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Commonality in Liquidity: Evidence from the First Transatlantic Exchange

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Commonality in Liquidity: Evidence from the First Transatlantic Exchange Commonality in Liquidity: Evidence from the First Transatlantic Exchange Pankaj Jain Department of Finance, Insurance and Real Estate The University of Memphis U.S. Securities and Exchange Commission Email: [email protected] Mohamed Mekhaimer Department of Finance, Insurance and Real Estate The University of Memphis Email: [email protected] Sandra Mortal Department of Finance, Insurance and Real Estate The University of Memphis Email: [email protected] This Draft: August 2013 Comments/Corrections welcome Abstract In this paper, we use the introduction of the first transatlantic exchange, NYSE Arca Europe (NAE), to examine the impact of transatlantic trading on commonality in liquidity. We find that transatlantic trading bring up a new source of commonality in liquidity, after controlling for home market co-movement. Using a control sample, we show that the new source of commonality cannot be attributed to regional or market- specific factors. The results reveal that the magnitude of common liquidity factor for NAE market is greater than the respective home market common factor. We also show that co-movement with NAE increases with firm size. Keywords: Commonality in Liquidity, Multi-Market Trading, Stock Market Integration, NYSE Arca Europe, NYSE-Euronext. JEL Classification: G11, G12, G14 1 1. Introduction The evolution of competition and integration of financial markets in recent years have shaken the stock exchange landscape, particularly in the USA and Europe1. While the words of former CEO of New York Stock Exchange John Thain ―Every country has a flag, an army and an exchange‖ were true ten years back, today, we have a different landscape with international stock exchange groups such as NYSE-Euronext and NASDAQ-OMX, London Stock Exchange-Borsa Italiana Groups, in addition to Alternative Trading Systems (ATS) and Multi-lateral Trading Facilities (MTF) that are powered, regulated and have staff and customers from different countries all over the world. In such an integrated complex stock market environment, the significance of a single physical national stock exchange has eroded significantly and multi-market trading becomes more common. In this paper, we take advantage of the introduction of the first transatlantic exchange, NYSE Arca Europe (NAE), to investigate the effect of multi- market trading on commonality in liquidity2. We find that trading in multi-market trading setting bring up a new source of commonality, in addition to the reported home market commonality (Chordia, Roll, and Subrahmanyam 2000; Hasbrouck and Seppi 2001; Huberman and Halka, 2001; Kamara, 1 Aggarwal and Dahiya (2005) provide a discussion of the main drivers of world stock market integration. Shahrawat (2008) show that, only between 2005 and 2007 the global exchange market saw 15 major M&A deals, valued at $42 billion. He further states that the two common aspects of these transactions are the combination of exchanges across countries and the coming together of firms trading different products. About 33% of the 15 transactions were cross-border deals, and over 50% of them were between firms trading different products. 2 NYSE Arca Europe is a traditional Multi Trading Facility (MTF) that aims to extend the exchange's European reach beyond Euronext-listed securities to compete with pan-European MTFs. Before March 09, 2009, stocks traded in NAE were traded only on its home exchange. After March 2009, these stocks are traded not only on the home exchange, but also traded on NAE. 2 Lou and Sadka, 2008; Brockman, Chung and Perignon 2009, Corwin and Lipson 2011)3. Simply stated, changes in NYSE Arca Europe individual firm‘s liquidity are significantly influenced by a common liquidity factor in the transatlantic market NAE after controlling for the home market co-movement. In addition, we find that firm size plays an important role in commonality in liquidity. Consistent with Chordia, Roll and Subrahmanyam (2000) and Kamara, Lou and Sadka (2008) we find that firm co-movement with NAE market wide liquidity increases with firm size. Moreover, the results reveal that, for most of the studied markets, the magnitude of common liquidity factor for NAE market is greater than the respective home market common factor. With respect to systematic liquidity risk, one can conclude that using the home market portfolio only to assess the systematic liquidity risk does not capture the true market portfolio that affect the systematic liquidity risk. The introduction of the Multi-Lateral Trading Facility (MTF) NYSE Arca Europe provides an ideal setting to answer our research questions. The market provides its traders, for the first time, the opportunity to trade U.S. stocks during European trading hours, along with other 12 European countries in the same market4. Before March 09, 2009, stocks traded in NAE were traded only on its home exchange, while, after March 2009 these stocks are traded not only on the home exchange but also traded on NAE. In addition, NAE is fully integrated with NYSE- Euronext systems. Existing NYSE Euronext members can trade on the same platform simply by extending their 3 Current literature on multi-market trading focuses on either the market quality of traded stocks or the distribution of trading volume among competing markets (Pagano 1989; Chowdry and Nanda 1991; Baruch, Karolyi and Lemmon 2007; Menkveld 2008; Moulton and Wei 2009; Halling, Moulton and Panayides 2013). However, to date, our knowledge lacks any empirical evidence of how commonality in liquidity is affected by multi-market trading or changes in stock market design. 