Creating Capital Markets in Central and Eastern Europe

WORLD BANK TECHNICAL PAPER NUMBER 295 A. i'V'O

Creating Capital Markets in Central andEastern Europe

Gerhard Pohl, Gregory T. Jedrzejczak,and Robert E. Anderson

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WORLD BANK TECHNICAL PAPER NUMBER 295

Creating Capital Markets in Central andEastern Europe

Gerhard Pohl, Gregory T. Jedrzejczak,and Robert E. Anderson

The World BankWashington, D.C.

Copyright ©) 1995The International Bank for Reconstructionand Development/THE WORLD BANK

1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing August 1995

Technical Papers are published to communicate the results of the Bank's work to the development com-munity with the least possible delay. The typescript of this paper therefore has not been prepared in accor-dance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibili-ty for errors. Some sources cited in this paper may be informal documents that are not readily available.

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ISSN: 0253-7494

All of the authors are with the World Bank. Gerhard Pohl is Chief of the Private Sector and FinanceTeam in the Europe and Central Asia/Middle East and North Africa Technical Department. Gregory T.Jedrzejczak and Robert E. Anderson are both Senior Private Sector Development Specialists on thatteam.

Library of Congress Cataloging-in-Publication Data

Pohl, Gerhard.Creating capital markets in Central and Eastern Europe / Gerhard

Pohl, Gregory T. Jedrzejczak, Robert E. Anderson.p. cm. - (World Bank technical paper, ISSN 0253-7494; no.

295)Includes bibliographical references (p. ).ISBN 0-8213-3370-41. Capital market-Europe, Eastern. 2. Capital market-Government

policy-Europe, Eastern. I. Jedrzejczak, Grzegorz. II. Anderson,Robert E. (Robert Edward), 1944- . Ill. Title. IV. Series.HG5430.7.A3P625 1995332'.0414'0947-dc20 95-32644

CIP

Contents

Foreword v

Acknowledgments vi

Sunmary vii

Introduction I

The Role of Capital Markets 3The joint-stock company as a transition device 4Western models 5Efficient financial systems 6Financial systems and corporate governance 6Control or arm's-length finance 7

Securities Trading Systems 8Order handling 9Market consolidation and competition 9Role of speculation 10Quote or order-driven markets 11Auction frequency 11Transparency 12Market stabilization 13

Clearing and Settlement 14Counterparty risk 14Alternative systems 15Legal form of securities 15Payment systems 15

Perspectives of Market Participants 16Investment funds 16Foreign investors 17A trade cycle: an investor's perspective 18

Regulation of Capital Markets 20Institutions 20Regulatory models 20Company law 21Securities law 22Self-regulatory organizations 22

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE iii

Investrnent find regulation 23Impact of the tax system 24Regulatory challenges 25Costs of regulation 25Regulatory priorities 25

Country Studies 27Czech Republic 27Poland 2 8Russia 29

References 3 1

iv

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

Foreword

Some of the countries of Central and East- nomies of the region. Is the role merely toern Europe have made remarkable progress provide a convenient and low cost marketin privatizing their enterprises by transfer- for buying and selling shares? Alternatively,ring ownership from the state to private cit- will capital markets be a source of badlyizens. This has created millions of new needed new equity capital to help with theshareholders. It is estimated that more citi- restructuring of enterprises in the region?zens now own shares of enterprises in Rus- Will capital markets encourage managers ofsia than in the United States and Great enterprises to undertake the neededBritain combined. restructuring and discipline them if they do

This initial distribution of share owner- not, for example, through low share pricesship will change over time as millions of cit- or hostile takeovers?izens and financial institutions buy and sell The second question is how and to whatshares. The countries of Central and East- extent the governments in the regionern Europe need to develop the stock should encourage the development of capi-markets and related institutions such as bro- tal markets. A laissez faire approach wouldkerages, clearing and settlement organiza- be to let the market participants develop fortions, and regulatory agencies to handle the themselves the best institutions andlarge volume of share trading that is likely arrangements for trading shares. Stockto occur after privatization. In the not too exchanges will arise spontaneously as thedistant future, it is likely that the stock mar- need for them arises. A more activekets of Moscow, Prague, Poland, Budapest, approach would be for governments toand Kiev will become as important in their sponsor the creation of stock exchanges andeconomies as those of New York, London, establish the overall legal and regulatoryParis, Frankfurt, or Tokyo. framework. It is hoped that this paper can

This study attempts to answer two basic help governments in the region adoptquestions. The first question is the role of sound policies for the development of cap-capital markets in the new market eco- ital markets.

Anil SoodDirector

Technical DepartmentEurope and Central Asia

Middle East and North Africa Regions

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE V

Acknowledgments

The authors are World Bank staff in the tion practitioners from the region to sharePrivate Sector and Finance Team, Techni- ideas, experience, and technical know-how.cal Department for the Europe and Central Where appropriate, references are madeAsia and the Middle East and North Africa to papers presented at the conference. Theregions. This paper draws heavily on pre- views expressed here, however, are those ofsentations made at a conference titled "Cre- the authors and should not be considered aating Capital Markets in Central and consensus view of the participants orEastern Europe," held November 17-19, sponsors of the conference. The authors1994, in Prague, Czech Republic. The con- thank Claudia Morgenstern (Internationalference was sponsored by the World Bank Finance Corporation) and Robert Pardyand the Central and Eastern European and Paul J. Siegelbaum (World Bank) forPrivatization Network (CEEPN). The their helpful comments and suggestions.CEEPN was founded in 1991 by privatiza-

vi CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

Summary

With the privatization of so many state adopting a diversified financial system inenterprises in the countries of Central and which different institutions and marketEastern Europe, policymakers are asking practices compete. Due to limited availabil-themselves how and to what extent govern- ity of financial inforrnation and uncertaintyments should promote the development of about the success of companies, markets areformal capital markets. At this stage, that likely to be dominated by large financialessentially means markets for shares of institutions that have better access tocompanies. As in the case of mature stock information.markets, governments should put in place Stock marketstrncture. Traders should notthe necessary legal and regulatory frame- be required to use a single exchange, butworks to ensure fair, efficient, and transpar- multiple markets should not be encouraged.ent trading. The details (floor or electronic Government-imposed trading in a singletrading, single or multiple exchanges, and market may result in monopoly and ineffi-so on) will vary from country to country. ciency. The trading system best suited toExperience elsewhere and in the region, countries of the region is the call market-however, suggests that some issues are com- that is, buy and sell orders are accumulatedmon to all countries and that some obser- over a period and executed simultaneouslyvations can be made. when a market clearing price is established.

Sharebolder protection. There must be With the necessary safeguards, dual-func-clear and simple legal rules about creating tion broker-dealers should be allowed; suchand running joint-stock and public limited- speculators bring price stability to stockliability companies. These regulations markets. All trading should be transparent,should be embodied in new company law or with fast reporting of the size and price ofin a revised commercial code. Both pre- trades.suppose that other legislation is in place- Voucher funds. In countries with vouchercovering property rights, contracts, privatization programs, investment fundsbankruptcy, and so on. can play a major role in capital market

Wbich type offinancialsystem? Bank-based development and in the supervision andor market-based? In bank-based systems control of enterprises. Funds should bebanks are both lenders to and big share- encouraged to use their voting power toholders in corporations. Such exposure pro- improve management and to bring pressurevides the banks with board representation on enterprises to restructure. Fund man-and allows them to play a strong role in cor- agers and sponsors should be banned fromporate governance. In market-based finan- dealing in the shares of enterprises in whichcial systems shares are widely held by the the fund has a stake. Moreover, fundspublic either directly or indirectly through should not be allowed to corner the sharesmutual funds, pension funds, and insurance in any industry or market.companies. Corporate governance is exer- Regulation. Because many countries incised by selling shares in poorly performing Central and Eastern Europe aspire to joincompanies. Countries in the region, how- the European Union, they might considerever, can have the best of both worlds by adopting similar or compatible regulatory

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE Vii

regimes. These regulations would cover bodies similar to those set up under themany areas, including accounting and U.K. Financial Services Act.auditing standards, capital adequacy Enforcement. Governments must pursuerequirements for banks (and restrictions on and prosecute with vigor all fraud, theft,insider lending), regulations on investment insider trading, and other criminal acts byfunds, and enabling statutes on securities market participants.market intermediaries and self-regulatory

Viii CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

Introduction

Many enterprises in the countries of Cen- price. In a public companv the shares can betral and Eastern Europe have been trans- sold to the public, including small investors. Capital markets inferred to private ownership-ofteni as In a private or closely held company the some transitionjoint-stock companies whose shares can be shares may be sold only by one largebought and sold. An important postprivati- investor to another, and shares are rarely economies arezation issue for these countries is what the traded in organized markets. already larger thanrole of government should be in developing Successful mass privatization has created those in manycapital markets where these shares can be market capitalization in some countriestraded fairly and efficiently. that, relative to the size of their economies, Western countres

These markets include organized stock approaches or exceeds that in many indus- relative to the sizeexchanges and associated institutionis such trial countries (figure 1). Countries that of their econonziesas depositories and clearinghouses, over- have not used mass privatization typicallythe-counter markets, and informal markets. have a small market capitalization becauseParticipants include financial services fewer companies have been privatized.providers (such as brokers, dealers, banks, Measuring market capitalization is diffi-pension funds, and mutual funds), as well as cult in countries that have used mass priva-individual investors. tization, such as the Czech Republic and

We use the term capital market here to Russia, because shares of many companiesrefer to markets for shares (equities) of are not traded, are traded infrequently, orjoint-stock companies and do not deal with are traded outside organized markets.markets for other securities, such as bonds, Moreover, some companiies may still beoptions, or futures. Equities ire more partially owned by the state, and thus maniyirnportant than other types of securities at shares are not available for trade. And thesethis stage of capital market development in measures of market capitalization maythe region. By issuing shares, a company overemphasize the importance of capitalraises capital for modernization and expan- markets since shares are rarely traded.sion and gives new shareholders ownership Many think of organized stockrights to monitor and control the manage- exchanges as the principal market for trad-ment of the company, for example, by elect- ing shares, but exchanges are just one typeing the board of directors. In other words, of market. Trading that occurs outside anthe shareholders play the dominant role in organized exchange is sometimes calledcorporate governance. "off-market.' Tqhis term is misleading since

Market capitalization is the market value any trade ofshares occurs in a market ofoneof all shares in publicly traded companies-- form or another.in other words, the number of shares issued In organized or formal capital markets,by the company times the current market traders regularly meet in person or over a

In English, the term "capital" has come to mean all sources of finiance for enterprises. including bank loans, cor-porate debt, and suppliers credits. "Capital market" has become synonymous with the tern "finiancial market.' Inthis paper we use "capital" in its more traditional meaning-the resources that a -c.apitalist" contributes to oper-ate his or her business. In English, the terimis "equity" and "shares" are now used instead of this narrow meanfingof "capital." "Capital" still has this narrow Tiieaning in most European language-, however, and probably will bemore familiar to Central and Eastern European rcadcrs than "eqluity."

