Market liquidity for further growth and development

Recently, the DSE achieved the Frontier Market Status by FTSE Russell.

Reading FTSE Russell’s qualification criteria one will notice that the DSE currently meets criteria for an Emerging Market Status, except for one key criteria, namely the liquidity of the market.

According to FTSE Russell the DSE liquidity is not sufficient to support sizeable global investments.

Furthermore, the recent OMFIF-Absa Africa Financial Markets Index 2019 Report painted the same picture with regard to our market. This report indicates we have made significant progress in many aspects to the extent that we were ranked number seven (7) from number fifteen (15) in 2018, out of the 20 benchmarked markets in Africa, but the one key impediments towards a better ranking is the lack of/limited liquidity in the market.

The reason provided is that we lack or have limited local investors capacity.

Whatever way one to look at it, liquidity seems to be the existing elephant in the room.

So, what is liquidity in the stock markets context?

Stock market liquidity can be broadly understood as the ability to facilitate large volumes of trade without causing excessive price movements, while still reflecting a steady and fair market price.

This concept of liquidity encompasses multiple dimensions, namely: (i) breadth of the market: i.e. the case where the cost of reversing a transaction position over a short period is minimal; breadth is usually identified (and measured) by the bid/ask spread (the tighter the spread, the better); (ii) the depth of the market: a deep market has large numbers of pending orders on both sides of the bid/ask spread.

This usually limits the influence of orders on price movements; (iii) the market resilience: this is speed at which stock prices return to stability levels after a shock; and (iv) immediacy of order execution: this is indicated by the speed at which trades can be conducted at a given cost.

Market operators, investors, regulators, and others use a range of metrics to assess liquidity.

These include bid-ask spreads, turnover, and turnover velocity (value traded relative to the overall market capitalization). For example, is we consider these past five years, annual turnover on the equity (shares) segment of the DSE has been Tsh. 475 billion while on the bonds segment it has been Tsh. 580 billion.

These figures are 5 percent and 6 percent of market capitalization for equity and bonds respectively. At any measure, these ratios are on the very low side.

That’s why improving market liquidity in our securities market seems to be the only way to go if we want to make any further progress.

It is important to note that liquidity in the stock exchange, like in other trading venues, is the fundamental enabler of the rapid and fair exchange of securities between stock market participants. Liquidity enables investors and issuers to meet their requirements in capital markets, be it an investment, financing, or hedging, as well as reducing investment costs and the cost of capital.

Liquidity has a lasting and positive impact on economies. As it were, stock exchanges, regulators, and other capital market participants needs to take action to grow liquidity, improve the efficiency of trading, and better service issuers and investors in their markets. The indirect benefits to our market economies could be significant.

So, why does liquidity matter?

The importance of market liquidity and its relationship to financial market development could better be understood by examining the impact it has on various market actors: (i) For investors -- more liquid markets are associated with lower costs of trading, an ability to move more easily in and out of the listed securities, lower price volatility, and improved price formation; (ii) Issuers -- are attracted to more liquid markets, as they reduce the cost of raising capital and produce more accurate share price valuations; (iii) Stock exchanges -- they value the increased attractiveness to issuers and investors, as this translates into greater use of the market, greater confidence, greater ability to attract new stakeholders, and greater ability to do business, which drives revenues both directly (through trading fees) and indirectly (through extending their product offering, for example); (iv) Economies/Countries -- as a whole benefit, with companies able to access capital at a reasonable cost, subsequently increasing investment in their business and driving increased employment and their overall contribution to the economy.

There are many ways in which the market can enhance its liquidity. However, the difficulty by market stakeholders, such as institutional investors, to work with exchanges towards the direction of enhancing liquidity is a major hindrance for the DSE.

The case for increasing participation of local institutional investors:

In many early-stage markets like where we are the DSE, the size of the institutional investor base is usually relatively small and often highly concentrated, with relatively low levels of assets under management and limited participation in equity markets. The reasons for this vary between markets, but for us these include: (i) implementation of mandatory and defined benefit pension schemes that restrict the development of a competitive private pension fund sector; (ii) preference to invest in low-risk financial instruments, thereby limiting pensions participation in equity markets; (iii) restrictions on who manage pension fund assets, thereby limiting the emergence of a competitive asset/fund management industry; and (iv) other restrictions, including restrictions of pension fund investment in listed equity markets, in preference for assets classes.

Many frontier and emerging market jurisdictions have sought to address these by transforming pensions schemes by reducing the size of defined benefit pension schemes, the removal or relaxation of legislative and regulatory barriers to investment in equity markets, and the use of tax incentives to encourage both the allocation of funds to institutional investors and the funneling of investments into equity markets.