International Finance Law and Economics

Introduction

Traditionally the capital and financial markets in most developing countries face strict governmental regulations. Stability of the financial markets and protection for investors has been the major arguments supporting such strict regulations. In addition, supervision has been another reason to maintain checks and balances on the constituent institutions of the markets. The economic stagnation during the 1970s forced economies to shift the focus of the regulations from stability to efficiency.

The deregulation measures taken by many economies have spurred the globalization of financial markets. Globalization introduced the need for more efficient regulations in the developing economies to achieve efficiency gains in the financial and securities markets. In the changing environment provided by globalization, there is the need to reconsider the general economic rationale for securities regulations from an efficiency perspective. In this context, this paper analyzes the efficiency gains of a small poorer country adopting and following exactly the security regulations of a large rich country.

There is substantial literature on securities regulations focusing on the effect of insider trading and discussing the need for its regulation. The literature also focuses on other issues of market manipulation, however this strand of literature does not deal with the motives for framing the security regulations. This paper reviews the available literature on securities regulations from an efficiency perspective, as they apply to a developing economy. Securities, for the purpose of this paper, refer to “organized and unorganized markets for financial securities, such as stocks, bonds, bills as well as derivative securities with stocks, bond and bills as underlying securities” (Niemeyer, 2001, p. 6).

The this paper focuses on secondary markets in a developing economy. In the context of this paper, regulation means government regulation.

Definitions and Overview

This section presents some of the definitions relevant to the discussion and an overview of the security regulations affecting the efficiency of the market in general.

Definitions

In order to understand the efficiency gains of a small poorer country because of regulations the country has adopted, it becomes important to explain some of the rules connected with the security of the markets. This section provides definitions and deals with these rules.

Insider Trading

Insider trading refers to a market participant who deals in the market based on information, which is non-public. Although the rules prohibiting insider trading are common in many of the jurisdictions around the world, there are significant variations in the specific regulations framed by the countries in this respect. Insider trading may take several forms. Since the release of non-public information is the main basis for indulging in insider trading, countries may pass regulations restricting the nature of communication between brokers and the public.

Market Manipulation

Market manipulation can take the form of price manipulation, volume manipulation and disclosure manipulation. Under price manipulation, a broker or group of brokers who collude with each other enter purchase orders at increasingly higher prices for every subsequent order. This will create a feeling that a particular stock is active. This activity is also known as ramping/gouging. Pre-arranged trading is another form of price manipulation. In this arrangement several parties collude and contract for trading in securities at the same time and for the same price and number of stocks.

Churning and wash trading are the two major forms of volume manipulation. Under churning, there is large volume of buying or selling in a share to give it artificial inflation. Wash trading refers to the act where an agent buys and sells for the same party. Both these acts are aimed at creating an impression that there is increased activity in a particular stock. Spoofing is another type of market manipulation to create a false impression of unusual activity in a stock. False disclosure arises when some of the market participants actively disseminate false or misleading information with intent to cause distortion in the market place. This also describes actions where required information should be disclosed but is not done so (World Bank, 2009, p 16).

Broker-agency Conflict

Conflicts may arise when the brokers do not act in the best interests of clients. Disputes may arise on actions of agents in charging excessive fees or investing in stocks, which do not match the risk/return profile of the customers. Specific regulations and provisions in contracts should cover the resolution of these conflicts (Neimeyer, 2001, p. 58).

Overview of Impact of Security Regulations

Research has identified a strong and robust effect of security regulations on efficiency and liquidity. A study by Cumming et al. (2009) found a positive association between trading rules and the velocity of the market. This study considered the influence of the international differences in securities regulations (La Porta et al., 2006; Jackson and Roe, 2009) on the efficiency of the market. Countries may enact regulations, having different intensities of control depending on the “economic, legal and institutional” situations prevailing in these countries, which demand monitoring. Markets in countries, which specifically recognize and prohibit some of the acts concerning the market dealings, tend to enhance investor confidence and hence they contribute to the efficiency.

According to economic theory, when agents can compete freely with minimal governmental interference, the market will be operating efficiently. However, there are exceptions to this when the free market faces some problems. Potential problems may arise from

  1. asymmetric information,
  2. public goods,
  3. different forms of externalities, or
  4. market power affecting the securities market.

There may be different forms of interventions considered, for improving the efficiency, in the allocation of funds and risks in some instances. In other cases the market will, on its own, cope with the problems and correct them.

