Regulatory Frameworks of the Equity Markets of Australia and the USA - Essay Example

Regulatory Frameworks of the Equity Markets of Australia and The USA Introduction Equity markets remain likely as the more competitive, inexpensive and highly liquid source of capital funds for publicly-traded corporations all across the globe. What with the many and diverse interests of investors trading on publicly-held corporate securities and accepting the risk factor of holding shares of stock; in exchange for the potential of capital gains, earnings per share growth and dividends at the end of the year. Technology has had much influence in the way equity markets and their exchange functions are structured today. Physical trading on the exchange floor traditionally carried out by brokers and market makers, or specialists in an order-driven market, is driving towards obsolescence and being outmoded by electronic and online trading systems. As this developed, the structure of organized exchanges and the trading policies imposed by regulatory bodies continue to influence the turnover of physical shares, price formation of equities and trading costs, while generally exerting pressure on the behavior of market participants and the overall competitiveness of securities markets. This report will discuss the structures and regulatory frameworks of the equity markets of Australia and the United States of America. As a reference point, the major exchanges in both countries will be compared, where the NYSE is used as benchmark to the exchange activities of ASX and Nasdaq. Also, the report will include a rundown of equity-funding alternatives for a listed US corporation, as required. Equity Market Structures The equity market of Australia is operated largely by its organized stock exchange, the Australian Stock Exchange (ASX). Trade of ASX stocks takes place on a fully competitive and automated order-driven trading system, known as the Stock Exchange Automated Trading System (SEATS) (Elvis Jarnecic, June 1999). Trading is facilitated through the placement of a purchase order by a market participant with a broker, either by way of telephone or online through the internet, on regular trading days. In contrast, the New York Stock Exchange or NYSE operates under a hybrid market structure. Kaj Hedvall (CEFA, 2006) defines hybrid markets as a specialists market and the NYSE as an order-driven, floor-based, continuous market with specialists. Also known as an auction market; these specialists converge on the floor of NYSE to facilitate the reporting of bids and asks, execute trade and maintain order in the floor. NASDAQ on the other hand is a quote-driven, dealer market. At present, there are over 500 dealers—also called market-makers, composed of large investment companies, who buys and sells shares of stocks through a personal inventory of NASDAQ-listed stocks to earn a profit from a regulated bid/ask spread. NASDAQ is the largest screen-based market in the United States. Screen-based means that there is no physical location, but trading is based on computers and other communication mediums (Block, S et al, 2002). Thus, NASDAQ market makers conduct the exchange not through a physical trading floor, but by way of an electronic network. While each security under Nasdaq has an average of 14 market makers competing against each other, only one specialist is designated to every NYSE-listed stock. It can be observed that Australia operates a purely order-driven market while the major exchanges of the USA, conduct trading in a purely quote-driven market for NASDAQ and a cross between the two pure market models, the hybrid market, a structure of the NYSE. The advantage of an order-driven market is the inherent transparency of the system since all buy and sell orders of participants are posted on the market, providing information on which prices investors are willing to buy or sell shares. This is not an attribute of a quote-driven market where only the bid and ask offers of market makers are displayed. However, investors enjoy a guarantee of the execution of orders in a quote-driven market since the market makers will only have to fill such order from his inventory. The guarantee of execution can be thought of as a contributory to the liquidity of this market structure. While the ASX conveys a high degree of transparency from being order-driven, Nasdaq is likely a more liquid exchange given its quote-driven structure. Both market structures present a negative correlation in the above attributes presented. Resolving the drawbacks to each market structure is the installation of a hybrid market such as the one operated by the NYSE. In terms of trading, the Australian market may be defined as a thinly-traded market relative to the US market (Sujoto et al, 2005). Bid and ask orders are relatively fewer in this market category, liquidity levels are likely lower and the market is deemed more risky, as share prices react even to small changes in the level of demand and supply. Turnover velocity serves as measure of market liquidity which is computed as a ratio of turnover to domestic market capitalization. Based on end 2005 data obtained from the International Federation of Stock Exchanges (IFSE), the turnover velocity for the ASX is 84% while turnover for Nasdaq and NYSE are at 250.4% and 99.1% respectively. In terms of domestic market capitalization, the NYSE is the most competitive with over US$ 13 billion dollars worth of capital, followed by Nasdaq at US$ 3.6 billion—both are listed among the biggest stock markets in the world based on capitalization. The ASX on the other hand falls short of the 10 biggest exchanges with its below US$ 800 million market capitalization. The figures established the four points in our discussion: (1) A quote-driven market achieves better liquidity levels compared to an order-driven market. This was confirmed by the very high turnover velocity rate of the Nasdaq exchange which is quote-driven; (2) The integration of transparency and liquidity in a hybrid market structure puts more capital on the equity market while maintaining an acceptable rate of liquidity as can be inferred from NYSE data. (3) The US equity market is generally more liquid and competitive than the Australian equity market. This is further validated by the figures derived Morgan Stanley Capital Indices which measures the equity market depth. For the 2002 All-Country World Index, Australia had a global rating of 1.5% as compared to the 56.3% global rating of the United States (Axxis Australia Writers, 2003). (4) Market structure determines the liquidity position of an equity market. The absence of a market maker in the ASX makes it more vulnerable to systematic liquidity, being order driven in the first place. The specialist in the NYSE serves