4 Section 3 provides, in more details, the institutional details of NYSE Arca Europe market. 3 membership5. Such a unique setting enables us to also investigate whether the indirect access given to NYSE and Euronext can add a new source of commonality to NAE traded stocks. Our results suggest that commonality in liquidity of NAE traded stocks is not affected by the indirect access of NYSE-Euronext traders. Prior research suggests that market-specific factors are possible sources of commonality in liquidity. For example Chordia, Roll and Subrahmanyam (2001) and Brockman, Chung and Perignon (2009) show that unemployment and GDP announcements have significant effects on commonality in liquidity. In addition, Karoyli, Lee and van Dijk (2012) find that commonality in liquidity is high during periods of high market volatility or large market decline6. One of the key advantages of using NAE setting is that it combines stocks from different countries that do not share the same macro-economic and other market-specific factors. This means that we cannot simply extrapolate the reported commonality to market specific factors7. However, around 90% of stocks traded in NAE are from Europe, which might reflect a regional source of commonality, other than trading on NAE (Brockman, Chung and Perignon, 2009)8. To rule out this possibility, we construct a control sample of firms that is also listed in the respective home stock exchange but not traded in NYSE Arca Europe market. Our results 5 NYSE, Euronext and NYSE Arca Europe are connected through the universal trading platform. In February 2008 NYSE Euronext began a two-year program to decommission of four platforms and create Universal Trading Platform (UTP) to support all of its markets. The ultimate goal of such project is that NYSE-Euronext, at the end, will have global network for both European and US customers. Appendices A and B show the integration process as well as the relationship between the three connected market NYSE, Euronext and NYSE Arca Europe. 6 The findings of Chordia, Roll and Subrahmanyam (2001), Brockman, Chung and Perignon (2009) and Karoyli, Lee and van Dijk (2012) are consistent with Bunnermeier and Pederson (2009) provide a model that links an asset‘s market liquidity and traders‘ funding constraints (i.e., the ease with which they can obtain funding). They predict that large market declines or high volatility would affect liquidity provision and hence increase commonality in liquidity. 7 In addition, we cannot attribute changes in liquidity commonality to factors such as common language, trading times, legal system and others because these factors were already in place before our main event. 8 Brockman, Chung and Perignon, (2009) document a regional co-movement in European stocks; however, they did not explain the source behind it. 4 confirm that only stocks traded in NAE show a significant liquidity co-movement with NAE aggregate market liquidity. Another possible explanation proposes that commonality in liquidity is primarily driven by correlated trading behavior within groups of traders and the prevalent increase in basket trading. Kamara, Lou and Sadka (2008) and Karoyli, Lee and van Dijk (2012) provide empirical evidence that the increase in commonality in liquidity can be attributed to the correlated trading decisions of institutional traders in the U.S. and international stock market respectively. Consistent with these results, Corwin and Lipson (2011) also show that commonality in liquidity is driven by program and institutional traders. In addition, the model of Gorton and Pennacchi (1993) predicts that equity basket trading increases the commonality in liquidity for the constitute stocks in the basket, but reduces liquidity commonality for individually traded stocks. Kamara, Lou and Sadka (2008) confirmed this prediction and find that index traders have increased the commonality in liquidity in the US market. Our results are consistent with the correlated trading behavior and basket trading explanation. Using our experimental setting, we show that trading a basket of equity stocks that are combined from 13 different countries, NAE market, add a new source of commonality in liquidity, in addition to the home market liquidity co-movement. These results support the prediction of Gorton and Pennacchi (1993) that basket trading increase commonality in liquidity. Moreover, our results can also be attributed to the correlated trading decisions of specific groups of traders (Kamara, Lou, and Sadka, 2008; Koch, Ruenzi, and Starks, 2009; Corwin and Lipson, 2011; Karoyli, Lee and Van Dijk, 2012).
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