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

communications network to buy and sell ularly small, unsophisticated investors.shares according to the established rules of Lacking efficient fornal markets, share-that market. Such markets include stock holders have no choice but to trade onexchanges with a trading floor and over- informal markets.the-counter markets where traders deal Thus the central policy question iswith each other over telephones and com- whether and how the governments in theputer networks. transition economies should promote the

Informal markets cover all other markets development of formal capital markets towhere buyers meet sellers and arrange trade the shares of newly privatized enter-transactions. These markets might include prises. Several issues must be considered:individuals buying and selling on street cor- * What is the role of capital markets inners, selling through advertisements in allowing firms to raise needed capital for

Formal, organized newspapers or on bulletin boards, brokers restructuring through the sale of new

capital markets are standing outside factory gates offering to shares?likely to better serve buy shares distributed to workers in mass * Will capital markets encourage man-

privatization programs, or institutional agers to restructure and to increase prof-the public investors such as funds buying and selling itability? In other words, what is the role of

large blocks of shares over the telephone. these markets in corporate governance?These markets may trade many more shares * Should development of capital marketthan formal markets, especially in the early infrastructure and institutions occur earlystages of capital market development. in the transition so that a well-functioning

One weakness of these informal markets market can facilitate privatization, oris their lack of transparency. It is difficult to should this wait until after privatization?know the prices at which shares are being . What are the minimum legal rights oftraded because there is no formal reporting shareholders to receive profits earned bymechanism. This can lead to an inefficient the company and to control management?market where the same shares trade at dif- How should these rights be defined in com-ferent prices depending on the region of the pany law, and how can they be enforced?country, the size and sophistication of the * Should the government sponsor ortrader, the trader's access to inside informa- own exchanges, share registries, deposito-tion, and so on. ries, and clearing and settlement institu-

A second weakness is that these markets tions?are usually unregulated, and so there is S What is the best trading system to begreater scope for cheating investors, partic- used in an organized market? Should dif-

ferent systems be used depending on the

Figure i. Ratio of market capitalization to gross domestic product, 1993 type of trading?(percent) * Should trading be concentrated in a

single exchange, or should competing0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 snl xhne rsol optn

United Kingdom 0 exchanges be allowed or encouraged?United States Should trading be allowed outside officially

Japan recognized exchanges?Czech Republic _ SECOND WAVE ' Should the government or exchanges

Russia OTHERS attempt to stabilize prices of shares, and if

Slovakia 25 LARGEST so, how?Estonia i How can the government ensure that

Mongolia an efficient system is in place for transfer-Poland ring shares from seller to buyer and for

Hungary transferring payment from buyer to seller?Slovenia * How should the government regulateLithuania capital markets to improve their efficient

Note: Czech second wave capitalization extrapolated from first wave. Total Russian capitalization operation and reduce fraud? What model ofextrapolated from twenty-five largest traded companies, regulation is best suited to the transitionSource: Athors' estimates from data supplied by country officials and IFC 1994. econonmies?

2 CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

The Role of Capital Markets

The countries of Central and Eastern even in some industrial countries, such asEurope are moving rapidly to privatize state Germany orJapan, and will probably not be Creation of capitalenterprises and to remove government con- important in Central and Eastern Europe markets should nottrols over industry and commerce. Seventy for some time. Government securities,years of socialism have yielded overwhelm- including bonds, notes, and bills, however, take precendenceing proof of Adam Smith's views that mar- will grow in importance as governments over other, moreket forces are more efficient in solving most find better ways to finance their deficits. fundamentalproduction and distribution problems than Many new exchanges in the region trade market reformslarge organizations and administrative long-term government securities.controls. Capital markets include not only the

Large finns survive in market economies infrastructure to buy and sell securities (theonly where technological or other scale stock exchange, electronic trading system,economies outweigh the monitoring and or coffee house, as the case may be), butcontrol (principal-agent) problems inherent they also include the applicable rules (for-in managing large organizations through mal and informal) and the market partici-administrative controls. Transition econo- pants that buy, sell, or own suchmies have inherited large firms and organi- instruments and advise on corporate con-zations in almost every line of economic trol transactions (spinoffs, takeovers, man-activity. agement buyouts, mergers, acquisitions,

Privatization of existing state enterprises and so on).is only a first step in the restructuring of Most capital market activity in Centraltransition economies. If market reforms are and Eastern Europe is secondary marketto be successful, the privatized enterprises transactions-that is, transfers of owner-must be profoundly transformed. For ship of existing shares. Primary marketexample, they must stop producing unprof- activity-the mobilization of investmentitable products; adopt better design, pro- finance through the sale of new shares orduction, and marketing techniques; spin off other securities-is likely to remain com-nonessential activities into separate firms; paratively small.and invest in new products and production While the opening of stock exchangesfacilities. The current universe of a few has attracted much attention, these effortsthousand firms eventually will be replaced were largely symbolic. The most importantby a more diversified set of a few hundred steps toward creating capital markets liethousand firms. This cannot be done at elsewhere. These include:once, and restructuring will be a continuing * Adoption of a legal infrastructure forprocess. Capital markets-markets for private sector activity, including a companyownership and control rights over firmns and law that sets out standard contractualassets-will play an vital role in this restruc- arrangements for limited-liability compa-turing. nies owned by many small investors.

Banks loans are likely to continue to be * Incorporation of state enterprises asthe most important source of debt financ- joint-stock companies.ing for enterprises. Corporate bonds are 0 Transfer of ownership to private indi-not a major source of capital for enterprises viduals.

CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE 3

The joint-stock company as a transition device institutions than in most other lines of eco-nomic activity. Directives of the European

The most important step is the removal of Union covering banking, mutual funds, andgovernment from commercial activities, investment services provide a useful guidethat is, the transfer of all state enterprises to to the minimum requirements that shouldprivate owners. Since most state enterprises be embodied in national legislation.are large, joint-stock corporations or public If company laws are clear and reasonablelimited-liability companies owned by many and if other necessary economic laws are inindividual shareholdcrs, they remain the place, restructuring can (and will) start. Butmost promising vehicles for fostering rapid this assumes that state enterprises have beenrestructuring of Central and Eastern Euro- transferred to the private sector and havepean economies. been cut off from government subsidies and

A good company While sales of a few firms to foreign- intervention. To ensure that hard budget

law should ensure investors may be feasible, more govern- constraints are imposed on privatizedthat managers act ments are realizing that a mass privatization enterprises, privatization should include

that managers act program. in which shares of enterprises are banks and other financial institutions earlyin the best interest transferred to the public for little or no pay- on.of sbareholders ment (for example, using vouchers), is the If company law is well designed,

most practical solution. investors can ensure that managers act inRcstricturing can be accelerated by their interest and will be disciplined if they

puttinig in place an appropriate capital mar- deviate too far from the objective of maxi-ket infrastructure that includes clear and mizing profits and thus shareholder wealth.simple legal rules about the creation and Monitoring of management can bemanagement of widely ownecl, joint-stock enhanced by promoting core investors (forcorporations (or public limited-liability example, voucher investment funds), bycompanies). These rules are normally making appropriate provisions for the rep-embodied in company law, but they pre- resentation of voting rights of small share-suppose that other elements of private eco- holders (proxies), and by forcing managersnomic law are in place, notably those to return periodically to lenders or to thegoverning property rights, contracts, capital market by providing them only withpledges (sectirity), and bankruptcy. short- or medium-term debt financing and

These laws may already exist in some requiring them to pay out profits as divi-Central and Eastern European countries in dends.old civil and commercial codes, but they Managers face other disciplines. Mostrequire exrensive revision. In other coun- important is competition in product mar-tries a new civil and commercial code, based kets. Where corporate governance is lax oron Western models, may be the simplest inefficient, product market competitionsolution. The conmiercial code should may force inefficient firms to shrink or exit,include rules about the creation and func- making room for more-efficient competi-tioning of at least three different types of tors. Low import barriers and stiff foreignfirms-partnerships, private limited-liabil- competition may bring even more pressureity companies, and pul)lic limited-liability to bear and stimulate higher efficiencycompanies. gains than domestic capital markets and

Dcpending on the extent of rules pro- good corporate governance. An essentialvided in these company laws, separate secu- complementary factor is the absence ofrities regulation may not be required. But government intervention and subsidies.tighter regulations than) those provided for Despite slow progress with privatization inpublic limited-liability companies are many Central and Eastern European coun-needed for banks and other financial service tries, some loss-making enterprises haveproviders (brokers, mutual funds, and so already begun significant restructuring byon), since there is more opportunity for reducing their work force once subsidiesfraud and impruldenit behavior in financial and bank lending have been curtailed.


Western models same functions-collecting informationabout investment opportunities, monitor-

Financial systems are classified as banking performance, and taking action on thisbased or market-based. Japan, Germany, information. WVhile capital markets areand most of Western Europe have bank- important, their role often is misunder-based systems, while the United States and stood.the United Kingdom have market-based Some of the most important but leastsystems. The main characteristics and com- understood features of financial systems inparative performance of these systems are market economies are:discussed in Walter (1993). * Retained profits are the dominant source

In bank-based financial systems banks are of enterprise finance in all market economies,both lenders to and shareholders in large accounting for 70 to 100 percent of net cor-joint-stock corporations. With substantial porate finance (investment funding, net of Countries are saidequity and debt exposure, banks act as accumulation of financial assets). Internal to have a bank-strong monitors. They have representation financing tends to be higher in the market-on boards of directors (and thus access to based systems (the lJnited States and thc based or a market-nonpublic information). Financial markets United Kingdom; table l). based financialtend to be smaller and less liquid, and trans- * Banks are the dominantsouzrce oJ erternal ys-temactions less transparent (at least to out- finance in all couintries. Over the past twentysiders). Bank control over corporations years, bank financing has been even higherneed not be based on shareholding alone. in the United Kingdom and the UnitedWV'here banks can engage in brokerage, States than in "bank-based" Germany. Onlytrust, or mutual fund business, they can Japan can still be characterized as a bank-exercise control by exercising voting rights based financial system.on behalf of small investors. Alternatively, * Veiy little netfinance is raised from seca-banks might write restrictive loan contracts rities mzarkets. In the United Kingdom andor lend only short term to retain influence the United States net equity issues haveover management decisions. been negative, as leveraged takeovers and

In market-based financial systems shares management buyouts have replaced sharesare held by the public either directly or with bank and corporate debt.through institutional investment vehicles, * Large firms rely increasingly on retainedsuch as mutual funds. Shares are actively earnings. Large firms often become finan-traded and corporate governance is exer- cial institutions in their own right. Smallercised by investors selling shares in poorly companies "go public" to raise risk capitalperforming companies. Poorly managed in equities markets, but larger firms arefirms may eventually become the target of a increasing financial leverage to lowerhostile takeover. One precondition for this financing costs (and strengthen manage-arrangement to be workable is extensive ment incentives).disclosure of reliable financial information. * This broad pattern also holds true for theHostile takeovers and leveraged buyouts emerging mark-et economiies of Asia and Latinare commonplace only in the United King-dom and the United States. Such takeovers Table 1. Sources of net corporate financing,reflect the absenice of insider controls on 1970-89(percent of net investment financing, excluding ac-management (for example, by large corpo- cumulation in financial assets)rate or financial stakeholders). In the United UnitedUnited States corporate control by financial Germany lapan Kingdom Statesinstitutions is severely restricted, not only internal 8a 69 97 91for banks but also for mutual funds and Bank 11 31 20 16insurance companies. Bonds -1 5 4 17

Shares 1 4 -10 -9Still, the differences between bank- and Trade credit -2 -8 -1 -4

market-based financial systems should not Other 10 o -8 -13be exaggerated. Both systems fulfill the Source: Corbett and lenkinson 1994.


