Jain, Pankaj K., 2005,

“Financial market design and the equity premium: Electronic vs. floor trading

,” Journal of Finance 60, 6, 2955-2985.

Floor versus Electronic

Market Design and Cost of Equity

Better Institutional features on Stock Exchanges

Improved Liquidity, lower spreads, higher turnover, better information

Lower illiquidity premium; Lower long term cost of equity for listed Firms

Literature Review Floor ElectronicTransaction costs and expected returns: Amihud et al (1986, 97)

Constantinides (1986), Vayanos (1998) 2nd order

Venkataraman (2001 JF): NYSE vs Paris;

Schmidt et al (1993): Germany; Jain (2001)

Muscarella & Piwowar (2001), Kalay et al (JF 2002): Paris/Israel, Domowitz & Stiel (2001) Barclay et al 1998Chiyachantana et al (2004)

Order Flow Transparency and Information

Limit orders hidden; Front running: Chung and Postelnicu (2003)

Better price discovery = better asset prices. O’hara et al (2002, 03), Ellul et al (2004)

Trader identity and adverse selection

Beneviste et al (1992): Repeated face to face interaction = reputation

Trader identity can be hidden. Jain et al (2004): LSE parallel markets

Liquidity factor is priced

Brennan & Subra (1996), Pastor & Stambaugh (2001)

Facilitates program trading: increases correlations

Competition Few market makers Numerous value traders

Floor versus Electronic• Face to Face• Order flow hidden• Best quotes only• Quotes evaporate• Slower execution• Slower settlement• Higher operating cost• Higher transaction cost• Expensive remote access• Reliance on single/few

market makers

• Trader identity can be hidden• Order flow displayed• All quotes• Quotes firm till withdrawn• Faster execution• Faster settlement• Cheaper• Deeply discounted brokerage• Better accessibility• Competition from numerous

value trades

Headline StoriesWall Street Journal 4/18/03 Financial Times (FT) 4/21/03

“Specialists at NYSE face probes of abuses: A lack of automation raises fresh suspicions of manipulation of trades (front-running),

FT, London Ed., Nov 28, 1997“Frankfurt exchange: Xetra electronic trading system goes live today:

"a new dimension" in bourse efficiency and transparency. .” Xetra will cut dealing costs and increase liquidity in German shares by automatically matching buyers and sellers. Xetra will make it easier to spot transgressions such as insider trading. "Market integrity is the most important asset on a stock market," "It means more fair play."

FT (London): Sep 18, 1992Survey of Pakistan: Foreign brokerages complain that since most local

broking houses are also stock jobbers, the lack of transparency in the marketplace provides ample room for abuse on the quoting of prices. With computer-assisted trading, the information flow is more rapid.

THE Karachi stock exchange was shut down yesterday after securities traders smashed windows and computers in protest at plans to end floor-trading making 2,000 dealers jobless.

Financial Market Design: Impact on Liquidity, Equity Premium, and Short Term Price Reaction

Hypotheses:

H10 : Electronic trading improves liquidity and

information. This reduces the cost of equity for listed firms in the long-run.

H20 : There is positive short-term price reaction to the

switch from floor to electronic trading (lower illiquidity premium reduces the discounting factor.)

H30 : The above effects vary by financial market

environment.

New Time Series Data (Dates) for 120 countries:

•Time series before AND after from MSCI, Datastream, IFC, www - Stock market indices (71), dividend yields (53), turnover (63 countries)

Methodology– Descriptive statistics; Multivariate regressions– Dividend growth model and International capital asset pricing model with

time varying betas using GARCH– Event study to examine short term effects

Country Estab. Elec. Annc. Source Data FreqInsider Liberal

1 Australia 1859 1987 1987 Handbook 94 1969 Monthly 1996 1969

2 Austria 1771 1996 1995 Handbook 01 1969 Monthly No 1969

3 Belgium 1801 1996 1993 Handbook 98 1969 Monthly 1994 1969

4 Canada 1878 1977 N.A. Steve.Kee@tse.com 1969 Monthly 1905 1969

5 Denmark 1919 1988 1987www.xcse.dk/uk/kf/historie 1969 Monthly 1996 1969

6 ….. … contd…

Figure 1. The Global Shift from Floor Trading to Electronic TradingBased on the leading stock exchange in 118 countries from 1975 to 2001

Fully ElectronicCombined Floor and Electronic

Floor Trading Only

0

20

40

60

80

100

120

140

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

Nu

mb

er o

f E

xch

ang

es

Figure 2. Declining Cost of Equity and Improving Liquidity after Automation

0.79%

0.02%

0.25%

0.38%

0.79%

2.14%

0.22%

1.05%

1.57%

0.85%

1.46%

2.00%

2.61%

2.36%

0.26%

-0.17%

6.14%

-1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

Trading turnover

Volatility (Variance of returns)

Country minus t-bill return ($)

Country minus world return ($)

Country minus world return (localcurr)

Div. yield + Capital gains (U.S. $)

Div. yield + Cap. gain (local curr.)

Dividend yield + growth

Dividend yield

Floor Trading

Electronic Trading

9.24%

County by County Analysis

Country DY DYCG DYCG$ DYG ERW$ ERT Turnover

1 Australia -0.04% -1.52% -1.13% -1.76% -0.30% -0.82% 0.0253

2 Austria 0.01% -0.46% -1.19% -0.01% -0.84% -1.14% 0.3063

3 Belgium -0.17% 0.06% -0.88% -0.83% -0.38% -0.83% 0.1724

4 Canada -0.08% 0.79% 0.45% -0.46% -0.41% 0.18% 0.0291

5 Denmark -0.10% -0.19% 0.27% 0.75% 0.80% 0.59% 0.0375

6 …. …contd..