Efficiency and Securities Regulations

In the context of a poorer small country effectiveness of the role of regulators and their efficiency in the financial sector, besides the need for developed laws and regulations, have developed into matters of serious concern. Many researchers would disagree that security regulations from developed countries are always appropriate in developing countries. One issue is that implementation may be incomplete (see Bhattacharya and Doauk, 2006) or that the level of security regulations may be too strong if companies and regulators have less money to enact them (See the argument presented in Romano, 2005).

It is agreed that the primary function of the market place is to ensure that the market participants can enjoy maximum liquidity. The extent of securities regulations has a strong influence on market efficiency. There are two contradicting hypotheses that can be developed concerning the influence of security regulations on efficiency of markets. First, it can be argued that imperfect legislations would lead to inefficiency.

This is because when the regulations are unclear, the investors are unable to decide on the legality and acceptability of the activities under the regulations. “Detailed rules, therefore, might give rise to greater investor confidence, greater dissemination of knowledge about prohibited conduct, and facilitate invigilation of such rules, which in turn might reinforce investor confidence in the marketplace” (Cumming et al., 2009, p. 3). Clearly laid rules might help improve efficiency and reduce uncertainty in the minds of investors. On the other hand, it can be argued that extensive legislation would lead to greater ineffectiveness, as the investors tend to manipulate the inherent deficiencies in the regulations. Under such circumstance, detailed regulations might have a negative effect on liquidity.

Securities Regulations and Insider Trading

“Prohibiting insiders from trading when they have superior knowledge and forcing them to disclose all their trades are measures aimed at reducing the asymmetric information and restoring market confidence among market participants and the general public” (Niemeyer, 2001, p. 19). The need for regulations to oversee and control insider trading has been the focus of a large volume of literature. According to Bainbridge (2001), there are three arguments, which favour implementing regulations. These are:

  1. insider trading harms investors and thus undermines investor confidence in the securities markets;
  2. insider trading harms the issuer of the affected securities; and
  3. insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm” (Bainbridge, 2004).

In this case, market solutions, such as signaling or reputation, may not be able to provide a solution to the issue. Therefore, the developing economy may have to implement suitable regulations to reduce asymmetric information, which would be welfare increasing, under the condition that a well-functioning market can be seen as public good. The developing economy in this case may adopt the same regulations as being adopted by a large rich country, provided however that the small poor country has the necessary agencies and infrastructure to implement the regulations effectively.

A number of recent studies have documented that enactment of insider trading legislation has caused moderate effects (Bettis et al., 2000; Bainbridge, 2001; Chordia et al., 2001). Durnev and Nain (2004) found that insider-trading laws are able to cause an increase in earnings capacity in markets, where controlling shareholders have ways to expropriate a firm’s wealth. Bris (2005) observed that insider trading enforcement results in an increase in the number of incidents and increased profitability of insider trading, because it would leave few insider traders to act, when many others are legally restricted.

However, Bris (2005) found that harsher legislation acts as a deterrent to incidences of insider trading. According to Bushman et al. (2005) there was an increased coverage by analysts after the enactment and implementation of insider trading legislation, especially in the context of emerging markets. In the case of firms that have diffused ownership, the enactment of insider trading laws has been found to be more effective in controlling such activities.

Securities Regulations and Investor Confidence

Investor confidence is an important element for the sustenance of the growth of securities markets in developing as well as developed economies. Institutional and individual investors are not likely to invest in any economy, if they are not confident of not only the returns but also about the safety of their investments. If insider traders are allowed to act freely to deal in the market, the asymmetric information problems would be aggravated and consequently the confidence of investors would deteriorate. It is possible to obtain investor confidence and credibility in different ways, although legislation and effective law enforcement is one of the ways of achieving this.

Irrespective of other considerations, there is the basic need to ensure enforcement of legal contracts. This becomes necessary, especially in the case of securities trading, where the contracts are of a complex nature. Enforcement of legal contracts is not specific to securities contracts but extends to all other contracts and trading transactions.

It must be understood that since the concept of confidence is problematic in securities contracts, it becomes indefinable, which is taken up as an argument for government regulations. However, there are solutions available to deal with the issue of investor confidence. Adopting different forms of self-regulations is another way to increase confidence of market participants. Generally, the professional market agents, dealers and analysts who deal in the securities market should be able to apply the appropriate rules based on their knowledge, since they are the ones who stand to lose most if market confidence deteriorates.

