage of the ETF have pushed up the market efficiency by activating the trading of underlying shares on the secondary market.
In 2006, the SSE introduced 9 call warrants and 8 put warrants. After listing, the trading volume of the warrants' underlying shares, under a stronger liquidity, saw a dramatic growth, with lower price impact cost, higher pricing efficiency and smaller pricing error coefficient.
The reformed call auction system has enhanced the market efficiency considerably. Both the market liquidity and the investors' trading desire are substantially increased. The trading volume and turnover of call auction added by 20.8% and 14.5%, respectively, with the zero trading rate dropping by 53.7%. The pricing efficiency has improved markedly. Besides, much more cost will be needed to influence the trading price in call auction. After the reform, the additional money for 1% fluctuation of the opening price rises by 6.6% in average, with an increase of 32.7% to push up the price by 1%. In addition, the introduction of the market order is also very effective for the improvement of market liquidity.
The market quality report gives direction to the market reform in the future
The indexes in the "Report" provide market participants with large amount of reference information for their decision-making. Besides, it also points a direction for the future market reform and development. For example, to improve the trading mechanism, the report offers evidence for the following improvement.
Firstly, the report shows that the price impact index, liquidation index, bid-ask spread and pricing efficiency index differ a lot on different boards. For instance, the indexes of the SSE 50 and 180 Indices' constituents are much better than other boards. This indicates that the current stock trading mechanism has different influence on stocks on different boards. To improve the liquidity and pricing efficiency, it is necessary to have different trading mechanisms for stocks on different boards. These mechanisms include the consecutive auction for stocks with strong liquidity and high pricing efficiency, the call auction for stocks with medium liquidity and pricing efficiency and the primary dealer mechanism for stocks with weak liquidity and low pricing efficiency, with bilateral quotations provided by primary dealers.
Secondly, the 3 indexes for the intraday time-sharing volatility, the intraday excess volatility and the intraday return volatility curve like an "L". This means the volatility is high at the market opening and closing, low in the middle time and high at the morning closing and afternoon opening. By carrying out the call auction through the reform of the current consecutive auction of afternoon opening, it will be effective to lower the trading volatility at the opening in the afternoon.
Thirdly, the liquidity cost for block trading of RMB3 million stocks in 2006 increased compared with that in 2000 or 2005. Besides, the buyer's cost was higher than that of the seller. This indicates that the proportion of institutional investors is still low in spite of a dramatic increase of investors in 2006. Lack of block trading, the impact of block trading on the price is huge. In addition, due to lack of short mechanism, investors can benefit from a rising market only, which leads to a higher trading cost of the buyer than the seller. Therefore, to improve the market efficiency, it is necessary to further expand the institutional investors and introduce the fictitious transaction, including the margin trading and securities lending.
Fourthly, from the relative bid-ask spread and the relative effective spread according to stock price grouping, the basic trend is that the higher the stock price, the lower the spread. This indicates that the minimal quotation unit of RMB0.01 is too big for the cheap stocks below RMB5. From the order depth based on stock price grouping, the order depth of expansive stocks over RMB20 is far lower than that of other groups. This shows that the minimal quotation unit of RMB0.01 is too small for the stocks over RMB20. Therefore, the reform for the current minimal quotation unit should be taken into consideration. The unit should be reduced for stocks below RMB5 and extended for stocks over RMB20. It can effectively lower the bid-ask spread of the cheap stocks to save trading cost, and enhance the order depth of expensive stocks for the disclosure improvement of order information.
Furthermore, the market quality indexes of the large-cap stocks and the stocks with derivatives trading such as the warrants are much better than other boards. To enhance the overall market liquidity and the pricing efficiency for further improvement of the market quality, efforts should be made to expand the market scale by wooing more large-scale blue-chip companies and developing more derivatives such as the ETF and warrants.
