Competition Among Securities Markets

COMPETITION AMONG SECURITIES MARKETS:

A Path Dependent Perspective (By John C. Coffee, Jr.)

I. THE MECHANISMS OF COMPETITION: Exchanges and other market centers have natural incentives to compete and attract order flow from rivals, but they cannot determine by themselves the trading venue. Rather, trading location is the product of decisions made by at least three different actors:

1.- issuers, who determine where to list;

2.- liquidity traders, who determine where to trade; and

3.- financial intermediaries, including brokers and dealers, who determine where to route trades and where to trade, themselves, as market makers (or their equivalents).

Competition among market centers thus hinges on a variety of different decisions by each of the foregoing actors:

1.- issuers can cross-list on multiple exchanges;

2.- financial intermediaries can move between markets, opting for whichever offers them the best trading environment;

3.- liquidity traders can opt for one market over another; and

4.- exchanges can form networks and/or merge in order to foreclose rivals. Potentially, nothing is stable.

II. WHY DO FIRMS CROSS-LIST?: The Competing Explanations. To this point, it has been argued that cross-listing is the dynamic and de-stabilizing force that will move liquidity from local exchanges to international “super-markets,” thereby impelling a consolidation among market centers. But this explanation leads to an obvious further question: what motivates firms to cross-list? The answer may seem obvious: firms can increase their value through cross-listing. The evidence here is relatively clear. But there answer only leads to a further question: why do stock prices increase when firms cross-list? Here, there are two competing explanations, one old and one new. The traditional explanation was that cross-listing broke down market segmentations and allowed the firm to reach trapped pools of liquidity. A variation on this basic theory has suggested that, as cross-listing increases the shareholder base, the firm’s risk is shared among more shareholders, which reduces the firm’s cost of capital. For a time, the empirical evidence seemed to confirm this explanation because abnormal returns incurred by cross-listing firms seemed to rise and then decline post-listing. Until recently, little evidence suggested that a dual listing actually increased firm value.

Essentially, the bonding hypothesis posits that cross-listing on a United States stock exchange (including Nasdaq) commits the listing firm to respect minority investor rights and to provide fuller disclosure. Listing on a U.S. exchange does so both because (i) the listing firm becomes subject to the enforcement powers of the SEC; (ii) investors acquire the ability to exercise effective and low-cost legal remedies (such as a class action) that are not available in the firm’s home jurisdiction; and (iii) the entry into the U.S. markets commits the firm (at least when it lists on an exchange or Nasdaq) to provide fuller financial information and to reconcile its financial statements to U.S. GAAP accounting principles. The premise of this hypothesis follows from the work of LaPorta, Lopez-de-Silanes, Shleifer & Vishny (“LLS&V”), who have shown in a series of important studies that immense differences exist between the capital markets of common law countries and those of civil law countries, with capital markets in the former jurisdictions being much deeper and apparently significantly more able to support dispersed ownership and a separation of ownership and control. LLS&V have attributed these differences to the greater protections that common law legal systems provide minority shareholders. Ultimately, neither the segmentation nor the bonding hypothesis requires the rejection of the other. They are to a degree complementary. But which explanation better fits the data? Four different types of evidence better support the bonding hypothesis than the segmentation hypothesis.

a. The Market Reaction to Cross-listings: An initial source of evidence consists of studies of the stock market’s reaction to a U.S. crosslisting by a foreign firm. Although there are numerous such studies, most do not consider the possibility that a U.S. cross-listing serves to protect and assure minority investors, and only one study has carefully focused on the market reaction around the announcement date, rather than the often much later date of the actual listing. The Miller Study found positive abnormal returns on the announcement of a prospective U.S. listing, without