Securities Regulations and Externalities

Liquidity in the securities market is characterized as possessing certain externality features. In the context of a developing economy, with the growing number of traders in securities, the benefits for every trader are likely to increase, which will lead to externalities in the market liquidity. The major issue with this externality is that it leads to consolidation of trading to a limited number of trading places and such concentration is most likely to restrict the competition among the participants. The financial market of a small poor country may not have the growth potential, if there is externality affecting the market.

One obvious remedy is a regulatory response, which lowers the barriers to entry, so that the competition among the participants will be stimulated. Although, concentration problem is common to other industries as well, financial markets are more exposed to this problem. The low transaction costs involved in the financial securities trading make market integration easy and therefore lead to more concentration tendencies, as more global investors are likely to be attracted to invest in financial markets which are safe and not costly. Secondly, securities regulations introduced for other purposes raise the barriers to entry and thus restrict competition.

Therefore, it becomes important for the small poor country to take into account the concentration tendencies of market participants while defining the securities regulations suitable to the economy. However, the country has to decide whether there is the need for specific regulations to control the concentration tendencies in securities markets or whether the general anti-trust laws and competition regulations may be sufficient to take care of the situation.

Regulations and Market Manipulations

There are other forms of market externalities and market manipulations which affect the efficiency of the securities market. For instance, all market participants would be able to derive the benefits of trading if everyone of the participants follow high ethical standards. However, this cannot happen in reality. If there are no rules and regulations to monitor the conduct of the market participants, many will have the incentive to follow unscrupulous moves, if everyone else acts ethically, with the result that all the participants would be worse off. There will be a market failure, if there is no alignment of the incentives of the market participants be it – exchanges, brokers, major investors, corporations etc.

The major issue here is that these market participants cannot coordinate their problems. Therefore, it becomes imperative that the government intervenes and introduces appropriate regulatory measures to align the incentives of all the market participants. The government may adopt different forms of regulations. Regulations may be designed to codify existing acceptable behaviors of the market participants or they may be drafted to change the public notion of what actions of the participants need to be outlawed. Considering the coordination problems, it may yield better results, when the regulations are codified. Outlawing price manipulations may be cited as an example in this respect (Neimeyer, 2001, p. 41).

Efficiency and Internationalization

Internationalization of securities trading is also likely to raise efficiency questions. One of the problems associated with internationalization is market fragmentation. With the fragmentation of the market, trading will take place on several markets, which would give rise to more instances of insider trading and market manipulation. When it is possible to indulge in insider trading in an international setting easily, it would provide more opportunities for frequent indulgence in insider trading. Under such circumstance, there will be the need for close cooperation between financial supervisors and the country may be in need of more resources to ensure effective supervision. This becomes important in view of the fact that trading at several venues will affect the supervision in addition to fragmentation of order flows and prices.

Another effect of internationalization is that there will be improved flow of information and the information is likely to be passed on to the professional investors more quickly. With the increased demand for information, companies would be interested in providing more investor-related information than they did earlier. This action is expected to result in improvement in market dealings. “However from a consumer protection point of view, there is a risk that the information gets more asymmetric, in that the difference in information level between professional investors and nonprofessionals increases” (Niemeyer, 2001, p. 54)

This gives rise to an argument in favour of introducing new regulations to ensure protection to small investors. However, with the availability of more and better information, large investors can work on the securities prices more accurately making the market more efficient. With this increased market efficiency, small investors will only benefit and therefore there does not arise the need for any regulation in this respect.

Security Regulations and Corporate Governance

According to the theory of Efficient Market Hypothesis, in a given point of time, all available information influences the stock prices. However, when the markets function efficiently and the ruling stock prices provide all the related information, then stock dealings entered into with an aim to outperform the market will be gambling rather than depending on the expertise of the traders. This is so because there are various other factors that have a direct or indirect influence on stock prices and which affect the movements of the prices upwards or downwards depending on their positive or negative impact on the buying or selling moods of the investors.

With more and more numbers of intelligent investors and traders entering the stock markets for transacting on various over valued and undervalued securities, the market tends to become more efficient to take the faster dissemination of information flowing from all directions and from all these people dealing in the securities. While the Efficient Market Hypothesis generalize the situation of stock price movements, technical analysis like moving averages and Support and Resistance techniques have tried to provide some scientific bases to predict the reactions of the stock prices.