America. The recent wave of utility privati- Europe is their failure to stop the financingzation in these countries, however, has of losers, thereby reducing financing forbriefly raised securities issuance. This has potentially successful firms.significantly increased stock market capital-ization, but reflects primarily a shift in own- Financial systems and corporate governanceership, rather than additional investmentfinance. A country's corporate governance system is

* Cross-border portfolio investments bave determined not only by company and secu-become a major source of external finance for rities laws but also by the subtle interplayemerging market economies. Foreign portfolio between different parts of econornic legis-investors hold as much as 20 percent of all lation. Small differences in legal systemsshares in Malaysia, Mexico, and Thailand. can lead to large differences in control tech-

Initial offerings of While portfolio inflows are still small in niques, financial patterns, and the institu-securities are Central and Eastern Europe, they may tional structure of the financial system. In

become a major issue in the future. If port- the United States, for example, securitiesunlikely to be a folio investors are to be welcomed, com- markets play a big role in the financial sys-

major source of pany law and securities markets regulations tem, and nonfinancial corporations are the

new capital should be closely aligned with those of main monitors of management (FrankelWestern market economies. and Montgomery 1991). In Japan and Ger-

many, however, banks are the principalE]frientfinancial systemts monitors and wield considerable influence

over management appointments, particu-The main aim of a financial system is to larly for firms in distress (Charkham 1994).allocate financial resources to the best uses. The exclusive reliance on market disci-This is easier said than done, particularly in pline in the United States is not a naturalthe countries of Central and Eastern outcome. It is heavily influenced by restric-Europe because of the limited information tive banking laws that have prevented banksabout enterprises available to investors, and from owning nonfinancial corporations andlenders' lack of skills and experience. There from nationwide branching, brokerage, andare thousands, if not millions, of firms and underwriting of securities. Insurance com-investment opportunities in any economy panies and mutual funds also face severeat any time. Investors and lenders must restrictions on ownership stakes and activeredirect new capital away from 'losers" governance in corporations. Since manage-toward "winners" who have the greatest ment also controls the proxy voting processchance of success. In this regard, the biggest (and nominations to the board of directors),problem in the countries of the region is the this leaves only stock market "exit' by indi-lack of speed and vigor in dealing with the vidual investors as a corporate controllosers. Too much capital is still provided to mechanism. Once market discounts arefirms that have little chance of success. This large enough, other corporations (or extra-capital often takes the form of bank loans ordinarily rich individuals) are attracted toprovided under government direction or launch hostile takeover bids to replace man-pressure. agement.

Even firms that could be winners fail to There is lively debate among the devel-maximize their cash flow by cutting costs. In oped market economies about which sys-Western countries winners usually finance tem is more appropriate (Walter 1993).themselves more from internally generated Proponents of bank-based systems arguecash flow than from bank or market financ- that banks have better access to informationing (see table 1). Better information enables and can react more quickly to managerialfinancial institutions and markets to move shortcomings. Supporters of stock market-resources more quickly from poorly to well- based systems argue that these systems pro-managed companies and thus to speed eco- vide more financing to entrepreneurialnomic growth. The greatest weakness of firms and that bank-based systems are toothe financial systems in Central and Eastern conservative. They also point out the


potential risks to the banking system if financing. Unsatisfactory performance canbanks become large owners of risky enter- only be sanctioned by selling shares. If bankprises, as well as the conflicts of interest lending is concentrated but share owner-between the role of banks as lenders to and ship dispersed, control may be exercised byowners of an enterprise. For example, there lenders while investors merely watch.are concerns in the Czech and Slovak Small differences in legal doctrines ofRepublics about banks controlling the large fairness may permit lenders to exercise con-voucher funds that in turn are major share- trol over firms in distress. Anglo-Americanholders of enterprises and banks. In Russia legal views are quite different from civil-lawthere is concern about "circular owner- countries in this regard. Such small differ-ship," in which enterprises own the banks ences in legal doctrine can lead to differentand the banks own the enterprises. financial market practices and structure (see

Empirical work has been unable to reject the discussion of "equitable subordination" Transitionthe hypothesis that banks are better corpo- in bankruptcy in Frankel and Montgomery economies shouldrate monitors than financial markets or that 1991).the existence of universal banks has a posi- Where are Central and Eastern Euro- incorporate the besttive impact on economic growth (Steinherr pean countries heading? Probably toward of both market-and Huveneers 1992). But the differences control-oriented finance, using contractual based and bank-between the two systems are small, and arrangements similar to those used by ven- based ofmany other factors (for example, educa- ture capital investors in the West. Suchtional systems) may be at work. investors will provide both capital and man- corporate

The choice is perhaps academic. It is agerial expertise but will insist on monitor- goverancepossible to have the best of both worlds by ing and, if necessary, controlling the gadopting a diversified financial system in management to protect their investment.which different types of institutions and As long as information is unreliable andmarket practices can compete. Put another disclosure limited, arms-length finance canway, there is no reason why banks should be work only when reliable and enforceablerestrained from participating in financial performance guarantees can be given. Liq-markets and corporate monitoring if they uid stock and corporate bond markets,are subject to appropriate prudential stan- widely dispersed ownership, and marketsdards (such as portfolio diversification, liq- for corporate control are thus unlikely touidity, and fiduciary rules). If banks, mutual develop soon.funds, or other financial institutions fail to A case in point is the Czech Republic.do a good job at corporate monitoring and Many early observers regarded widely dis-control, there is still the possibility of a persed ownership as the weak point of masstakeover by another (nonfinancial) corpo- privatization. The outcome showed theration, assuming that shareholders can be opposite. Nowhere else in the world (exceptconvinced of its merits. Few takeovers have perhaps in Japan) are core investors asoccurred in bank-based financial systems. prominent as is the Czech Republic, where

a dozen investment funds manage almostControl or arm'sr-length finance one-half of all shares on behalf of individual

investors.It is perhaps more useful to distinguish Control-oriented finance is more similarbetween "control-oriented" and "arm's- to the structures and instruments used inlength" financial practices than between the past. It is also easier to carry out becausebank- and market-based financial systems. it requires less development of related insti-If firms have core investors with significant tutions and skills such as brokers, organizedstakes (or proxy votes), management will be exchanges, auditors, lawyers, and financialunder more scrutiny. If share ownership is specialists. Large investors deal directlywidely dispersed, however, and solicitation with the managers of an enterprise, provideof proxy votes is controlled by manage- experts to evaluate the company, and canment, shareholder influence is small and trade with each other without benefit of annot much different from arm's-length bank organized exchange.


Securities Trading Systems

A trading system is simply a mechanism by tions, commissions and market access wereStock exchanges which buyers and sellers are brought deregulated, computerized trading systems

around the world together and agree on prices so that a trade were introduced, and transaction cost,have adopted many in securities can take place. Securities mar- including taxes, were lowered.

kets are not unique in this regard since At the same time, the (then) Europeandifferent trading trading systems must exist for all services Community (EC) allowed greater freedomsystems and commodities in a market economy. for investors to trade on any exchange in the

Trading systems for securities can range EC. Exchanges in other European coun-from small investors trading on street cor- tries began to lose customers to the moreners to national stock exchanges using the efficient and cheaper London exchange,latest in computer technology. leading them to deregulate their markets

Organized stock exchanges tend to be and to improve their trading systems. Sincethe best type of market for small to many countries in Central and Easternmediumii-size trades of shares in large corn- Europe want eventually to join the (now)panies. Investors wishing to buy and sell European Union, EU trading systems andbigger block-s of shares, however, tend to regulatory regimes are useful examples fortrade directly with each other in informal them to follow.markets. In many countries (for example, Cohen and others (1986) discuss tradingthe Czech and Slovak Republics and Rus- practices before the Big Bang. Pagano andsia), most trading is done outside organiized Roell (1990) and H-luang and Stoll (1992)markets. Such trading will only move to an discuss trading practices in markets aroundorganized market if it offers a better service. the world. An easy-to-read description ofMature market economies offer a variety of the issues facing the U.S. capital marketstrading systems or markets. can be found in U.S. OTA (1990).

In establishing an organized market an Securities tradingis changingrapidlydueimportant issue is the structure of the to improvements in communications andtrading system or systems. The number of computer technology. Private exchanges-trading systems has increased due to dereg- not the government-should choose theulation, increase(d competition, and new most appropriate trading system. Officials,telecommunications and computer tech- however, must understand trading systemsnology. '[he first major deregulation to be able to exercise proper oversight andoccurred in the U.S. securities market in to create suitable regulation. Government1974. Then in 1986 came the "Big Bang" regulation also may influence the economicderegulation of the London securities mar- attractiveness and feasibility of differentket, which had a huge impact throughout trading systems.Europe. Before the Big Bang the London Trading systems can differ according to:Stock Exchange had relied on a privileged * Mlarket consolidation-a single stockgroup of market makers (called jobbers) to exchange versus a number of competingensure a smoothly functioning and stable stock exchanges and over-the-counter mar-market. After the Big Bang the exchange in kets.London-and eventually in most of Europe Auction timing-continuous markets-was opened to other financial institu- versus batched (or call) markets.


* Functions of intermediaries-brokers * Duration. Limit orders usually have aversus dealers and market makers. fixed duration after which they expire.

* Entry restrictions-prohibiting banks Orders remain active until they are exe-or other financial institutions from engag- cuted, withdrawn, or expire.ing in direct market-making. * Volume. Trading systems often deal

* Transfer of securities-physical move- separately with small and large (block)ment of securities versus dematerialized orders.systems.

* Payment for securities-cash, check, or Market consolidation and competitionbank wire transfer.

