Market participation, Liquidity and Price formation

Consistently with the literature, it is evident that when liquidity is low in the stock exchange, prices becomes more inefficient, and trades’ impact on prices increases. There is also evidence that trading participant types contribute heterogeneously to price formation, in most cases, with retail and foreign investors being better informed investors, while domestic institutional investors contributing marginally less to price discovery. This pattern holds for different liquidity levels, and that lower liquidity is associated with lower price efficiency and higher price impact of trades for all trading participant types. This is a normal phenomenon key to developing markets and is key in informing the enhanced growth and development pursuance.

As it were, stock markets have two main functions: the first is to provide platform for liquidity creation (and enhancement); the second is to ensure that prices incorporate new, relevant information (in the process of price discovery) and enterprises are as close as possible to the fundamental value of (listed and traded) securities. While the concepts of liquidity, price discovery and price efficiency are distinct, they are in fact closely related: not only has liquidity been found to lead to both better price discovery (Riordan and Storkenmaier, 2012; Frijns et al., 2018) and enhanced price efficiency (Chordia et al., 2008a; Chung and Hrazdil, 2010), but literature also suggests that prices are better reflective when are more readily to incorporate new information.

It is well-established that different types of market participants (i.e. retail investors, domestic institutions, foreign institutions) contribute differently to trading activity depending on a jurisdiction’s historical, cultural and institutional factors (WFE and Oliver Wyman, 2016), i.e. trading participants contribute heterogeneously to liquidity. Even more importantly, the literature agrees that different types of trading participants possess different levels of information (Chan et al., 2007; Froot and Seasholes, 2001; Gonçalves and Eid, 2017; Grinblatt and Keloharju, 2000; Xu and Wan, 2015) and abilities to interpret market movements (Dvořák, 2005), and therefore contribute heterogeneously to price formation. Thus, a question is does the contribution of different trading participants to price formation also varies depending on liquidity?

To respond to such and the like questions, a recent study by World Federation of Exchanges (WFE) used the proprietary timestamped limit order book and trades data from the Stock Exchange of Thailand (SET). SET’s choice in addition to other factors, such as specific information on trading participant categories (i.e. retail, domestic institutions and foreign institutions), liquidity — which for the case of SET is spread across stocks of all sizes, and efficient price discovery; but primarily SET is characterised by high levels of transparency, with over 95 percent of the trades passing through the limit order book, few bilateral (block/pre-arranged) deals, and no designated market makers. In addition, the Thai market has no fragmentation, a relevant feature as fragmented pools of liquidity are a confounding factor in the estimation of both liquidity and price discovery. These factors are aligned across frontier and emerging markets.

According to the study, trades between different investors’ categories are characterised by heterogeneous information contents, supporting the assertion that the interaction between market participation, price formation and liquidity defines the speed to which the growth and development of a stock market is determined. At SET, for example, there is evident that the most informative trades are between retail investors (R-to-R), between foreign institutions (F-to-F), and between retail investors and foreign institutions (R-to-F).

There is further evidence that the contribution to price discovery of F-to-F trades is more pronounced for lower levels of liquidity. Trades between domestic institutions (D-to-D) and between retail investors and domestic institutions (R-to-D) are instead the least informative.

In accordance with the study, it is evident that higher illiquidity is associated with larger price impacts for all trading participants. This evidence suggests that retail and foreign investors contribute proportionally more to price discovery than domestic institutions, which are to larger extent likely to be the buy-and-hold institutions – a similar experience to our market. The evidence that both retail and foreign investors positively contribute to price discovery adds to more value to our own experiences, understanding and lessons to be drawn for our better future.

As it is with SET, it applies also for us that domestic institutions (i.e. pension funds, insurance companies, etc) play a marginal role in the price discovery process. This pattern is consistent across all liquidity levels, though the price impact of trades increases monotonically with illiquidity for all participants’ types.

From a theoretical perspective, it is unclear who should possess better information between domestic and foreign investors, as on one hand international investors have to face cultural and language barriers that put domestic investors at an informational advantage, though on the other hand foreign investors are typically more experienced traders/investors than domestic ones. Therefore, determining whether information is largely held by domestic or foreign participants is an empirical question.

Under normal circumstances it is expected that domestic investors should have an overall information advantage, even though there are many cases where some foreign institutions are better informed and performers probably due to their superior experience in multiple jurisdictions. It is further clear that brokerage firms, who also conduct research and advisory services, have a role in providing better information, as clients of global brokers have higher long-run profits than clients of either local or regional brokerages. In our case however, the role of brokerage firms on research and investment recommendation leaves more to be desired.

Based on the above we conclude that price discovery can largely be attributed to retail investors and to foreign investors in the mid-low liquidity segments. That, trades by domestic institutions are impactful only when foreign institutions take the other side of the trade, consistently with domestic institutions being large buy-and-hold players whose trades are not motivated by speculative reasons. Under such circumstances, it can be argued that for progressive development of the market we collectively need to create structures, products, infrastructure and institutions that will enable more retail participation, this is ideal for liquidity enhancement, better price discovery and valuations as well as wealth enhancement which is one of the key functions of a stock market.

