Executive Summary:
Impact of Legal and Political Institutions on Equity Trading Costs
Through their study of the equity trading costs of 44 countries, Assistant Professors of Finance Venkat Eleswarapu and Kumar Venkataraman document how the overall quality of legal and political institutions impacts the cost of trading. The findings of their study have far reaching implications for how policymakers should be viewing the relationship between their home country institutions and financial markets, which ultimately impacts the macro-economy. Macro-level institutional quality will affect equity trading costs through its impact on information risk and investor participation.
Groundwork
Some groundwork must be laid for added context to the findings. A good legal environment in a country reduces information risk by curbing insider trading, creating market transparency, boosting investor confidence, and encouraging investor participation. The rule of law will prevail in the presence of a strong and independent judicial system; corruption will be lower in a system of checks and balances. Thus, sound political institutions are vital to the development of vibrant and liquid capital markets vis-à-vis the level of trust they engender. The authors surmise that stocks from countries with better legal and political systems have lower trading costs due to higher investor participation.
The Findings
In the study, 412 NYSE-listed American Depository Receipts (ADRs), stocks from other countries packaged and denominated in dollars, from 44 countries reveal the key findings. Stocks from countries with better ratings for judicial efficiency, accounting standards, and political stability have significantly lower trading costs as witnessed by the effective spread (proxy for trading costs) and price impact of trades (the cost or risk due to other informed traders).
Trading costs are significantly higher for stocks from French civil law countries than for those from common law countries of English origin, partly because of poorer investor protections. The trading costs based on effective spreads (quoted spreads) would be 0.96% (1.19) from a French-origin legal system compared to 0.63% (0.78) from one of English-origin.
Institutional quality measures and averages are presented for the 44-country sample (see Table 1 in full paper). Countries are further measured and compared by judicial system efficiency, whether insider trading laws exist, accounting standards, and political stability. Stocks from countries with more efficient legal systems and better enforcement of rules will generally have lower adverse selection risk and cost of liquidity as the results indicated. Also the study shows that investor participation is higher and hence the cost of liquidity (the ability to move in and out of stocks) lower as the political stability of a country increases.
The empirical relation measuring the impact of institutional quality in the regression analysis is both statistically and economically significant. As an illustration, the authors estimate that the effective spread of a stock would decline from 1.3% to 0.5%, if the same stock is based in Sweden, having the most sound institutions, rather than in Venezuela, with the least sound institutions.
The results support the basic thesis that stocks with better institutional quality rankings, i.e., countries with sound macro-level institutions, are rewarded with higher liquidity, and thus greater ease with which investors may buy and sell securities. “The market behaves as if it already knows this information. However, policymakers need to understand the importance and implications of having strong institutions,” said Dr. Eleswarapu. “The results suggest that any improvement in macro-institutions will reduce trading costs and thereby increase stock market valuations which has significant public policy implications,” concluded Dr. Eleswarapu.
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