Besides simply matching buyers with Securities often are traded in several mar-sellers, a well-functioning securities trading kets, and many countries have more thansystem provides four services to market par- one exchange. Transactions also can be con-ticipants: ducted off-market when a buyer and a seller

* Price discovery. Trading systems estab- trade directly or when buy and sell orderslish market prices that balance supply and are matched by a broker.demand for securities. Rapid dissemination Policymakers face some key decisions inof prices enhances transparency. determining the best kind of stock market

* Market stabilization. A large volume of structure (table 2). In the past twenty yearstrading (liquidity) and participation of there has been much debate concerning themany well-informed and well-capitalized benefits and drawbacks of consoLidating alldealers who are willing to engage in short- trades in a single exchange. Some expertsterm speculation leads to more predictable point out that, just as competition is bene-and stable prices. ficial in other markets, the competitive

* Market surveillance. Securities trading effects of multiple exchanges will lower thesystems can be used to monitor trades and costs of trading securities. Others point outto protect market participants from fraud that multiple exchanges have a detrimentaland manipulation. effect on market quality, volume of trade,

* Quality certification. Through mem- and price stability faced by individualbership and listing requirements, securities traders.trading systems can ensure minimum stan-dards of competence and integrity of mar-ket intermediaries (members) and of Tabte 2. Options and recommendations for stock market structuresecurities traded. Recom-

mendation Option Comment

Order bandling Fragmentation Traders should not be required to use av Integration single exchange, but multiple

Buy and sell orders to be executed on a secu- exchanges should be integrated to theextent possible to create a singlerities trading system can differ depending market.

on several factors, including: Single function brokers and dealers Broker-dealers are needed to ensure the* Price instructions. Orders are usually Sv Dual function broker-dealers. presence of speculative traders but

either limit orders or market orders. A limit create conflicts of interest.

order gives a miaximumn price for a buv order Dealer (quote-driven) market Unofficial speculators and dealersand a minimum acceptable price for a sell V Auction (order-driven) market should be allowed to participateorder. Market orders are executed at the in auctions to increase stability.best price offered by the market. V Discreet trading (call market) A call market is best until order flow

* Role of agent. Brokers simply act as Continuous trading increases to a level adequate forintermediaries, matching sell and buy continuous tradingorders at predefined prices and volumes. Opaque system (slow or no reporting) Transparency is increased in order-Dealers buy and sell securities for their own v Transparent system (fast reporting) driven markets. An issue is reporting

, , ~~~~~~~~~~~~~~~~~~~~~~~oF off-market transactions.account and may buy or sell at announcedprices to any investor who wishes to accept Source: Based on the presentation by Marco Pagano at the November 1994 Prague workshop on 'Creating

Capital Markets in Central and Eastern Europe' sponsored by the Central and Eastern Europe Privatizationtheir offer. Network and the World Bank.


It is probably true that trading is more medium term, and result in similar pricesefficient and costs are lower if all buyers and for similar securities. The process of deter-sellers of a security are brought together in mining a market equilibrium price-thea single market. Trading of shares in a price discovery mechanism-is perhaps theparticular company may naturally consoli- most important but least understood func-date at a single exchange, resulting in a tion of securities trading systems. Price dis-more efficient market. But if this exchange covery depends on the design of a tradinghas high costs and poor service, traders system, including the extent of market con-should have the option of buying and sell- solidation, participation of intermediariesing through a competing exchange or off- acting as market makers, role of quotationsmarket. and orders, dissemination of information,

Some regulatory authorities or ex- costs of operation, and market growth rate.Forced changes have attempted to force consolida- Investors and traders can be divided into

consolidation of tion of trading in a single exchange. This two categories, though no investor is neces-has been done by forbidding cross-listing, sarily always one or the other. Long-term

trading may result by restricting in-house matching by bro- investors buy shares for price appreciation

in an inefficient kers, by requiring notification of the official and dividends and expect to hold the shares

monopoly exchange about off-exchange transactions for some time. Short-term investors, or(put-throughs), and by establishing a cen- speculators, buy and sell based on theirtralized depository of securities. expectation of a significant change in price

The efficiencies of consolidated trading over the near term and plan to hold themay be enjoyed even if more than one shares only for short periods. Speculatorsexchange exists. Each exchange can special- also are called dealers, jobbers, or special-ize in the shares of certain companies. For ists. We will use the term "market maker" ifexample, one exchange may specialize in the participant has an official role in thelarge companies, using a trading system exchange and "dealer" if the role is unoffi-most suitable for shares with heavy trading. cial.Another could specialize in small companies Market makers and dealers play a keyusing a trading system suitable for lightly role in price discovery and stabilization.traded shares. In Germany, steel and mining They actively buy and sell securities forstocks were traded mainly on the Dussel- their own account in response to expecteddorf exchange, while automobile and for- short-run fluctuations in the price of secu-eign stocks traded on the Frankfurt rities or changes in supply and demand.exchange. Systems also have been devel- Brokers buy or sell only on behalf of theoped to link different exchanges trading in ultimate investor. Broker-dealers do both.the same shares, thus producing a single Some exchanges have official marketnational market. makers. The role of market makers is to ini-

Russia is an interesting example in this tiate and drive the process of proposingregard. Because of its size, poor communi- equilibrium prices within a bid and offercations, and local or regional ownership of spread and to react to the response to thesemany companies, multiple regional prices. Market makers on the New Yorkexchanges will exist for some time. The Stock Exchange (called specialists) areissue is how these regional exchanges can be responsible for keeping trade of assignedintegrated over time to create a national securities liquid and orderly, which meansmarket for enterprises whose shareholders standing ready to buy and sell shares at a fairare not limited to a single region. price, if necessary. Market makers in the

London Stock Exchange and the U.S. NAS-Role of speculation DAQ are obliged always to give two quotes:

bid and ask.A well-functioning market is expected to set Dealers play an important, though unof-prices that maximize the volume of transac- ficial, role in exchanges without formaltions, are responsive to the changing mar- market makers (for example, in the call mar-ket environment, are stable over the kets commonly seen in Central and Eastern


Europe). Dealers attempt to make a profit In order-driven markets (also called auc-by buying shares when a temporary excess tion markets) market participants revealsupply causes a price fall and by selling their orders to buy or sell at specific prices.shares when a temporary excess demand These markets can be continuous or call,causes a price increase. In doing so, dealers operated only by brokers, only by marketstabilize the market. Trading systems that makers, or by a mix of brokers and marketexclude dealers or other short-term specu- makers.lators have larger price swings. There are a number of arguments for

The trend in other countries is away order-driven markets. Depending on thefrom trading systems that rely on official patterns of supply and demand for shares,market makers to find the market price that they can provide a better price discoverybalances supply and demand. Instead all mechanism. In a quote-driven system, it istraders are allowed to make offers or orders. impossible for all orders to interact. This Sbort-terimDealers still participate in one form or argument is particularly valid for Central speculators bringanother and bring stability to the market. and Eastern European countries, with their . .

One question is whether brokers should thin and erratic markets. In addition, the stabtlity to capitalalso be allowed to be dealers, since such an new brokers in these countries may not marketsarrangement may produce a conflict of have adequate capital to act as dealers orinterest. Broker-dealers may put their own market makers, which would require theminterest as dealers ahead of the interest of to hold inventories of shares.clients for whom they act as broker. Forexample, a dealer may sell securities from Auction frequencyinventory to a client at a price above that atwhich the same securities could be pur- Auction markets can be call or continuouschased elsewhere. markets. In a call market buy and sell orders

The active involvement of dealers and are accumulated over a specific period andother speculators increases the efficiency executed simultaneously when a market-and stability of capital markets. Thus deal- clearing price is established-that is, wheners should be encouraged, especially in the the market is "called." In a continuous mar-early days of capital market development ket orders can be executed whenever bidwhen few participants may have the ability prices (buy order) and asking prices (sellor resources to be active speculators. Bro- order) cross, in other words, whenever thekers should be allowed to be dealers and buy order price exceeds the sell order price.dealers to be brokers, to encourage the par- The main advantage of call markets isticipation of dealers. But regulatory safe- their simplicity of price discovery and theguards are needed to avoid conflicts of ease of disseminating information tointerest between these two functions. investors. The timing of an order in a call

market is not as important because allQuote or order-driven markets orders brought to the market before call

time are treated equally. This is importantDifferences in the role of dealers and mar- for markets in Central and Eastern Europe,ket makers are most pronounced between where communications systems are poor.trading systems that rely on price quota- The advantage of continuous markets istions and systems that rely on orders. In that they allow traders to learn and adjust toquote-driven markets (also called dealer current market conditions from observationmarkets) market makers compete for orders of incoming orders, bid and ask quotations,by publishing bid (buy) prices and ask (sell) prices, and volume of transactions. As a re-prices. Thus the market maker is ready to suit decisions better reflect current (minute-accept orders on both sides of the market. to-minute) market conditions. ContinuousThe rules of the exchange determine the markets also guarantee execution of ordersextent to which dealers must reveal to the at the market price and trading withoutpublic any restrictions or volumes attached delay. Both features are particularly impor-to the proposed prices. tant for speculative investors.


The main disadvantage of continuous Though most experts generally favormarkets is their vulnerability to manipula- transparency, some argue against it in cer-tion and abuse. This can happen when the tain cases. One is when the market relies onrecording of the time sequence of order market makers or specialists, in otherinflow and trading priority rules are impre- words, price- or quote-driven markets.cise and when rules of conduct of market Continuous quote-driven markets reportintermediaries are not enforced. Although best bid and ask quotations but not thecall markets are probably better suited to entire flow of orders. This is mainly due tothe needs and technological capacity of the the opposition of market makers, whocountries in the region, the two systems would lose a competitive advantage sincecan be used together. A call market may be they have better and earlier informationused for thinly traded shares or for orders than the rest of the market participants. It is

Call markets rather that have accumulated overnight. A con- argued that sharing this information with

than continuous tinuous, computer-assisted system may all participants would make it harder formarkets are best then be used during opening hours for market makers to bring order and liquidity

stocks with heavy trading of small or to the market.suited to the medium-size orders. A less formal system A second case involves large block trades.

countries of the involving negotiated trades may be neces- It is argued that such trades should not havesary for orders that are too large for the to be reported until some time after theyregion continuous system. take place-say, ninety minutes. The trader

may want to split up the large block intoTransparency smaller trades and would not want to dis-

close an early partial trade for fear that itA basic assumption of the theory of com- would cause a large price change in the mar-petitive markets is that they are fully trans- ket, to the trader's disadvantage. The issueparent and information is available free of of transparency is discussed in detail incharge. Securities markets are far from this IOSC (1992).ideal. The cost and availability of informa- The optimal degree of transparency maytion differ significantly from country to also depend on other factors, including:country. * Structure of the trading system. Call

Transparency can increase both the effi- markets will benefit little from online infor-ciency and fairness of securities markets. mation about prices and volumes, sinceComplete transparency would require such information cannot be used before theboth the disclosure of all bids, offers, and market is called. In highly automated con-orders before transactions takes place (pre- tinuous markets with computer-supportedtrade information) and the volume and trading, however, earlier access to informa-prices of transactions completed (posttrade tion (measured in seconds) can create sig-information). nificant gains.

