Introduction: Microstructure in Asian Capital Markets

Hee-Joon Ahn, Sungkyunkwan University

The area of market microstructure has seen tremendous growth over the last three decades. However, most theories developed and empirical evidence presented thus far have focused on the workings of security markets in the U.S. and a handful of European countries only. Significantly less attention has been given to the market structures and trading behaviors of investors in markets in other parts of the world. For instance, the traditional theoretical literature on market microstructure focuses on the strategic role market makers play in supplying liquidity. However, many markets outside the U.S. do not operate with market makers and there are no concrete theories about how the market microstructure operates in these markets, including Asia. Asia has some of the fastest growing capital markets in the world. As of 2013, its equity markets account for one third of the total value of the entire global market, representing 30 percent of the world’s equity market capitalization and 35 percent of global equity trading value1. Yet the security markets in Asia have market structures and investor compositions distinct from those in the U.S. The existing market microstructure theories and empirical findings from U.S. markets may not be readily applicable to these markets. More efforts should be made to better understand how these markets operate and their investors behave. In this regard, the five articles that I introduce in this virtual issue take an important step forward in facilitating our knowledge of the distinct economics of the security markets in the Asia-Pacific region.

Many of the security markets in Asia share several characteristics, some of which are idiosyncratic to the region. Almost all equity markets operate in an automated, order-driven system without market makers. Unlike western markets, where institutional investors dominate trading scenes, in many Asian markets, individuals are the major players and have a pivotal role in providing liquidity to the market. Information transparency is closely tied to the region’s distinct corporate governance systems. Order flows from foreign investors generally exert significant influence in the market. Governing bodies usually have strong influence on market operation and often introduce dramatic rule changes. Some exchanges provide high quality market data with detailed order flow information at a level that cannot be matched anywhere else. All of these features offer interesting and often unique research opportunities. Of the five articles introduced here, four (Chung et al., 2012, Choi et al., 2013, Lin et al., 2013, and Lee and Choe, 2014) explore these issues in one way or another. Some rely on a multi-country analysis to search for a unified framework that has general implications for global markets. Others focus on specific issues arising from unique features of a single market. Taken together, these four articles greatly improve our knowledge of the market microstructure of Asian capital markets. Stoll (2014), which explores high-frequency trading in U.S. markets, does not cover Asian markets. Nonetheless, the article bears important implications for Asian markets given the growing popularity of high frequency trading in the region.

1 Source: World Federation of Exchanges statistics (2014). During the last two decades, U.S. stock markets have witnessed dramatic changes in trading patterns. One such change is the substantial increase in trading frequency accompanied by a significant decline in trade size—primarily driven by high-frequency trading. The growth of high- frequency trading was partly fueled by changes in the trading environment, such as recent technological developments for order routing and trade executions, regulatory changes, increased competition and reduced transaction costs, and developments in the informational environment, which enabled faster and wider information dissemination. Stoll (2014) examines the effects of high- frequency trading on market quality by analyzing the trade/quote data in the U.S. equity markets over the past two decades. Most extant studies on high-frequency trading rely on microscopic analyses using data measured in milliseconds. Such an approach, however, inevitably limits the investigation window to a short time span. The long investigation period of two decades in Stoll (2014) allows him to offer a macroscopic view. Stoll concludes that high-frequency trading is largely beneficial for market quality. He finds that high-frequency trading contributed to lower bid-ask spreads, smaller temporary price swings, and faster price reversals, without disrupting patterns. No evidence of increased herding is found. Based on a cross-sectional regression of trading frequency on identifiable firm characteristics, Stoll confirms that the above-mentioned improvement in market quality was made possible without altering the basic structure of the market.

A liquid is fundamental for market efficiency. Liquidity is closely related to informational transparency. If effective corporate governance and better legal and regulatory environments to protect investors enhance market transparency, the resulting increase in transparency will lead to less information asymmetry and improved liquidity. Chung et al. (2012) explore how corporate governance structures and legal and regulatory environments affect liquidity by analyzing data from 25 countries, focusing on whether these complement or act as substitutes for each other in their influence on liquidity. They find that liquidity is greater in countries with an effective internal corporate governance structure and legal/regulatory system with greater shareholder protection. In addition, they find that the positive effect of corporate governance on stock market liquidity is greater in countries with a legal/regulatory environment providing better protection for shareholders. This result suggests that the two elements complement each other in their influence on liquidity. The finding emphasizes the importance of an effective legal/regulatory system for stock market liquidity. Better protection for shareholders by an effective legal system not only directly impacts liquidity in a positive manner but also has the indirect effect of enhancing liquidity through improved corporate governance.

