Over the past few decades, there has been a notable increase in the number of new exchanges and capital markets being formed around the world. This is not entirely surprising; many developing markets consider the establishment of a stock market to be a strong signal of sophistication and development which, in turn, holds the potential for increased foreign investment and liquidity.
I’ve been at the forefront of a number of new market formations and, based on my experience, I believe there are five key steps that must be taken to ensure that new markets are successful, sustainable and well-functioning.
Developing economies must first start by thinking about what type of market to set up. Those economies driven primarily by commodities may, logically, want to focus on establishing a commodities exchange. Those seeking to increase capital inflows into the national economy will focus on creating liquid primary markets, while those with existing primary markets may, to enhance market liquidity, want to consider creating a derivatives market. The culture of an economy will also play a role where more centralized economies tend to take a longer-term strategic view of their markets.
Exchanges need to be strongly supported by the state, regulatory authorities and any supervisory bodies to achieve integrity. Proper incentive structures must be created for banks and brokerage firms to ensure a minimum level of order flow that supports continuous trading. Market maker functions must be assigned and spread restrictions set. However, creating these conditions can often be more difficult than first thought, particularly in countries with only a nascent understanding of complex trading environments.
When a liquid market is established, the trust of private individuals and issuers that the market will function grows exponentially. But to establish this trust, it is important that local parties enter the fray. Strong clearing parties – or, for commodities exchanges, a secure infrastructure of warehouses – may make it easier to establish trust in the markets. Trust is also created (or lost) by the setting of fees and spreads; participants must know they can make money without being gouged.
The integrity of the new market will be key to investors and participants at the formation of a new market and during ongoing operations. Good rule making is central to creating a transparent environment for trading, as is maintaining a rigorous process for ensuring that rules are maintained and controlled, and that market participants are properly screened. However, integrity also requires markets to provide a reliable and resilient IT platform on which to trade; a potential challenge for those markets dependent on less reliable infrastructure.
Sustaining the growth of a new market requires operators to have a keen sense of the potential risks facing the local, regional and global markets. A strong risk management strategy would cover a range of issues from outages or instances of insider trading through to reputational issues or increased competition from exchange-traded funds (ETFs) and cash markets. Throughout, managing relationships with key stakeholders – regulators and the media in particular – can have a positive influence on how challenges influence the market’s reputation.
One final tip to those considering setting up a new market: prepare for a long journey. Many markets have taken upwards of five years to develop properly (the development of the EOE option market in the Netherlands took at least this long), so plan your activities accordingly. The longer between the initial announcement of the market and the actual start up time, the more people’s interest and trust in the venture will wane.
I am greatly optimistic about the growth potential for new markets in emerging and developing economies. Indeed, many of the most exciting markets today – whether commodities markets in Malaysia, liquid primary markets in China or derivatives markets in South Africa – have emerged from countries once considered ‘developing’. I look forward to seeing what the next wave of market formations will bring.
KPMG member firms have actively supported the development and functioning of capital markets around the world. In the setup of new markets, we provide support in areas ranging from the development of a strategic roadmap and the implementation of a well-functioning, liquid market to matters such as governance, compliance frameworks and the IT and operations infrastructure that are required to maintain a sound and reliable exchange.
The global exchanges article series looks at key issues in the stock exchange space from the perspective of executives at stock exchanges.