Most trading systems report price and * Size of the market. With only a fewvolume of trades at the end of the day (clos- market makers, full transparency of theiring price), while a few report only price. positions can result in oligopolistic tradingPrice and volume information is available strategies, resulting in collusion amongthrough exchanges, newspapers, and televi- them against external traders (the public).sion. All major markets also provide online Informal and less-regulated marketsinformation about prices and volumes dominate trading in some countries of thethrough specialized domestic communica- region. One consequence is that sophisti-tions networks and international commer- cated traders and dealers who have bettercial networks, such as Dow-Jones and access to information about companies,Reuters. A few markets open their limit demand and supply conditions, and pricesorder books to the public at large, conceal- may earn substantial profits at the expenseing only the names of buyers and sellers. of less-sophisticated and less-informedThe most prominent are Toronto CATS investors. The long-term solution is toand the Tokyo Stock Exchange. increase the information available and to


regulate to ensure equal treatmenlt for all intcgrating sLIbiiii-kets ;uol encritiragin-g

investors, market maikers or dilclers.II] selectilng aI tr.ldirig svstem11, there is

M-farket sutbilization often a tradcoff I wtweTCi 11n11e(dIMcv (t hc

abilitv to trade promptly) annd price stabil-

By one definition, a milarket is efficieit if thc it. (C ontilluons rit lirdi systcnis pro i(Iiprice ofa company's shares reflects all avail- imI1IediacI but, IccaUisC Of thiil tr:iedI rig.

able informnation about its fiuture operatioiis prices mla Ib unstable. lIn call ml lkets

and earnings. 'T'hus prices shoul(d change trailers 1m0ay have t, w 'a t foir an auctioll. but

only when new information becomes avaiil- the batching of iririieroLis orders will resultable. In reality share prices fluctuate simply in imore price stability. TIhin ttradingu andl

because of random increases in supply or price instability have led roost exchanges illdemand that have little to do with the ulider- Central and Eastern I auropc to a.dopt call AMarketlying fundamentals of a company's opera- auctions rather thlil co0nrinuous trading. stabilization shouldtions. One measure of a xvell-functioninig Some exchanigcs Nvith ()ntinonIs tradingmarket, however, is stable prices or prices systemosehaveintroduced pslicies toiultm1n pricethat do not fluctuate wil(ll. Since prices pric stabilitm. The,se policies;are risky, bow- manipulation ormust change when new informationl is avail- ever, because theyZ (c;anI ilitelfere II the ad- conntrolsable, however, it is difficult to judge whether justmcnt of priccs ti) ne equllibiulml ievels.

share prices are moving to a new equilib- If price instabilitN is a serioqus ipriolleiim the

rium level or fluctuating excessively, better choice niav Ie C to risc a c-all ma1cti()n.One prerequisite of an efficient aiid sta- Policics to Cnleiulrige price stabilirt

ble market is liquiditv. Liquidity can be includ:cmeasured by the relationship betvecn * Cpecial markct-oprning proccnrar. (ion-

money volume of trading and changes in tinuoius markets are only open durilig nor-

market prices. The greater the money vol- m3al business hours. -1 huse a;ch morning the

ume needed to cause a significant chainge in inarket iunst dcal wcith orders rcceived

the price ofa stock, the greater its liquidity. overnight. M1ost colitinlilouis marilets rise

In other words, random changes in supply proeidlurcs for setting i peniri.g prices that

and demand would not cause a large change resemble call markets. All rivernight ordecrs

in the price of shares in a liquid market. arc hatched, and in eqtuililiriuni price isLiquidity can be xiewed in terns of three established that .iaX1i1i7CS the voluirIe of

market characteristics: trade.D Depth-a market has depth if orders * Prict linuits. Imposing specific percent-

exist at prices above and below the current age limiits on the f1iuctuat1!i inf prices froi oequilibrium price. scssioii to sessiol Is the minost direct and

* Breadth-a market has breadth iflarge most widcelv ose(i instrmiienit of stihili7a-orders can be absorbed without large price tion. If the Iimiiit is rec1clced. officials an fur-

changes. tiher trades for a i ort pci-io d and 1 nav* Resiliencv-a market has resiliency if anilounce the "heavy" side of the market

price changes due to market imbala,nces (supply iir dcninani In Sonic c;ases traiingquickly attract new orders to the market oni may r(vcrt to a call iLnCtion. SnIch limits.the shortage side. however, shoul(d ii(it atte-mpt to pr( vei t

Ensuring sufficient liquidity should be fundamienital changcs in the ma;lrket cle;aringgone of the main considerations of miarket price. In such cases limnits tan he suspendedparticipants, policyrnakers, and regulators. to allow an adjustimliit to the nes ciluilib-Low liquidity may result from the small vol- riuLm1 price level.ume ofshares of publicly traded companies * Rfiusal no dcns- di:ualvilizing wrderk.the small population of investors. and the Sonie trailing systeliis lo uiot allow officildesire of investors to keep shares rathei niarkct imakers to place dcscalili-zing i-ders

than trade them. Market liquidity can bt on their own account--tom cxamnpic to scienhanced by such measures as widely andI when priccs aire fal1ling Ir IIto hui X hcmrquickly disseminating price infori:itaion, prices arc rising.


Clearing and Settlement

After a trade has been made, payment for completed because the buyer did not makeThe clearing and securities must be transferred from buyer the required payment.

settlement to seller and ownership transferred from In most exchanges the two parties areseller to buyer. Clearing refers to the typically brokers acting as intermediaries

organization tprocess of verifying the number and iden- for the ultimate investor. TIhus the brokersusually guarantees tity of shares in a particular transaction, the must be satisfied that their clients will meet

the performance of price and date of the trade, and the identity their obligations to either deliver the secu-both buyer and of the buyer and seller. Settlement involves rities or make pavment. If the ultimate

two steps-transferring payment from buyer or seller does not meet their obliga-seller buyer to seller and transferring legal own- tions, then the broker will in most cases be

ership of the shares from seller to buyer. If liable.these two steps are done simultaneously, WVhat assistance does the exchange orthe system is said to have achieved "deliv- the clearing and settlement organizationery versus payment." Serious problems can provide to guarantee the performance ofarise if one step occurs much before the the two parties to the trade? Because of theother. need to ensure the performance of the two

parties, there often is a close relationshipCounterparty risk between the stock exchange and the clear-

ing and settlement organization. TheThough clearing and settlement may exchange or its large members may own andappear to be merely administrative or ac- operate the organization.counting procedures, problems can arise if Trading is hindered without theone party to the deal does not live up to the assistance of the clearing and settlementagreement. The worst situation occurs organization because each party miust inde-when the ownership of the securities is pendently verify the creditworthiness of thetransferred but the payment is not made, or other. One party may refuse to participate inwhen the payment is made but the owner- a trade that has been arranged by theship is not transferred. The loss of one of exchange because of lack of confidence inthe parties could then equal the full value of the counterparty. The clearing and settle-the security traded. ment organization, in cooperation with the

Even if the trade is canceled because one exchange, can reduce this counterpartv riskparty does not meet its obligations, the in three ways. The first (and rarely used) isother party may still suffer. For example, a to require that both parties provide securi-seller may discover that the price of the ties and payment in advance of executingsecurity has fallen after the sale was agreed the trade. This is essentially what is done byto, or the buyer may discover that the price the RMS exchange in the Czech and Slovakhas risen. It is generally considered unac- Republics because it deals with many smallceptable for a stock exchange to have to can- investors who do not trade through brokers.cel a transaction because one party did not The second way is for the exchange ormeet its obligations. For example, the stock clearing and settlement organization toexchange cannot tell a seller some days after restrict participation by, for example,the trade was carried out that sale cannot be requiring that brokers meet certain capital


standards. This usually means that the paper certificates must be physically trans-clearing and settlement organization will ferred from the seller to the buyer.limit membership to the most reputable and * Paper certificates may be immobilizedcreditworthy brokers, dealers, and market in a central depository (for example, theparticipants. Nonmembers may participate Depository Trust Company in the Unitedonly through one of the members. The States). Share owners may be legally enti-member must then insure the creditworthi- tled to receive a paper certificate but areness of the nonmember. willing to leave them with a depository for

The third way is to organize a mutual easy trading.guarantee system whereby all members of * Shares may be "dematerialized" andthe clearing and settlement organization no paper certificates exist. The only proofagree to collectively stand behind the per- of ownership is ani entry in the database offormance of members. the central share registry. "Dematerialized"

A clearing and settlement organization is Clearing and settlement is simpler and or "immobilized"not required in off-market trades where the cheaper in the second and third cases.buyer and seller deal directly with each Either may be difficult to achieve, however, share certijcatesother. In such cases the two parties make because of outdated regulations, political are besttheir own arrangements for clearing and opposition, inadequate technology, and thesettlement and for satisfying themselves need for speed in privatization. The bestthat the other party will meet its obliga- compromise may be to recognize papertions. share certificates but to encourage a move

toward share depositories. This could beAlternative systemis done first for the largest investors (brokers,

dealers, funds, and banks) and eventuallyThe systems used by clearing and settle- for small investors, as happened in manyment organizations are complicated, vary WVestern countries.greatly from country to country, and are The Czech Republic and Russia illus-beyond the scope of this paper. A compre- trate some of the benefits and difficulties inhensive description of the various systems choosing a legal form forsecurities. Becauseappears in IOSC (1992a, b). the Czech Republic used a centralized com-

The Group of Thirty, a nonprofit orga- puterized system for its voucher auctions, itnization of market participants from thirty was relatively simple to register each share-industrial countries, has rnade recommen- holder in a central computer, thus avoidingdations on the operation of clearing and set- the need for paper certificates. In contrast,tlement systems that have become Russia's mass privatization program wasunofficial standards. These recommenda- decentralized because of the size of thetions are intended to ensure an efficient and country and because creating a central sharelow-risk system. Among the recommenda- registry would have slowed mass privatiza-tions: that final settlement occur within tion. The end result is a dematerialized sys-three days of the trade, that settlement be tem, but the registries are managed hy"delivery versus payment," that netting of enterprises and can be used to hinder ortransactions be considered, and that a cen- manipulate share trading.tral share registry or depository be used tothe maximum extent possible (for more Payment systemsdetails see Zhou 1991 and Pardy 1992).

Clearing and settlement must be closelyLegal formn of secir-ities integrated with a country's banking and

payment system. A poorly developed pay-'I'he system used for the transfer of securi- ment svstem may be the biggest obstacle toties depends greatly on the legal form of the development of capital markets. Thereownership. There are three options. is little point in striving for rapid transfer of

A paper share certificate may be the share ownership if payment takes days oronly legal proof of ownership. In this case, weeks to complete.