The efficiency of the stock market operation has its own reflections on the trading in securities both from the angle of the investor and the company whose shares are being traded (Fama, 1998; Rozeff and Zaman, 1988). As it is implied that public information cannot be used to earn abnormal returns, the average investor should decide on a particular portfolio with the minimum cost of trading and base his decision on a host of information, which are timely and valuable to make the otherwise efficient market to his advantage. The companies should be encouraged by investor pressure, accounting bodies, government ruling and stock market regulations to provide as much information as possible to enable the stock market to react sharply and accurately to ensure proper pricing.

As far as the companies are concerned, the market efficiency will be greatly affected by the company either manipulating or withholding of information, which consequently will reflect on the price of their securities. With the short term profitability in view, if the company reacts in an undesirable way it will be detrimental not only to its shareholders but to society as well. This is so because based on the incorrect information, the stock market may react with incorrect pricing, which will affect the wealth of the old shareholders and new shareholders alike. This calls for stricter regulations to ensure good corporate governance.

According to Halpern (1999), the governance system will have a strong impact on the wealth creation efforts of a country. McGee (2009) states that effective corporate governance helps to increase share prices and enables companies to obtain additional capital. Corporate governance is required where there is ownership concentration (Shlefier and Vishny, 1997). Regulations ensure transparency in corporate financial reporting, which in turn works to make sensitive information available to the capital market. The objective of corporate governance regulations is to protect the rights of the capital market by ensuring that the timely and complete information necessary to assess the financial performance of companies, and to estimate the financial ability of them, is available to investors (Bhattacharya et al., 2003; Klapper and Love, 2002).

However, regulation is justified only when the benefits to society exceed the cost of regulations. Cost of regulations involves

  1. cost to companies of meeting regulatory requirements,
  2. cost of maintaining and implementing the regulation and
  3. cost of improper/incorrect regulations (Merton, 1987).

Companies derive benefits like reduction in risk, increased liquidity of stock and easy access to capital markets. Since the benefits to the companies far exceed the cost, regulations in the developed countries are more than justified. The implementation of Sarbanes – Oxley is one example of such benefit arising from enhanced regulatory requirements. Enactments of various corporate governance regulations in developing countries depend largely on the costs to the companies as the compliance cost may affect the profitability of the companies.

Security Regulations in a Small Poor Country

Regulations have become an integral element in the developing policy frameworks of developing nations (Minogue and Carino, 2006). The role of regulations has been found to be important in supporting market-led pro-poor growth of these nations. The poor countries could increase their competitiveness by improving institutional environment and regulatory governance to improve market efficiency and attain growth objectives. Regulatory reforms find a significant role in improving corporate governance (Kirkpatrick, 2004, 2006; Jacobs, 2003).

The objective of this paper is to examine how far poor small countries can adopt the same or similar sets of security regulations, in the same way as the larger rich countries adopt, to increase market efficiency. While looking at the efforts of the poor countries in adopting securities regulations, it is necessary that the countries should focus on the elements of regulatory policies of the government, the tools available to the government for the implementation of the regulations and the strength of the institutional infrastructure available within the country to comply with the regulations.

There is the need for centralized and concerted efforts on the part of the governments of poor countries to integrate these elements. Nicoletti and Scarpetta (2003), Estache (2004) and Dollar and Kraay (2002) suggest that good governance in general and regulatory governance in particular are critical to ensure a sustainable development process in poor countries. At the same time, excessive regulation may have a negative effect on private investment and international trade and economic growth (Djankov et al., 2002). However, practically, some people claim that governments in developing countries have concerns for local markets being monopolised by multinational corporations, which happens if a company monopolises a particular business activity; it controls that activity by preventing other companies from being involved in it.

Similarly, this will also create negative impact on these countries economically, as other local companies will face losses, in addition, bad effects would occur on citizen investors (Charles, 2009). Parker (2002) suggests that these countries have appropriate regulatory frameworks to meet the challenges of market failure. Poor countries also need regulations to ensure proper alignment of market-led developments with social development objectives and to ensure environmental protection.