Possibly one of the most debated issues in emerging market finance is the role of foreign investors. On the positive side, foreign investors supply much needed capital to emerging financial markets, and may also help improve information transparency and corporate governance by demanding better accounting standards and monitoring firm management. However, foreign investors are also accused of destabilizing financial markets and escalating information asymmetry. Choi et al. (2013) study the effects of foreign ownership on the informational environment in the largest emerging financial market in the world, China. Chinese stock markets offer a unique setting to explore the role of foreign stock investments, as the markets are segmented and provide foreign investors with limited access to A shares. Market transparency is generally low, with state ownership as a dominant presence in stock markets. These attributes may contribute to lower information transparency. Whether foreign investments improve China’s informational environment or increase information asymmetry is itself an interesting question. Choi at al. (2013) find that information asymmetry measured with bid-ask spreads increase with foreign ownership. The authors conclude that foreign investors have information advantages over domestic investors, and exploit their advantages more than they enhance market-wide transparency in China.

Individual investors occupy a significant portion of the trading public in Asian security markets. Individuals are generally regarded as uniformed noise traders or traders prone to behavioral biases, as compared with institutions that are typically believed to trade with information advantages. However, empirical studies exploring actual trades by individuals are scant at best. This is because trades made by individuals cannot be separated from others in most equity trading data. The Korea Exchange (KRX) is one of the few exchanges that provide detailed equity trading data with trader type classification. Lee and Choe (2014) use the KRX trade and quote data to examine return predictability of individuals. An interesting feature of this study is that they examine the return predictability of market trades and limit trades separately, both made by individuals. The authors find significant short-term return predictability from both market and limit trades by individuals. It further appears that the predictability of individuals’ limit trades is caused by compensation for liquidity provision while the source of the predictability of individuals’ market trades is private information. However, the authors conclude that even if the return predictability of individuals’ trades is pervasive, it is economically insignificant to allow any arbitrage opportunities.

Another exchange in Asia offering detailed market-wide trading records by investor types is the Taiwan Stock Exchange (TWSE). Lin et al. (2013) employ comprehensive data covering all equity transactions and limit orders on the TWSE to investigate herding behavior of various investor groups. The authors find that while both domestic and foreign institutions’ herding is induced by information and subsequently reduces trading noise, individuals’ herding is irrational and adds noise in returns. They further find that institutional herding has predictive power for future returns while individuals’ herding is negatively related to future returns. The authors conclude that their findings confirm the general view that institutions trade on information while individuals do not.

Undoubtedly, these five articles offer interesting and important findings, which significantly enhance our understanding of the workings of financial markets in general or those in Asia. However, these are not the only ones. Many additional articles in past issues of the AJFS explore the market microstructure of Asian capital markets. One particular issue, No. 3 of Volume 39 (Special issue: Studies on market microstructure on emerging markets), is entirely devoted to the topic of market microstructure. Interested readers are encouraged to read the five articles published therein.

References

Choi, J. J., K. C. K. Lam, H. Sami, and H. Zhou, 2013, Foreign ownership and information asymmetry, Asia-Pacific Journal of Financial Studies 42(2), pp. 141-166.

Chung, K. H., J. S. Kim, K. Park, and T. Sung, 2012, Corporate Governance, legal system, and stock market liquidity: Evidence around the World, Asia-Pacific Journal of Financial Studies 41(6), pp. 686- 703.

Lee, H. J. and H. Choe, 2014, Individuals’ return predictability in market and limit trades, Asia-Pacific Journal of Financial Studies 43(1), pp. 59-88.

Lin, W. T., S. C. Tsai, and P. Y. Lung, 2013, Investors’ herd behavior: Rational or irrational?, Asia- Pacific Journal of Financial Studies 42(5), pp. 755-776.

Stoll, H., 2014, High speed equities trading 1993-2012, Asia-Pacific Journal of Financial Studies 43(6), pp. 767-797.