Perspectives of Market Participants

Investors have different needs and objec- willing to invest the time and effort neces-Investment funds tives. The interests of investment funds and sary to perform this function. Funds in the

improve the other institutional investors, for example, Czech and Slovak Republics are alreadyrlic of Capital are likely to be quite different from those of beginning to monitor and influence man-

efliciency ojcapztat foreign companies. agers of enterprises that were privatized

markets and the through vouchers (Anderson 1994; Coffee

system of corporate Investmentfinds 1994). This is less the case in Russia, wheregovemance funds typically own a minoritv of shares ingovernance Investment funds are likely to be important a company and the managers (insiders) are

investors in Central and Eastern Europe, dominant (Blasi 1994).particularly in countries that have already Though funds may improve the gover-carried out mass privatization using vouch- nance of enterprises, what about the gover-ers, such as the Czech and Slovak nance of the funds? Funds are typicallyRepublics, Russia, and Lithuania. In other owned by thousands of small investors whocountries planning similar privatizations, may have little influence over the fund man-many vouchers will be transferred to such agers. The ability of the fund owners tofunds. Thus the larger funds may own more control the fund managers can be increasedshares than any other single investor. In the through appropriate regulation (discussedPolish mass privatization scheme, all shares in more detail below).will be held by funds. Large investment funds may make it dif-

Investment funds can both facilitate and ficult for capital markets to functionhinder the functioning of capital markets. smoothly because they tend to trade largeFunds help the development of capital mar- blocks of shares. All exchanges have diffi-kets in three ways. First, they allow investors culty in handling such trades while avoidingto own part of a diversified and lower-risk a large drop in price when a block is sold orportfolio of shares and thus encourage citi- a big increase when a block is purchased. Azens to invest in shares. Second, they make less formal trading system is usuallycapital markets more efficient. (A market is adopted where large institutional investorsefficient if the price for shares reflects all trade directly with each other. This is theavailable information about the future prof- case in the Czech and Slovak Republics.itability of the enterprise.) Investment funds where most trades by the large funds areare better able to obtain information about done off-market. This practice may make itthe prospects of enterprises. Thus they will appear that trading on the official exchangetend to bid for undervalued companies and isthinandilliquidbecausealargepartofthesell overvalued companies and will bring trading is done outside the exchange. Somestock market prices more in line with future observers have even proposed that funds beprospects of companies, thus creating a required to trade only on an exchange. Thismore efficient market. approach would be a mistake because

T hird, the funds' large shareholdings in exchanges are unable to deal with largeenterprises make it easier for them to mon- block trades. In anv event, traders should beitor, supervise, and influence the behavior able to use whatever trading mechanismof managers. Small investors are not able or best meets their needs.

l6 CREATING CAPITAL MARKETS IN CENTRAL AND EASTERN EUROPE

A different argument, however, can be nance and can influence enterprises tomade that large institutional investors undertake needed restructuring.

should still report the prices at which they Foreign investors may find it easier totrade shares, even if the trade is done off- purchase an enterprise from private ownersmarket. In this way information that funds than from the government during the pri-may have about the value of companies is vatization process. The sale of an enterpriseshared with all investors. from one private owner to another is less

political and is subject to less public scrutinyForeign investors and criticism. Many citizens oppose the sale

of public enterprises to foreign investorsForeign investment can take two forms. during privatization, and politicians useThe first is called foreign direct investment. these nationalist sentiments to win votes.Here, a (usually Western) company invests One recent example is the cancellation of Foreign investorsdirectly in a local company or starts a new the sale of a Hungarian hotel chain to for- will provide capitalenterprise (a "greenfield" investrnent). eign investors.Such investors insist on some influence or Countries that sold their enterprises to only if tbey arecontrol over management to ensure that mostly domestic investors in a mass privati- given influence ortheir investment is protected. Some zation program may see an even larger wave control over theinvestors may insist on owning at least a of foreign investment as the initial privatesimple majority of shares so that they can owners sell all or part of their enterprise enterprsecontrol daily operations. Others may insist shares to foreign investors. This mayon owning a "supermajority"-two-thirds already have begun in the Czech Republic,or three-quarters of outstanding shares- where the ratio of foreign direct investmentwhich allows them to control fundamental to GDP is 3.4 percent, among the highestchanges in the company. in the world (see figure 2).

The second form of foreign investment In Russia, where workers and managersis portfolio investment. Here, Western became the dominant owners of enter-financial institutions, such as mutual or prises, owners may be forced to sell to out-pension funds, buy shares in established siders in order to attract capital forcsompanies. Such investors usually do not expansion and modernization. The insidersattempt to exercise direct influence over may have to give up control to outsiders inthe management of the enterprise. If they exchange for the survival of the enterprise.are unhappy with the management, they Portfolio investors can buy shares in a"vote with their feet" by selling their company without gaining control, but theyshares. are only likely to do so if the shares are

When the reforms began in Central andEastern Europe, many believed that foreign Figure 2. Ratio of foreign direct investment to gross domestic product, 1993

capital, management skills, and technical (percent)expertise would rush in, bringing about a

expertise would r-ush in, bringing about a Transition economies 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0rapid restructuring of the economy. That Hungary

expectation proved unrealistic, but there Czech Republic

has been a substantial flow of foreign invest- Polandment to the region, and this flow could BulgariaRomaniaincrease as reforms continue. Other developing

Few countries have enjoyed a larger countriesinflow of foreign capital compared with the Chinasize of their economies than have Hungary Morocco

Portugaland the Czech Republic (figure 2). Hungary Mexicoand some other countries have seen a high Indonesiadegree of foreign investment because they Egyptsold enterprises to foreign investors during Brazilthe initial privatization. Foreign investors Source: OECD balance of payments data.

can play a major role in corporate gover-


offered at low enough prices to reflect the macroeconomic environment, includingrisk. Recent examples include purchases of GDP growth rate, inflation, and exchangeshares in energy and natural resource com- rate stability.panies in Russia at prices substantially * Financial benefits. This includes returnbelow the asset value of the companies. on investments and portfolio diversifica-

Such portfolio investments are highly tion. Diversification means reducing finan-speculative. These investments have a cial risk by including securities frompotentially high return, but if company law markets where price changes do not closelyfails to protect the interests of minority follow other markets. In technical termsshareholders and the company is controlled there is low correlation between priceby insiders (workers and managers), out- changes in these markets (van Agtmnaelsiders may not share in future profits. 1993).

A capital market is At the end of the day, a capital market is * Insitutional efficiency. Foreign

only as good as it is only as good as it is perceived by its investors demand that securities trading beinvestors. The views of foreign portfolio smooth, safe, and fast. This requires effi-

perceived b its investors are the best test of the perfor- cient custodian services, a depository forinvestors mance of an emerging market because of securities, a trading system, and clearance,

their wide experience and high standards settlement, and payment systems.(Mullin 1993; van Agtmael 1984). Theseinvestors have some concerns about Central A trade cycle: an investor's perspectiveand Eastern Europe, including:

e Market environment. This covers all Investors in equity markets follow a tradecomponents of sovereign risk, including cycle. The cycle begins with the decision topolitical stability (for example, risk of rena- enter the market and ends with the realiza-tionalization), legal stability, taxation, for- tion (and perhaps repatriation) of investedeign exchange rules, and restrictions on capital and profits. Both foreign investorscapital and profits repatriation. Legal sta- and domestic investors may be challengedbility includes, in particular, the ability to in Central and Eastern European marketsenforce contracts. Also important is the by problems that arise at different points in

this cycle (table 3).Custodian agent. When foreign investors

Table 3. Problems encountered by Investors during the trade cycle decide to enter one market they have to:

Phase Problems ' Acquire local currency.*Select a domestically licensed broker.

Market access * Legal limitations on foreign portfolio investments. * Appoit a custoian bank.* Foreign exchange limitations. * Appoint a custodian bank.* Only "on the spot" transactions, no possibility of trading The shortage of reliable custodian ser-

offshore. vices seems to be the most severe institu-

Custodian agent selection * Shortage of qualified local institutions. tional bottleneck for potential foreign* Internationally recognized custodian banks not yet present. investors in Central and Eastern European

Trade * Lack of information on market practices and investment markets. Investors appoint custodian banksopportunities. to ensure conhdentiality, to limit exposure

* Small number of traded securities.* Incompetent domestic brokers, and foreign brokers not to credit risk, to protect assets, to gather

allowed to trade. information, to act on behalf of the investor

Settlement, cash side * Slow payment system. in the clearing and settlement process, and* Margin transactions not allowed. to commnunicate with the depository. These* Require full, up-front payment.* Counterparty's failure to pay. services are particularly essential for insti-* No guarantee fund. tutional investors, such as mutual or pen-

Settlement, securities side * Nonexistent or inefficient depository. sion funds, which often have strict internal* Slow physical delivery. audit rules requiring high-standard custo-* Borrowing of securities does not exist. dian services. The use of custodians by* Counterparty's failure to deliver, mutual funds is usually required by law.

Market exit * Limitation on repatriation of capital and dividends. Internationally recognized custodiano Liquidity. banks often move into countries with


emerging stock markets to develop a long- may not be available because it is not pre-term market presence and to deliver custo- sented in internationally accepted formats,dian services to their international clients. because it is not actively marketed to for-In most Central and Eastern European eign investors, or because international rat-markets, there is a Catch-22. Foreign ing agencies do not rate investments in theinvestors cannot invest because of the lack country. Promotion of portfolio investmentof custodians, who are not present because opportunities is not only the responsibilitythey lack clients. Domestic banks can help of exchanges and brokerage houses, but alsofill this gap. As a first step, international cus- of banks and government agencies.todian banks usually select local banks or Clearing and settlement. Internationalbrokerage houses as subcustodians (Fry investors are sensitive to settlement safety1991). and speed.