Insider trading, as observed earlier, will lead to lack of investor confidence in the market. La Porta et al. (1998, 2000) and Bhattacharya and Daouk (2002) observe that “This lack of confidence in the integrity of the market may not only reduce the liquidity, but also slow down the pace of share offerings, affect the efficiency of resource allocation and raise the cost of capital for companies, thereby reducing their value ” (Gilbert et al, 2007, p. 4). Insider trading is another area where poor countries have tried to implement adequate regulations to control the practice. By the year 1998, 87 out of 103 countries that have capital markets have enacted legislation covering insider regulations. According to Benny (2005), prohibitive legislation in these countries, to deal with insider trading, has led to widespread share ownership. However, Ackerman and Maug (2006) find that implementation of insider trading legislation is more effective in industrially advanced countries than in poor developing countries.

Regulations become important in poor countries to ensure good governance, especially in view of the fact that in these countries a weakness in regulatory rule making is pervasive. In addition, “lack of accountability, transparency and consistency in policy formulation and implementation” (Zhang and Thomas, p. 3) largely affect market efficiency in poor countries. It has been observed that poor countries, where regulatory frameworks are not up to the mark, foreign and local investors shy away from investments. Regulations for investment are also different between countries, thus it depends on the situation of each country, economically, politically and culturally.

These factors could have the effect of reducing the level of activity of the private investment sources in the developing markets, thus there is bound to be an influence on the market’s efficiency. Therefore, despite the resultant advantages to improve market efficiency and thus to improve economic growth, drafting and implementing regulations in poor countries face considerable challenges. The major difficulty that may be observed in instituting sophisticated regulatory frameworks in poor counties is in transferring the “best practice” models, which are embedded in several economic, social and political contexts of industrially advanced countries.

There exists a reality gap between the ideas of best practice prevalent in larger rich countries and the actual political, legal, administrative and economic processes, which are observed in the poor countries. This implies that when the poor countries adopt a “one size fits all” approach in introducing securities regulations, such action is most likely to produce perverse outcomes. This situation thus will lead to “fatal remedies,” (Hood, 1998, p. 208). However, each government has different legal systems to organize its financial sector. Each system works duly to assist the economy somehow to grow in the areas of weakness as long as society needs and development demands (Charles, 2009).

Another major challenge in the introduction of new and sophisticated securities regulations aimed at improving market efficiency in the poor countries is the lack of effective institutional underpinning that may hinder the effectiveness of the regulatory reforms. More specifically poor countries are short of resources and expertise required to implement the regulations. The most important consideration is that the regulatory policies and reforms in poor countries must consider a wide range of social objectives and the regulations just cannot meet the ‘market efficiency improvement’ objective.

The regulatory policies in these countries must necessarily be pro-poor, which will lead to conflicts in the objectives of securities legislation. The cost of implementing the regulations and the cost of compliance by the companies operating in the poor countries is another serious consideration. Therefore, although market efficiency in poor countries is subject to the same type of risks as the larger rich countries face, it may not be possible for poor countries to adopt the same types of regulations as larger countries adopt because of several constraints discussed within this section.

Conclusion

There are two reasons why poor and emerging countries adopt securities regulations. The first reason is that the investors in these countries provide less capital and demand more returns, if their interests are not adequately protected. Second, transnational institutions such as the World Bank, the International Monetary Fund (IMF), the Organization for Economic Cooperation and Development (OECD), the European Union (EU), and the International Organization of Securities Commissions (IOSCO) require their member countries to adopt corporate and securities regulations to protect the interests of the investors.

However, there are many reasons why corporate and securities regulations could not be enforced in poor countries. There are reasons such as “lack of political will, poorly funded and incapable regulatory institutions, high burden of proof, or unfriendly courts” (Bhattacharya and Daouk, 2004). The same reasons may hold valid in arguing that poor countries cannot adopt the same regulations as the large rich countries.

This paper argues that the implementation of securities regulations in developing countries has to be considered in the light of regulatory policies, tools and resources available for implementation and the strength of institutional framework of the respective countries to ensure the effectiveness of securities regulations. Of course, in order to improve the efficiency of the markets in such countries, there must be considerations to implement suitable modifications and adjustments to be undertaken to the enactments of large countries, when poor countries want to adopt such legislation. Additionally, simple and direct bureaucracy with comparative financial legislation, which is at least similar if not exactly in the same structure and similar speed of process to that of western bureaucracies, can be considered as essential components toward building more confidence to the global investors.

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