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Eleswarapu And Venkataraman-The Impact Of Legal And Political Institutions On Equity Trading Costs A Cross-Country ...

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The Impact of Legal and Political Institutions on Equity Trading
Costs: A Cross-Country Analysis
Venkat R. Eleswarapu *
and
Kumar Venkataraman *
First draft: November 2002
* Department of Finance, Edwin L. Cox School of Business, Southern Methodist University, P.O.Box
750333, Dallas, TX 75275-0333. Contact information for Venkat Eleswarapu is (214) 768 3933
(e-mail: veleswar@mail.cox.smu.edu), and Kumar Venkataraman is (214) 768 7005 (e-mail:
kumar@mail.cox.smu.edu). We thank Madhu Kannan at the NYSE for providing us with data on ADR
listings, and Usha Eleswarapu for comments and suggestions.
The Impact of Legal and Political Institutions on Equity Trading
Costs: A Cross-Country Analysis
Abstract
We examine whether the quality of legal and political institutions impact the trading costs
of stocks originating from a country. A study of liquidity costs of 412 NYSE-listed ADRs from
44 different countries reveals a number of interesting findings: The average trading costs are
significantly higher for stocks from civil law (French-origin) countries than for stocks from
common law (English-origin) countries. After controlling for firm-level determinants of trading
costs, effective spreads and price impact of trades are significantly lower for stocks from
countries with (i) more efficient judicial systems, (ii) better accounting standards, and (iii) more
stable political systems. These empirical relationships are economically very significant.
Surprisingly, in the presence of firm-level controls, the enforcement of insider trading does not
explain trading costs. Overall, we document that macro-level institutional risk is an important
determinant of equity trading costs.
Key Words
: Bid-ask spreads; Adverse selection risk; Institutional risk; Legal systems
I. Introduction
Following the seminal work by Demsetz (1968), a number of researchers have studied the
determinants of transaction costs in stock markets. Broadly, these studies have focused either on
firm-level characteristics or on market structure to explain equilibrium trading costs.
1
In contrast,
this study examines the impact of macro-level systemic risks that result from the level of
institutional development in a country on the liquidity of stocks originating from it. Institutions –
defined broadly as both legal and political – may impact the liquidity of capital markets in
different ways. In this paper, we discuss these linkages and empirically explore the relationship
between the quality of a country’s institutions and equity trading costs.
The legal environment – both rules and their enforcement – affects the perception of
“investor protection” and therefore the willingness of small investors to provide equity capital.
More specifically, countries with weaker legal institutions have less developed markets and more
concentrated inside ownership due to lower participation by outside investors (La Porta, Lopez-
De-Silanes, Shleifer and Vishny (here after, LLSV) (1997), (1998)). That is, the float of the
equity is smaller in countries with weaker institutions.
2
A smaller float in turn implies a smaller
pool of uninformed traders and higher trading costs. A second possible effect on trading costs is
through the legal framework in place to curb insider trading. As the risk of insider trading
increases, investors will be less willing to provide liquidity.
3
The willingness to provide liquidity
is also influenced by the level of transparency mandated by the rules governing corporate
1
See for example, Tinic (1972), Benston and Hagerman (1974), Tinic and West (1974), Stoll (1978), Ho and Stoll
(1981), Copeland and Galai (1983), Amihud and Mendelson (1987), Stoll (1989), Huang and Stoll (1996),
Bessembinder and Kaufman (1997) and Stoll (2000).
2
In a related vein, Dahlquist, Pinkowitz, Stulz and Williamson (2002) show that the “home bias” in the average
equity portfolios is, in part, caused by differential levels of aggregate float of equity markets in various countries.
3
In support, Bhattacharya and Daouk (2002) find that the average cost of equity is lower in countries where insider
trading laws are enforced. That is, a lower risk of insider trading improves the stock’s liquidity, which in turn
lowers the cost of capital. Theoretical expositions of these linkages are made in Amihud and Mendelson (1986) and
Easley, Hvidkjaer, and O’Hara (2000).
1
disclosures. In particular, the quality of a country’s accounting standards will affect the degree of
information asymmetry between inside and outside investors. For all these reasons, we
conjecture a link between the quality of legal institutions and the liquidity of stocks from a
country.
Further, investor participation depends not only on the legal rules in place but also on the
confidence
that a strong and independent judicial system will enforce them fairly. However, the
effectiveness of law enforcement is, arguably, affected by the level of corruption and general
adherence to the rule of law in the country. And, these factors in turn are shaped by the political
structures within the country. For example, Treisman (2000) argues that the prevalence of
corruption is related to the country’s historical, cultural, economic and political characteristics.
Among other factors, he finds that the exposure to democracy, in addition to the origin of its
legal system (common law versus civil law), is a key determinant of the level of corruption in a
country. Similarly, Rose-Ackerman (2001) finds that the length of exposure to democratic
structures affects the incidence of corruption. All this suggests that, in addition to legal
institutions, political institutions are also vital to the development of capital markets, through the
level of trust they engender.
4
An ideal research design to capture the effect of institutional risk(s) is to compare trading
costs of
identical
securities from
different
countries that trade on
similar
market structures. In the
spirit of such an experiment, we examine trading costs of 412 American Depository Receipts
(ADRs) from 44 different countries that trade on the NYSE. We believe that our empirical
design has several advantages. First, our trading cost measures are not contaminated by the
impact of trading environment and market structure, as all our stocks trade on the same venue
4
The importance of public trust to capital markets can be seen from Lee and Ng (2002), who find that firms from
more corrupt countries trade at lower values, after controlling for other known factors.
2
(the NYSE). Clearly, this would be a problem if one were to compare trading costs of stocks
listed on exchanges in different countries. Second, we explicitly control for the firm-level
determinants of liquidity to isolate the effect of institutional risk(s). Third, the stringent NYSE
listing and SEC reporting standards
5
imply that our sample of ADRs have significantly better
disclosure practices than the typical firms in their home countries.
6
This is especially true for
firms originating in countries with weak institutions. Therefore, to the extent that differences in
the firm’s disclosure policies are attenuated, the differential risk that we study is essentially
systemic
– resulting from the legal and political institutions in the country of origin, and
obviously beyond the control of the firms and its managers. Further, any evidence that
institutional risks affect trading costs is particularly convincing, since the design is biased against
finding such a relationship.
We document substantial evidence suggesting that the perceptions of legal and political
risk impact equity trading costs. Our key findings are as follows: The average trading costs are
significantly higher for stocks originating from countries with civil law (French-origin) than
those with common law (English-origin). After controlling for firm-level determinants of
liquidity, effective spreads and price impact of trades (a measure of adverse selection risk) are
significantly lower for stocks from countries with (i) more efficient judicial systems, (ii) better
accounting standards and, (iii) more stable political systems. Perhaps surprisingly, when we
include firm-level controls, the enforcement of insider trading laws in a country (as identified by
Bhattacharya and Daouk (BD, here after) (2002)) does not explain trading costs. The empirical
5
For example, the SEC requires all foreign securities to annually file form 20-F (the equivalent of a U.S. firm’s
10K), which includes a reconciliation of the reported earnings and book value of equity to US-GAAP from home-
country accounting principles.
6
Doidge, Karolyi and Stulz (2001) argue that foreign firms that list shares on U.S. exchanges have lower agency
conflicts and better disclosure practices than firms that are not listed here.
3
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