Depository receipts. A related issue is the Market exit. Some policymakers and Foreign portfiilioincreased use of American Depository politicians in Central and Eastern Europe investors needReceipts and Global Depository Receipts as view capital markets as one-way "money reliabl custodianvehicles for foreign investors to buy and sell traps." According to this view, once moneyshares. These receipts represent a claim to is invested it should stay in the country and agentsownership of shares held by a depository or dividends and capital gains should be rein-custodian in the home country, often a vested in the local economy, if not in thebranch of a foreign bank. Shares repre- same company. This is not acceptable tosented by these receipts are not traded on international portfolio investors. Countriesan exchange in either the home country or in Central and Eastern Europe are compet-in the country where the investor is located. ing for portfolio investments with manyInstead a depository receipt is traded in the other countries that offer similar invest-investor's country. To be traded on a foreign ment opportunities in terms of return andexchange, depository receipts usually must risk. For investors, conditions of exit may bemeet the same standards for listing as any more important than return on invest-other share traded on that exchange. ments. Unlike some direct investors whoDepending on the country, the depository use accounting tricks and unofficial chan-receipt performs other important services nels to repatriate income and capital, port-for the foreign investor, such as collecting folio investors must use official channels. Asdividends paid on the shares and exercising a result, limitations on repatriation of capi-voting rights at the annual meeting. tal and profits result in low inflows of capi-

Information availability. The information tal.available to foreign investors regarding spe- One final concern is market liquidity:cific investrnent opportunities, market can large international investors sell sharespractices, services, foreign exchange, and on the local marketwithout greatlydepress-taxes is limited but increasing rapidly in ing the price?Central and Eastern Europe. Information


Regulation of Capital Markets

Capital markets need to be regulated in a government play an important role. ButGovernment needs more detailed way than the basic require- problems can arise when particular market

to establish the ments of contract or company law. The key segments or functions are supervised by dif-

basic rules of a policy question facing governments in Cen- ferent arms of government.tral and Eastern Europe is, what type of reg- * Lawmakers. Parliament or the presi-modern market ulatory regime should be established? dent are usually the sovereign sources of

economy There are two approaches. The first is to law. In some countries a referendum is usedidentify the key characteristics of capital to decide fundamental issues. Internationalmarkets, identify why these markets pro- organizations are the souice of conventionsduce less-than-optimal outcomes, and and directives.design a regulatory regime that correctsthese market failures. The second is to Regulatory modelsexamine the regulatory regimes that havebeen adopted in other countries (see, for The basic principle of a market economy isexample, OECD 1988) and, based on expe- to leave as much as possible to private par-rience in those countries, choose the regime ties and for the government to regulate andbest suited for the conditions of Central and control as little as possible. A preferredEastern Europe. The first approach might option is for the government to set out sim-be called theoretical, the second might be ple principles and standards and to leaveconsidered practical. enforcement to participants, for example,

through civil legal action.Institutions Historically, capital markets have

emerged when governments stepped asideVarious government and private bodies and and left it to the private sector to enter intoinstitutions play an important role in any contractual arrangements to raise funds forregulatory regime. These include: large ventures. The emergence of these

* Self-regulatory organizations. Self- markets was closely linked to the appear-regulatory organizations may comprise ex- ance of joint-stock or public limited-changes, issuers, organizations of investors, liability companies. The most importantand professional organizations of financial step was the removal of government char-services providers. These groups can oper- tering (concession) requirements forate as formal organizations or as informal such companies and their replacementlobbyists. Government regulatory agencies with a few standard rules governing themay supervise their activities and give them corporate contract among sponsors, in-official recognition and status. For example, vestors, and management. Rapid techno-the government may require that all quali- logical progress and the onset of scalefied participants in a particular profession or economies in industrial production turnedgroup become members of a self-regulatory this small legal innovation into a majororganization and may review the organiza- economic force.tion's terms and conditions of membership. Hard on the heels of economic liberal-

* Administration. Local authorities, the ization, however, came imprudence, oppor-central bank, and agencies of the central tunism, and fraud by company managers


and owners, which led some governments Despite these differences, company andto impose stricter rules on limited-liability, securities laws and regulations in all thesejoint-stock corporations. In Western countries have the same aim-to renderEurope these rules were generally included capital markets fair, efficient, and transpar-in commercial codes. In the United King- ent. Slight differences in the rules and sub-dom and the United States company law tle interactions between different laws orand other special statutes complemented or regulations (company, contract, banking,replaced the evolving "common" law. The securities, bankruptcy, and so on) can, how-objective was to provide a set of "best prac- ever, lead to different patterns of monitor-tice" rules for corporate contracts that pro- ing and control of public, limited-liabilitytected third parties, such as creditors and companies by their owners.minority investors, from abuse. The bewildering array of national laws

Even so, a great deal of regulation is left and regulations led the (then) European EU directivesto market participants. Much regulation is Community to issue company and capital represent ainformal and relies on reputation. Some is markets directives to enhance fairness andmore formal and carried out by self-regula- transparency in the common market. These consensus view ontory bodies, such as a stock exchange or directives are embodied in national legisla- capital marketassociation of securities dealers. The tion (often in quite differently labeled laws). regulationUnited Kingdom has maintained a strong These directives are useful models for sev-tradition of minimal legislation and exten- eral reasons: they are compatible with thesive reliance on informal rules and policing. civil law tradition of most Central and East-The United States, by contrast, has become ern European countries; they represent athe most legislated, regulated, and litigious modern consensus view of how much regu-society. lation is necessary; countries aspiring to

In most European countries company membership in the European Union willlaw is at the core of capital market regula- eventually have to comply with these rules;tion. In the United States company law is and the sequencing of the directives givesthe responsibility of the individual states, some hints of what may be most essentialbut the federal government can regulate (for example, the contents of the first fourcompanies indirectly through securities company law directives). An overview oflegislation if securities are offered for sale in these measures is provided in Balling (1993)more than one state, which is usually the for company law and in Walter and Smithcase. (1989) for securities regulation.

Capital market rules vary considerablyacross countries. What is legislated in detail Company lawin one country is left to informal practicesor self-regulation in another. For example, The objective of company law is similar inGerman cornpany law requires an indepen- all market economies: to mediate amongdent supervisory board composed only of groups of claimants, such as majority andoutside directors. A similar objective is minority shareholders, management, andachieved in the United States through New creditors. Until recently provisions inYork Stock Exchange rules, which require company laws varied dramatically fromall listed companies to establish an audit one country to another. In the Unitedcommittee composed only of outside States company law even varies by state-directors, and in the United Kingdom although some uniformity has been intro-through a voluntary code (the Cadbury duced by federal securities legislation.code). Similarly, European Union company EU company law directives now cover alldirectives require extensive disclosure of major areas (box 1). The directives are con-financial information for all large compa- cerned mainly with the disclosure of infor-nies, regardless of ownership. In other mation to investors and the protection ofcountries stock exchange regulations or investors, creditors, and other interestedsecurities laws mnay lay down disclosure parties. The major subjects that a companyrequirements. law must address are:


General forcement of existing laws. Enacting mod-* Legal entity ern laws following the best Western exam-* Limited liability pies is of little value if the laws are not* Free transferability of shares enforced. Enforcement may be poorManagement and control because of weak or nonexistent commercial* Allocation of powers between sharehold- courts and inefficient or corrupt adminis-ers, directors and management tration. It may also be in the interest of* Appointment, rights, and duties of the some managers of privatized companies toboard of directors keep regulations vague and unenforceable.* Appointment and responsibilities of Experts on company law have attempted tomanagement draft a law that is largely self-enforced andRights ofshareholders thus still effective even in the absence of

Much regulation * Voting rights, appointments of directors, enforcement by the courts (box 2).

can be left to self- fundamental changes* Transfer of shares Securities law

regulatory * Access to information, audit

organizations * Rights of minority shareholders For a long time Western economies usedCapitalization and distributions only company law as the basic capital mar-* Shares, types, voting rights ket regulation. Company law provided the* Authorization, subscription monitoring, control, and disclosure frame-* Preemptive rights work for the most risky securities-that is,* Dividends equity shares that are residual claims on theFundamental changes in corporate structure net worth of companies. Other securities,* Formation such as bank notes or corporate bonds, were* Capital increase or decrease less risky, more easily understood, and did* Change of articles (charter) not require specific regulations beyond* Mergers and acquisitions contract law. Securities regulation on the* Dissolution level of the European Union remains lim-

A common problem in most countries of ited, reflecting the importance of companyCentral and Eastern Europe is poor en- law directives for trading in shares (box 3).

A directive on investment services in thesecurities field, modeled on the U.K Finan-

Box 1. EU company law directives cial Services Act, also has been proposed but

i. General rules, rights and obligations of not yet enacted.the company and its directors.

2. Disclosure requirements for formation, Self-regulatory organizationsmaintenance, and alteration of capital.

3. Mergers and acquisitions. Except in the United States, securities reg-4. Financial reporting. ulations beyond company law usually cover5. Structure and management of companies o r o c

(pending). only regulation or certification of market6. Division of companies. intermediaries (such as brokers, dealers, or7. Consolidated accounts for company investment funds) to limit fraud and theft.

groups. This can be left entirely to self-regulatory8. Qualifications of auditors. organizations, usually professional associa-9. Conduct of groups of companies (pend- o o t

ing). tions, or to a combination of statute law thatio. Cross-border mergers (pending). sets out broad rights and obligations of1i. Disclosure by foreign branches. market participants and detailed rules12. Single member limited-liability compa- established by self-regulatory organiza-

nies. tions.13. Takeover bids (pending). Professional associations of financial ser-14. Dissolution and liquidation (pending). vice providers usually adopt minimum

Source: Balling 1993. financial standards, codes of ethics, and self-I insurance mechanisms. The risk with self-


regulatory organizations is that they canalso oppose competition and create cartels Box 2. A self-enforcing company lawor monopolies, especially if self-regulation A company law can be designed to be could require board directors who areis sanctioned or enforced by government effective even though judicial enforce- not managers of the company or share-regulatory agencies without adequate over- ment is weak. Experts who have drafted holders themselves to appear at generalsight. For example, setting unreasonably a company law for Russia followed cer- meetings to approve key decisions. Thehigh standards for new brokers to enter the tain principles to make the law self- law could also specify voting proce-market may become a way of limiting entry, enforcing: dures that must be followed at thesereducing competition, and raising brokers' * High penalties for violatdons of the meetings, such as cumulative voting.reducmmissiong p ettio law. Because the probability of both dis- * 'Bdght line" rules of behavior.comrmissions. The revised UK Financial covering a violation and successfully Western laws often give general princi-Services Act of 1986 provides a useful exam- prosecuting it is small, the penalty for ples for the behavior of companies andple of how to combine broad statutory reg- violations should be high. Thus the law their managers. These principles haveulation with self-regulatory organizations will still be effective in deterring viola- been interpreted and refined by manyto set and enforce detailed rules (see Secu- tions. court decisions, and judges are experi-rityand Investment Board 1989). * Pocedural protections instead of enced in judging whether violationsprohibitions. Company law could have occurred. In a self-enforcing law,

attempt to prohibit certain behavior or however, clear and simple rules ofInvestmentfind regulation activities, but it is difficult to clearly behavior should be provided that

define these activities. Instead the law require little judicial interpretation andInvestment fund regulation is one area should specify that company manage- that help guide companies and man-where regulatory practice in Central and ment must follow certain procedures in agers toward proper behavior.