Weathering the COVID-19 Pandemic at the Exchange

Our experience with the Pandemic

The COVID-19 pandemic is undoubtedly causing unprecedented disruption to both businesses and economies and has triggered the need, for nations to delicately balance public health priorities on one hand and preservation of lives and sustenance of economic activity on the other.

In responding to the pandemic, we took measures and approaches relative to its own circumstances aligned to our specific social, cultural, and economic challenges. Some of these measures partly impacted business output resulting into renewed financing and operating models and opportunities. From the stock market perspective, central to recovery is the need to maintain solvency, attract liquidity and enable sustainable access to capital.

In responding to policy interventions (monetary and fiscal) by the Government including relief measures offered by alternative suppliers of capital, the DSE enhanced its engagement with key stakeholders to raise awareness of the alternative approaches that could be deployed to tap into pools of contractual savings through various instruments on the market.

Inarguably, the DSE, as for similar markets has over the years relied on international investors as the key source of liquidity, volatility, and price discovery. Pre-Covid, international investors contribute over 80 percent of liquidity on the equity segment, but from mid-March to-date foreign investors participation has declined to less than 20 percent of market liquidity, resulting into liquidity challenges. For cultural, structural and policy reasons domestic investors and suppliers of capital have remained narrow. Low participation of domestic investors poses the biggest threat to the resilience of the market especially under current circumstances. It has now become clear that without the support of a vibrant domestic investor base sustainability and resilience of the market could be threatened.

The one thing that is expected to challenge DSE participants, also an opportunity, is the existence of means, tools and mechanisms with capability to reach to potential domestic suppliers of capital and participants in the securities trading and investment and hence increase the domestic investor base.

Operations and Resilience Challenges – New opportunities

Whether access to capital via capital markets IPOs, or mechanisms and tools of mobilization of IPO funds, or payment of dividends and bonds coupon, or remote access to market infrastructure, etc — the silver lining seems to be on the Financial Technology (Fintechs) whose innovation will enable entrepreneurs access to capital, as well as financiers and capital suppliers to invest and get their returns back in efficient manner. Seeking to integrate technology to develop financial services with limited operational costs seems the way to go for the market.

At the DSE, we believe that Fintechs can help mitigate the economic cost of lockdowns and avoid irreversible damage to the social economic fabric of our society. That, low-cost Fintech solutions hold the key to reaching out to more than 99 percent of Tanzanians who do not have investment accounts with the DSE.

So far, mobile money developments seem to be the most utilized feature of Fintech. According to Statista Data, the mobile (money) payment market in Tanzania surpassed US$ 3.6 billion (Tsh. 8.3 trillion) worth of transactions – attributed to 23 million subscriptions – on 257 million transactions. Measured against the total population of approximately 58 million, around 40 percent of Tanzanians made use of mobile money in 2019. The same can be transformed and provide leverage into the market.

Based on the foregoing, the COVID-19 crisis provides an opportunity for the DSE and Fintechs in Tanzania to mutually engage on the urgent need to leverage on the existing development, adapt and innovate financial inclusion solutions and limit the long-term negative impact of such pandemic and provide buffer against similar crises in the future.

The DSE believe that by prioritizing Fintech, we will have ensured that the vulnerable among us not only survive new cases (if any) of Covid-19 pandemic, but also, that they are given a fair chance to thrive post-pandemic.

Enhanced Engagements with SMEs

The DSE established the SMEs financing (Enterprise Growth Market) segment in 2013. It has meet mixed outcome. Now, in encouraging more SMEs to access public capital and listing, the DSE considers possibilities of providing a platform to listing the pre-IPO SMEs whose investor base would be Private Equities (PEs), Venture Capital funds (VCs) and other Qualified Investors (QIs). Meanwhile, towards this end, the DSE is currently running the Enterprises Acceleration Program — which helps build capacities to SMEs on various aspects of capital raising and sustainable businesses management. The program also provides an opportunity to profile and enhance visibility to the public for such enterprises, providing a good platform for future capital raising needs.

The way forward — Focus on Technology and Innovations

On the lessons leant and the urgency to act that is being necessitated by the pandemic, the DSE in collaboration with development partners and government agencies are currently developing fintech solutions to enable: access to securities trading and investments; entrepreneurs and issues of financial instrument access to wider capital base; implement financial inclusions and inclusive economic empowerment policies.

Some of the several ICT projects that are geared to address the current market challenges are: (a) Mobile Trading Platform — the DSE is developing this platform with the objective of enabling remote access and increase its outreach to retails investors whose are currently not served by stockbrokers’ networks; (b) M-Akiba bonds, targeting retail investors – the DSE and other key stakeholders are developing the  Mobile Phone Platform to enable Tanzanians to invest and trade in Micro Saving Bonds enhance liquidity in the secondary market — widening the domestic investor base of the Government’s financing source; and supporting the country’s Financial Inclusion framework; (c) Automatic Fail-Over Process – during this pandemic the DSE has focused on enhancing its Business Continuity process and has automated the fail-over mechanism to the Disaster Recovery Site (DRS) to allow live trading, clearing, settlement and other operations to continue at the DRS without any interruption in case of continuing or further impact of the pandemic; and (d) Request for Quotations trading Module (RFQ) – the project whose purpose is enabling brokers and bonds traders to request for bonds prices and accept quotations from other participants in more transparent and competitive manner hence enhancing bonds price discovery process, volatility and transparency in price discovery.