THE CRITERION OF PROCEDURAL EFFICIENCY AND OTHER CRITERIA FOR ASSESSING THE QUALITY OF SECOND ARYSTOCK MARKETS

THE CRITERIONOF PROCEDURAL EFFICIENCY AND  OTHER CRITERIAFOR ASSESSING THE QUALITY OF SECOND ARYSTOCK MARKETS

So far, proceeding  from the interests of the market

participants, we have established procedural  efficiency

as the main criterion  for assessing  the quality of

stock markets. Besidesthis,we have shown what  cost

elements  in the three functional  spheres of the

secondary  stock market - cost elements  influenceable

by the way the  stock market is organized  - prevent

the cost of capital to an issuer being equal to the

aggregate yields enjoyed by the investors who hold

his issue over a period of time. From this  discussion

it emerged, firstly, that the sub-total of the  costs

influenceable  in the individual market spheres  could

serve as a sub-criterion  for judging  procedural

efficiency  and we saw, secondly, what might be the

crucial points  for an improvement in the quality  of

the secondary  stock market and what problems  arose  in

that connexion. Before proceeding to examine  secondary

stock markets in the countries of the  European

Communities  in the light of these findings, it would

seem a good idea to show the relationship  between

the yardsticks we have developed  in this  study  and

other criteria  for assessing  the quality of  a stock

market which  are commonly  to be found in the  relevant

literature.

In the more recent American  literature  the  criterion

of internal or operational  efficiency  is often  used.

This criterion  is basically  the same  as that of

procedural efficiency except that it mainly  includes

sub-aspects of the efficiency of the execution  sphere

and does not, for example  - unlike  "procedural

efficiency"  - include  the set of problems relating  to

investor protection because of its narrower  definition

of transaction costs. Internal or operational  efficiency

is contrasted with external or "allocational" efficiency,

although operational  efficiency  is regarded as a

prerequisite  for allocational efficiency;  in other

words,if market-organization-determined  costs were zero,

funds would be routed via the stock markets ("allocated") to the optimal uses. It would be a prerequisite for this that the

relevant information was available and that a fairly large number, at least, of mutually independent market participants

evaluated it correctly and promptly. Stock prices would then at all times be the best possible reflection of the distribution and amounts of future payments by issuers. But the higher the

market- organization-determined  costs - and in particular

the higher and more unpredictable the transaction costs

that have to be borne – the wider the deviations from such optimum allocational prices that can arise and persist, since it

would not pay market participants who spotted these deviations to induce a change in prices by making appropriate transactions (for example, where the deviations

are not greater than the expected transaction costs of the switching transactions that appear - at a first glance

 profitable because of these deviations). From the point of view

of optimum allocation, it is particularly unfortunate if comparable stocks have to bear market-organization-determined  costs of varying amounts, whether because of

differing capital resources among market makers

in these stocks, because they cannot be dealt in on the same market and therefore attract different rates of commission,

or because minor and major issuers have to bear the same amount of fixed ctsts for servicing securities. Irrespective of whether the market-organization-determined  costs vary with

the number of transactions or not or are dependent on the volume of theissue or not, the less and the more uniformly they burden a transaction unit or an issue unit, the more accurately will the share

price be able to indicate the earning power of the

issuer.

 Accordingly, procedural efficiency  in the

stock market and in connexion with the individual issue

is in fact essential if allocational efficiency is to

be achieved. Procedural efficiency also prepares the

ground for allocational efficiency by demanding

rational methods of prompt communication of business

and company announcements. Where a large number of alert

investment analysts and investors stand ready to

receive and interpret such announcements, one can count

on share prices that properly perform their function of

guiding funds to the optimum uses.

Procedural efficiency, expanded into allocational

efficiency, includes nearly all the criteria normally

used for assessing the quality of stock markets even

if not always to the full extent  (see diagram).

 It is worth briefly examining a few of these criteria and

requirements.

Diagram 1 

Allocational efficiency of secondary 

stock markets 

The greater the choice of securities, the more

attractive is a market to investors. Therefore the

breadth of a market, measured by the type and number

of issues traded on it, is rightly regarded as an

important criterion. On a procedurally efficient

market the costs of capital are as low as they can

be given the yield requirements of the investors.

Such a market is attractive to potential issuers and

will have breadth even where there is competition from

an efficient banking system. If procedural efficiency

is improved, this will, ceteris paribus, give scope

for reductions in the cost of capital and/or increases

in yields to investors. As a result, the market becomes

more attractive to both investors and issuers.

Another requirement if there is to be allocational

efficiency is that all issues should receive equal

tax treatment and that contracts and transfers should

not be taxed. Taxes on stock exchange purchases and

for sales and on the transfer of securities must be

judged in the same way as transaction costs. Ideally,

both should be zero; in the case of transaction costs

this cannot be achieved, but it can with the taxes

named.

