Liquidity is a fundamental enabler for the rapid and fair exchange of securities between participants in the stock market. Liquidity enables investors and issuers to meet their requirements in the stock market, be it on investments, financing, capital raising, or risk management as well as in reducing investment costs and cost of raising capital.
At the Dar es Salaam Stock Exchange there has been various efforts and actions that the exchange, regulator, and other markets participants have taken in order to grow liquidity, improve efficiency of trading and in offering better services for issuers and investors in our market. In the past few years, we have focused on enhancing our core market infrastructure such as electronification of our trading, settlement and depository systems; enhancement of our settlement cycle to international standards as well as our pro-active engagements in investor education and awareness campaigns in order to attract more issuers and investors into our market. We have also been working collaboratively with the Government to bring about various tax incentives for both issuers and investors who participate in our markets — these includes zero capital gains tax on listed shares transactions, a five percent withholding tax on dividends (instead of 10 percent for investors in non-listed shares), zero stamp duty, etc. For issuers, there is a reduction of 5 percent in corporate tax rate, there is also a tax deductibility of all Initial Public Offering (IPO) costs for the purposes of income tax determination by the tax authority.
Other efforts and actions have included pursuing the regulatory framework that have a fair combination of both merit-based and disclosure-based regulatory regime in approving public offerings and in admitting listings into the exchange. We have recently changed our regulations in order to attract more foreign investors and international issuers. We are pursuing actions that encourages more companies to list into the exchange — establishing the enterprise growth market and our plans to establish exchange traded funds and exchange traded derivatives are all some of the efforts to encourage more depth and liquidity in the market place. Despite all these efforts, one thing which is usually significant in increasing the breadth, depth and liquidity in the market is number of issuance, and especially the size of those issuances and listings. In this end, the government’s pro-market growth policies becomes imperative. As it is, private sectors conducts are usually less for public good compared to the public sector conducts and practice, where public good is the fundamental focus. In pursuance of self-interest, as the private sector normally does, sometimes they have wait for the necessary market resillience and liquidity levels that will match their self-interest valuation motives, growth and profitability desires before they may seriously pay attention to calling to conduct IPOs, list into the stock market and become transparent thereafter. Meanwhile, the government — which looks for the general public good — performs several supporting and interventions measures to ensure market growth. This is what our government, like many other governments, have been doing. And it has included pursuing tax policies, privatisation policies via IPOs and listings as well as other policies and legislative actions that encourages or requires some firms in certain sectors to list into the stock market, all in efforts to encourage the growth of the local capital market — why?
Empirical evidence from other markets indicates that development of capital markets has been driven to a great extent by offering of State Owned Entities (SOEs), with large-scale privatization programs typically being followed by substantial market capitalization and liquidity as well as strengthening of regulatory and corporate governance frameworks.
With existence of relatively sizeable IPOs and listings, secondary markets can then be enhanced mainly to provide an exit route for investors and facilitate better price discovery – the accurate valuation of instruments that ensures issuers are paying an appropriate price for their access to finance and investors are adequately compensated for the risk they take in providing it. For this, market makers and liquidity providers are crucial to this latter function, as they take advantage of their superior expertise and information in order to arbitrage away inconsistencies in valuations as well as differences in risk appetites between investors.
Investors in capital markets need immediacy exit opportunities, in order to match the maturity of available securities to their own preferred portfolios. This requires the function of market institutions, key being stockbrokers/dealers and the other aspect of intermediaries which is currently missing in our market i.e. liquidity providers/market makers who are willing to build inventories of financial instruments. While sometimes these key market intermediaries are frequently denounced as mere speculative in their dealings with investors, their function is essential. In fact, insufficient liquidity is very often cited as the primary barrier to capital markets growth and development.
Evidence demonstrate that liquidity providers are generally attracted to critical mass of investors (including security borrowers and lenders) but equally they need a set of rules governing trading that are not unduly restrictive.They also benefit from trading mechanisms, including supporting clearing and settlement systems, which do not impose prohibitive transaction costs. To minimize learning costs, liquidity providers tend to require relatively large issue sizes and frequent and/or regular issuance or, alternatively, long maturities. Finally, liquidity providers rely on the existence of financial instruments whose risk profiles incorporate mostly or exclusively market risk as opposed to plethora of different risks; alternatively, other instruments through which market risks can, at least in theory, be isolated (e.g. by hedging all other sources of risk).
When market rules and trading conditions are much more benign for liquidity providers than for other investors, a market can accumulate liquidity in good times, sometimes from overseas investors, whose presence in the market can be relatively volatile in some cases and in certain situations. Such excess liquidity during booms may be associated with the rapid loss of market liquidity that several developed markets saw during the financial crisis of 2008/9 and the sovereign debt crisis of 2010-12 in many developed countries. In fact, such phenomena could prove to be self-reinforcing as fear that liquidity may drain from the market at short notice is likely to drive investors away.
The strength of the disclosure system (disclosure rules, monitoring and enforcement and information dissemination) is positively correlated with stock market liquidity. The timely and credible disclosure of company information tends to not only promote investor confidence and encourage more active participation in the market, but also to attract additional listings, thus broadening the benefits to the domestic economy. On top of mandatory disclosures, voluntary disclosures have also been shown to increase stock market liquidity by reducing bid-ask spreads. Disclosures also have an indirect effect on emerging bonds market liquidity.
It is however important to note that overall market liquidity is not an end in itself. Investors normally demands a premium from smaller firms listed in small stock markets above and beyond what would be justified by market liquidity. Thus, there is case for policies that ensures that capital markets not only attract liquidity, but also direct it towards the most productive firms, regardless of size.
To conclude, market liquidity is fundamental and very beneficial for the growth of any stock market. Market operators, investors, regulators and others needs to constantly pursue a range of metrics to assess and enhance the level of liquidity in the market place. Some markets uses Liquidity Enhancement Schemes such as those mentioned in this article and others. In the overall — more product offerings, more investors, a meaningful regulatory regime and an efficiency market infrastructure matters a lot.