Proportion (-) 72% 82% 83% 62% 72% 82% 25%

Wilcoxon Rank Sum Test

U 1195 1263** 1139** 1279 1694** 1172** 2817**

Z -1.62 -5.13 -5.64 -0.47 -3.37 -5.50 2.91

More Evidence on Improvements in Liquidity

• Table 1: Turnover

• Jain (2001, companion working paper): retail spreads• Chiyachantana, Jain, Jiang, and Wood (forthcoming JF)

– Institutional trading costs (price impact and commisions)

• Ellul, Holden, Jain, and Jennings (2003, N.B.E.R./ Morgan Stanley working paper) – Direct Plus executions are faster but not costly.

• Jain, Jiang, McInish, and Taechapiroontong (2003)– London dealers versus SETS: No reputation effects from face

to face trading

• Anecdotal Evidence: BSE versus NSE in India

ICAPM(returnit–rft)= 0 + covhiwt + (1-)varhit +eit  

• Estimate betas and prices for world market risk and local variance risk allowing for time varying integration of the markets with the world.

• ARCH model (returnit–rft) = c1 + it,(worldt –rft) = c2 + wt,

hit = b1 + a1(1/22

it-1 + 1/32it-2 + 1/62

it-3),

hiw = b2 + a2(1/22

wt-1 + 1/32wt-2 + 1/62

wt-3),

hiwt = b3 + a3(1/2it-1wt-1 + 1/3it-2wt-2 + 1/6it-3wt-3),

• If risk factors explained equity premium completely, then residuals should be orthogonal to other variables. Regress residuals eit  on Automation and other variables

wtiwt

iwtitwtit hh

hhN ,

0

0~,

Table 4. Effect of Electronic Trading: ICAPM with Time Varying Betas

A. Dependent variable is excess returns

Parameters Coefficient Std. Error P-Value

Alpha 0.0040 0.0011 <.0001

Price of world covariance risk 4.3927 1.8419 0.0171

Price of own-country variance risk 1.3015 0.1147 <.0001

B. Dependent Variable -> Residuals from ICAPM model  

Independent Variables Coeff. Std. Error P-Value  

Intercept 0.0006 0.0132 0.9617  

Electronic Trading -0.0046 0.0023 0.0411  

Enforcement of Insider trading laws -0.0025 0.0020 0.1964  

Liberalization -0.0038 0.0025 0.1280  

Market Capitalization -0.0010 0.0009 0.2928  

Developed Markets 0.0015 0.0024 0.5431  

Time Trend 0.0001 0.0004 0.7150  

B 2. Interaction between electronic trading and level of economic development.

Intercept 0.0025 0.0011 0.0300  

Electronic * Developed -0.0036 0.0020 0.0762  

Electronic * Emerging -0.0069 0.0021 0.0008  

Impact of Automation on cost of equity with time varying risk using ICAPM: Different time horizons

before and after

years Parm. Est. Std. Error t-stat P-value

full -0.00450 0.00230 -1.98 0.0471

10 -0.00656 0.00240 -2.73 0.0063

5 -0.00613 0.00273 -2.25 0.0245

3 -0.00497 0.00317 -1.57 0.1170

Figure 3. Cumulative Excess-over-world Returns

-5%

0%

5%

10%

15%

20%

25%

30%

-24

-23

-22

-21

-20

-19

-18

-17

-16

-15

-14

-13

-12

-11

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Month Relative to Announcement/ Implementation of Fully Automated Trading

Exc

ess

Cou

ntry

Ret

urn

Min

us E

xces

s W

orld

Ret

urns

..

Implementation

Announcement

Illiquidity Equity-Premium Studies: A comparisonStudy Reason Premium

This paper Lower liquidity on floor 5.35% pa

Pastor & Stambaugh(2001)

Higher sensitivity to market liquidity 7.50% pa

Bhattacharya-Daouk(2002) Illiquidity due to insider trading 7.00% pa

Illiquidity Price-Discount Studies: A comparison

Study Reason Discount

This paper Price reaction on Switch 6.27%

Silber (1991) Stocks with 2-year lock-in 30.00%

Loderer and Roth (2001)

Stocks with higher bid-ask spreads

35.00%

Dimson and Hanke (2000)

Equity linked bonds 9.00%

Robustness of Results• Switch dates cross checked from 3 sources in 70% cases.

– MSCI handbook of world’s stock exchanges, Website of exchange, Email/Snail mail/Literature directly from exchanges

• Results are Robust to additional analysis:– by sub-samples like full history, 10, 5, 3 years – Gross Returns, Excess over World, Excess over Risk

free returns.– Drop internet boom & bust period 01/99 to 06/01– Allow for transition period of 1 or 2 years.

• Control Variables– Liberalization, Enforcement of Insider law, Level of

World returns, developed vs. emerging markets, Time varying risk factors, a Trend variable.

• Cost of equity reduces by 0.31%/month after automation

– Sharper results with ICAPM model than with dividend growth – Reduction comparable to those due to liberalization, lower systematic

liquidity, and insider trading enforcement

• 59 out of 71 countries (83%) that switch experience reduction

• Bigger effect in emerging markets than in developed

• Positive price reaction of 7.87% in announcement month

• Annual trading turnover increases by 37% of market cap

• Bid ask spreads drop by 40% (based on a smaller sample)

Paper available at: http://www.people.memphis.edu/~pjain/automate.pdf

Summary of Results & Conclusions: Floor vs Electronic