to maintain an acceptable level of liquidity in the market. IFSE data for year 2005 reveal that the NYSE generated the largest investment flows for the year from both initial and secondary public offerings with over US$175 million worth of new capital raised by shares of stocks. The ASX follows with over US$ 37 million investment inflows followed by NASDAQ with only US$ 12.2 million; with no secondary public offerings. The NASDAQ however holds the most number of listed companies, with over 3,000 domestic and foreign companies trading under this exchange. The NYSE follows with 2,270 and the ASX with 1,714 enlisted companies. Only ASX however increased its enlistment to around 8% from 2004 figures while both NYSE and NASDAQ had a reduced number of listed companies by 2005 at a rate of less than 1%. Regulatory Framework The Australian Stock Exchange is a self-regulatory organization. Much like its counterpart in financial market operations, which is the Sydney futures Exchange (SFE), the ASX serves both as a front-line regulator and market supervisor. The ASX conducts its supervisory functions through the subsidiary ASX Market Supervision. The Australian Stock Exchange (ASX) was the first stock exchange to both demutualize and be admitted to its own official list of companies. (Holthouse, 2001). This allows the ASX to operate, both as a market supervisor and a listed company. The Australian Securities and Investments Commission (ASIC) is the independent statutory agency that supports the functions of key players in the financial markets. ASIC's role is to enforce and regulate company and financial services laws to protect Australian consumers, investors and creditors. (Answers.Com) The US equity markets on the other hand are largely regulated by the Securities and Exchange Commission (SEC). The SEC is a government commission created to regulate the securities markets and protect investors (Investopedia.com, 2007). The commission generally requires the full disclosure of any trading transaction and due reporting of such, particularly in the event of insider trading. The SEC is quite adamant to the prosecution of any fraudulent trading practices that would undermine the interests of other investors in the spirit of level trading and access to vital corporate information. While both the NYSE and the NASDAQ operate a joint self-regulatory system in an integrated effort to keep markets free of fraud and from unfair dealing (Farell, G., 2006), these organized exchanges are subject to regulation and policy control by the SEC. EQUITY FUNDING ALTERNATIVES FOR LISTED CORPORATIONS While the Initial Public Offering on an organized exchange or an over the counter market is a funding alternative for new business entities, corporations already enlisted in a stock exchange with issued shares of common stock already trading in the equity market, often find themselves in need for additional capitalization to fund expansion plans, to develop and introduce new products in the market, to pay-off indebtedness or simply to roll-out its strategic plans. The equity market or stock market, as a secondary market may have the ability to secure additional capitalization as required by the corporation, but it is possible that the issuance of additional shares of common stock would have a dilutive effect on the price per share of current investors. The same strategy is also not feasible when existing market conditions do not call for this action. In these instances, a capital-needy corporation would have to consider other options in order to source-out the much needed capital. Discussed below are a few of the equity funding alternatives available to an established and listed US corporations, including the risk and return profile for each of these alternatives. Mezzanine Financing This type of financing is a cross breed of equity and debt financing that allows a publicly traded corporation to obtain capital without necessarily giving up a share in the interest of the business much like in equity finance. Mezzanine financing constitutes an unsecured debt and therefore presents high risks of default to the creditor in the event that the funds do not generate enough stream of income to implement annual repayments. However, lenders have the right to convert their exposure to equity in the event of default. Mezzanine fills the financing gap between equity and debt and can be structured with features of either debt or equity to achieve an optimal combination that matches the specific situation and requirements of the company. In a company's capital structure it can be a substitute for both debt and equity (Frank, R., May 2004). Due to the unsecured nature of this type of financing, it relies on very high interest rates in the 20-30% range to make it profitable (McGuigan, B 2007) Hybrid Securities Hybrid securities are financial instruments that have both debt and equity features. They are also used to meet the requirements of a very sophisticated group of investors. The more popular forms of hybrid securities are the Convertible bond and Basket D Security. A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period (Financial Pipeline Contributor, 2007). Basket D is a reference to a point on Moody's debt-equity continuum scale that treats the hybrid as 75% equity and 25% debt (Answers.com contributors, 2007). It is also the most popular type of hybrid among financial institutions. Hybrid investments are gaining popularity among investors because of its ability to earn higher interest rates than other fixed interest securities such as corporate bonds. These securities also offer frankin dividends and a few even offer tax-deferred benefits (Whittingham, A. 2007). In exchange for asymmetric risk, sustainable average returns of 7.5% per annum may be expected which is notches away from the average returns of corporate bonds. Bibliography Answers.com contributors. (2005). Australian Securities and Investments Commission. [Online]. Available: http://www.answers.com/topic/australian-securities-and- investments-commission. March 11, 2007. Axiss Australia Writer (2003).The Australian Equity Market .[Online]. Available: http://www.axiss.gov.au/assets/documents/axissinternet/EQUITYDATAFILE20050617160104.pdf. March 10, 2007. Axxis Writers (2003). The Australian Equity Market [Online]. Available: http://www.axiss.com.au/assets/documents/axissinternet/EQUITYDATAFILE20050617160104%2Epdf. March 11, 2007 Block, S. & Hirt, G. 2002. Foundations of Financial Management. 10th ed. New York: McGraw-Hill Companies, Inc. Frank, R. (May 17, 2004). 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Available: http://www.schroders.com/StaticFiles/Schroders/Market%20Strategy%20And%20News/Articles%20and%20Interviews/Article-hybrids-200512.p.pdf. March 11, 2007. Read More