What has been said about allocational efficiency and

in Section   above has already shown clearly that

competition is a significant determining factor in

procedural and allocational efficiency;

 thus, there is no need to treat it as an additional criterion.

Procedural efficiency also includes the protection

of investors. As explained in the previous section,

the costs of guarding against transaction risks and

custody risks are determining factors, in the form

of transaction or custody costs, of procedural

efficiency. The investor protection measures that

contribute to procedural efficiency are those that

reduce these costs or, more precisely, that reduce

the total of all market-organization-determined  costs 

. Investors may have no interest in

obtaining perfectionist protection measures that go

further than this as such measures are not economically

justified. Demands for investor protection that are

based on purely ethical or legal considerations may

therefore sometimes go further than those covered by

the economic criterion of procedural efficiency. The

dividing line between economically justified investor

protection measures and other investor protection

measures is often obscure, particularly  since the

imputed costs of guarding against transaction risks

are difficult to calculate and vary with the passing

of time. Some measures clearly fall into the second

group, however. In Germany, for example, a security

dealer who has accepted an order is allowed to

charge his commission even if he is taking or

supplying his client's securities for his own account.

As he has not taken the order to the market, it seems

unjust that he should charge a commission. For that

reason members of the Stock Exchange in the United

Kingdom, for example, are not allowed to charge a

commission in such cases. Moreover, in both cases

the price at which the dealer trades may not be less

favourable than the price obtainable on the stock

exchange.

 Let us suppose a client wishes to buy shares.

Assume that the commission is 2, that the share can

be sold on the market at 198 and bought at 200, the

latest price quoted was 199 and the dealer acting

is prepared to let the client have shares at 199.

In Germany the client must pay a gross 201, but in

Britain - under the ethically more acceptable rule -

he must pay 202, since his broker is better off

if he himself sells on the market for 198, buys for

the client at 200 and can charge 2 for commission;

on a sale to the client the broker would have

obtained only19 9(as opposed to 200 on executing

the order on the market and selling his own shares

in a separate transaction). Both the dealer and the

client come off better under the rules that are alleged

to be against the best interests of the investor.

Two further criteria which should be mentioned in this

connexion are confidence in the reliability of the

security-dealing  firms and confidence in the markets.

The less reliable the security dealers, the greater -

without any doubt - the cost of market supervision

and the imputed cost of guarding against transaction

risks.

 This criterion is therefore covered by the

criterion of procedural efficiency. Confidence in the

markets is also determined by procedural efficiency,

but it may in cases of doubt be adduced as an additional

criterion, for example when it is a matter of deciding

who shall have the deal where there has been

simultaneous acceptance of an offer by more than one

dealer: from the point of view of investor protection

it would be good enough to decide by throwing a coin,

but to give priority to investors would create more

confidence.

Marketability of securities, market depth or fluidity

or liquidity of the market are all terms used to

denote a criterion, that is very frequently mentioned.

This  is another criterion that is subsumed  within 

the criterion of procedural efficiency. What  is 

meant  is the possibility  of obtaining  an  instant 

bargain, whether large or small  in volume, at

acceptable  immediacy  costs  (see Annex 3). Market  depth 

makes  it easier to plan  investment, to execute  orders 

and to adjust prices promptly  in response  to new

information. Yet not all investors  are interested  in 

market depth, particularly  if it means that the cost

of immediacy is going to be arbitrarily high, as will

become increasingly plain as we  go on. Nor must  it 

necessarily  be market makers who offer the  opportunity 

for instant trading. As will emerge when the  individual 

markets are analysed, market makers  improve  procedural 

efficiency mainly  in securities with  a medium  volume 

of turnover.

Often the liquidity  of securities  is mentioned  as a

criterion.  It is measured by the ratio of the  lowest 

expected net sales proceeds to the value which  the 

investor regards as representative  for his  planning 

period. The smaller the difference between the  two 

values  - i. e. the smaller the possible  loss on

liquidation of the holding  in question  - the more

liquid  is the security  regarded  as being. In the very

short run this loss is determined primarily by  the 

four component elements of transaction  costs and by

comparable  taxes; the liquidity  criterion thus covers,

inter alia, the costs of immediacy  and hence the

market-depth  criterion.  In the longer run, however,

liquidity of securities may be influenced by  changes 

in all other market-organization-determined  costs  and 

thus embraces the whole of the procedural  efficiency 

criterion. Nevertheless, we shall not make use of

the criterion of liquidity of securities here, since

liquidity is in the longer run dependent also on

changes in market rates of interest, in the business

and financial situation of the issuer and in certain

circumstances on changes in taxation; in other words

it is also influenced by non-market-organization-

determined factors. In principle, such factors are

no help in explaining or evaluating integrated or

fragmented stock markets. Therefore procedural

efficiency, not the liquidity of securities is the

more appropriate criterion for this study. 

 the source by Dr.Hartmut Schmidt