Eastern Euroeshulddiffrfomaking decisions designed to protectEastern Eur optie snthouldu fer fiom crn- shareholder rights. For example, the law Source: Black. Kraakman, and Hay 1994.

mnon practice in the European Union andthe United States. In EU directives invest-ment funds are referred to as "undertakings shareholder in multiple firms in the same Investmentfundsfor collective investment in transferable industry. should besecurities." By tradition, both in the United Another concern is that smaller funds encouraged toStates and in the European Union, funds with a large shareholding in one particularare not allowed to play a role in corporate company may be putting all (or most) of exercise their rightsgovernance-that is, to exercise influence their eggs in one basket. To protect as ownersover companies in which they own shares. investors, it may be necessary to requireThis approach grew out of an early-twenti- funds to have a minimum amount of diver-eth-century populist movement that sification in their portfolio. Investment inopposed concentrations of economicpower. One consequence is that in theUnited States even large investors own only Box 3. EU securities law directivesa small percentage of shares of a particularcompany, although there is a trend toward i. Conditions for admission of securities toallowing pension and mutual funds to exer- stock exchange listing,cise greater influence over companies. In 2. Disclosure requirements at the time of

offering ("listing particulars"),Germany banks and Insurance compnamesofeigCIsngprcuas)Germany bak n nuan3. Financial reporting requirements for listed

have always been permitted to own large companies,blocks of shares and to exercise influence 4. Disclosure requirements for unlisted secu-over enterprises, but mutual funds have not. rities offered to the general public,

One concern about large financial insti- 5. Disclosure of acquisition or disposal oftutions owning controlling blocks of shares major holdings in listed companies,

6. Insider dealing, andis that they may use this power to create 7. Investment funds ("undertakings for col-monopolies. For example, a fund with a lective investment in transferable securi-large share ownership in most of the firms ties").in an industry could encourage them to col- 8. Investment services in the securities fieldlude in setting prices and thus reduce com- (proposal modeled after the UK Financialpetition. Antimonopoly agencies should Services Act).have the authority to block a single financial Source: Walter and Smith 1989.

institution from becoming a major


the shares of any one company may not capital markets, tax laws are just as impor-account for more than, say, 10 percent of a tant. A poorly designed system of corporatefund's assets. taxation can greatly harm the functioning of

Meeting these concerns about monopo- joint-stock companies and capital markets.lization and portfolio diversification may (For a more complete discussion, see Blackrequire special rules or procedures. But 1994.)these concerns should not be used to ban all High corporate income tax rates arefinancial institutions from exercising influ- harmful in a number of ways. They:ence and control over enterprises, espe- * Reduce the flow of information from con-cially since there is a shortage of large panies to shareholders. High tax rates encour-investors in Central and Eastern European age companies to hide profits and to lie tocountries. Rather, banks, funds, and other tax authorities. As a result companies do not

High corporate tax financial institutions should be encouraged provide accurate information to sharehold-

rates inhibit capital to exercise influence and control over ers, who have no way of judging the perfor-

market enterprise managers through their share- mance of the company. The market price ofholdings. One major reason for the failure the shares will be reduced, making it diffi-developpment of the communist economic system was the cult to raise new capital.

state's poor conduct as owner of enter- * MWake contract eniforcement difficult.prises. It is important that good private Companies may enter into informal agree-owners be found. Though not perfect, ments to hide profits from the tax collector.banks and funds are likely to be the best For example, the company may appear to beavailable owners (see Anderson 1994 and selling its product at a low price under anCoffee 1994). Some basic principles for official agreement while in reality selling atregulating funds, however, need to be fol- a high price under an informal agreement.lowed (box 4). Such informal agreements, however, can-

not be enforced in the courts. CompaniesImpact of the tax rystem may be forced to use illegal (even mafia)

means of enforcement.Though company and securities laws * Encourage corruption. To avoid payingreceive the most attention in developing high taxes, companies have a strong incen-

tive to bribe officials to not enforce the law.

Box 4. Regulation of voucher funds Similarly, tax officials may use the tax lawsto create obstacles for a company unless

In countries with a voucher privatization pro- they receive a bribe.gram, voucher funds will likely play a major As more companies move into privaterole both in the capital market and in the ownership and individuals begin to receivesupervision and control of enterprises. The substantial income from dividends and cap-regulatory regime for such funds should be ital gains, governments in Central and East-based on five principles:

i. Funds should be encouraged to exer- ern Europe will need to develop a fair taxcise their ownership rights over enterprises system. High taxes on these sources ofand to influence them to restructure. income compared with other income can

2. The owners of the funds should be discourage citizens from owning shares andencouraged to exercise their ownership rights thus impair the development of capital mar-over the fund managers and to influencethem to improve the management of the kets.funds. A special problem arises with investment

3. Fund managers or sponsors should be funds. If a corporate income tax is levied onprohibited from self-dealing and other ways funds as well as on joint-stock companies,of using the fund's assets for their personal investors in funds will have to pay substan-gain.

4. Funds should not be allowed to ially more taxes than other investors. Cor-monopolize particular industries or markets. porations will pay the tax on profits and pay

5. Taxation of funds should not discour- out dividends to the funds; the funds willage investors from participating in funds. then pay corporate income tax again on this

dividend income. There must be a way to


exempt fund income from the corporate * Contract enforcement. Financial con-income tax. tracts are difficult to enforce because the

actions of buyers and sellers do not occurRegulatory challenges simultaneously. Delivery versus payment

systems attempt to render performance atCapital markets are perhaps the best exam- the same time, but any settlement and clear-ple of the incompatibility between existing ance system requires some time for tradesregulatory systems, inherited from a com- to become final.mand economy, and new market require-ments. The regulatory and legal framework Costs of regulationfor capital marklets is thin in almost all thecountries of Central and Eastern Europe. A good system of regulation can improveWith few exceptions, securities law is not the operation of capital markets, a poorly Poorly designed orsupported by executive instructions and designed one can be harmful. Some of the implementedcourt interpretations. And the broader legal costs and distortions caused by poor regu- renvironment, including the civil code, com- lation include: regwlaton can bepany law, and bankruptcy law, is not devel- * Creation of monopolies and cartels. Gov- harmfuloped enough to deal with more complex ernment regulation has reduced competi-questions. The first few years of experience tion and created monopolies and cartels inin capital market regulation in Central and some countries.Eastern Europe show that the main effort S Regulatory capture. Because financialshould focus on the following: service providers have the incentive and the

Legality. Much needs to be done to resources to influence the regulatoryimprove the legal systems in Central and agency, they may be able to manipulate theEastern Europe. Investors are particularly agency for their benefit at the expense of thesensitive to unclear legal situations. One public or ordinary investors.consequence of this uncertain framework is * Excessive regulatory costs. Regulatorsthat investments require a high premium to may impose requirements on the industrycover the additional risk. For most Western where the high cost of compliance is greaterinstitutional investors, even a high risk pre- than benefits to investors.mium may not compensate for the uncer- * Inhibit innovation. Regulations maytainty, and thus they may not invest at all. not keep pace with technical progress and

* Self-regulation. In mature markets, limit innovation.areas not covered by laws are regulated bycourt decisions and interpretations, self- Regulatory prioritiesregulatory rules, customs, and rules ofproper behavior. This framework does not Based on international experience, regula-yet exist in Central and Eastern Europe, tory regimes should have the following pri-and it will take time to build. orities:

* Regulatory administration. Court pro- * To introduce or revise civil and com-cedures to solve conflicts related to capital mercial codes to reflect modern practices.market contracts are slow and costly. The company law sections should be com-Administrations or agencies that regulate patible with the first four EU company lawsecurities markets should be granted the directives and should be largely self-legal authority to act quickly and efficiently. enforceable;They should be empowered to freeze com- * To introduce international accountingpany bank accounts, confiscate assets, con- and auditing standards (fourth and fifth EUduct searches, and seize documents. company law directives);Elaborate and complicated laws regulating * To introduce strict standards for bankssecurities markets are often accompanied incorporating capital adequacy rules, port-by weak enforcement. One concern, how- folio diversification requirements, andever, is that regulatory agencies may use insider lending restrictions (first and secondtheir power for political ends. EU banking directives);


* To introduce regulations on invest- cial service providers is the most effectivement funds similar to the EU directive on regulator.

A a result of mass undertakings for collecting investment in * The primary goal of regulation shouldprivatization in the transferable securities, but without Article be to increase informnation disclosure so that

25 on voting control limits; and investors can make the best possible deci-Czech Republic, * To introduce enabling statutes on sions-for example, by requiring compa-shares in many securities, market intermediaries, and self- nies to issue detailed financial statements,

companies are regulatory bodies similar to the UK Finan- funds to issue prospectuses, and stocktraded, but trading cial Services Act. exchanges to disclose prices at which shares

In drafting special securities market laws trade.is dominated by a or regulations, three principles should be * The government should vigorouslyfew large funds followed: exercise its police powers by discoveringw Regulation should promote competi- and prosecuting theft, fraud, insider deal-wvhose trades occur tion-not create a monopoly stock ing, and other criminal acts. The problemoutside of the exchange or lirmit the number of financial in many countries is not that the laws ororganized service providers. Actual or threat of com- regulations are inadequate, but that they areexchanges petition among exchanges and other finan- not enforced.


Country Studies

Development of capital markets has taken with only minimum disclosure require-quite different paths in the countries of the ments and market regulation.region. Table 4 gives data, where available, Available public information was aug-on organized stock exchanges that have been mented by the analyses undertaken by largeestablished in the region. In some, notably investment funds and by a learning processHungary and Poland, capital market devel- in the consecutive rounds of voucher auc-opment was emphasized early in the transi- tions. Unsophisticated small investors whotion process. One objective was to privatize did not transfer vouchers to the funds andenterprisesbysellingtheirsharesonthenew made their own investment decisions stillcapital markets. benefited from this analysis because the

Other countries, such as Russia, empha- funds bid up the prices of shares in attrac-sized rapid mass privatization and left tive companies and forced down prices fordevelopment of capital markets for later. unattractive ones.Though there are now more privately Investment funds arose spontaneouslyowned, joint-stock companies and share- when their sponsors saw a profitable oppor-holders in Russia than in almost any coun- tunity to attract voucherholders to partici-try in the world, Russia has a rudimentary pate in the funds. Many promised tocapital market. provide a high return on investments and to

exercise their ownership rights vigorously.Czech Republic After the funds appeared, the government

put in place a light-handed regulatoryThe emphasis in the Czech Republic was on regime to control some of their activities.rapid transfer of ownership from the state Banks established most of the large funds,to private citizens, mainly through voucher and these funds in turn became major own-privatization. Capital market development ers of the banks. Representatives of funds sitwas closely integrated with privatization. on supervisory boards of privatized compa-Privatization has been rapid, and the total nies and often on management boards.value of shares in private companies (mar- The secondary capital market has beenket capitalization) now approaches or shaped by two factors. First, a large numberexceeds that in many Western countries (see of companies were offered to the publicfigure 1). simultaneously. Second, about 75 percent

From the beginning, secondary trading of the adult population became investorsof shares was seen as the main vehicle for directly or through investment funds. Thusconcentrating ownership and thus for a securities market with a large tradingstrengthening corporate governance. Due capacity was required immediately.to the speed and scale of mass privatization, The government's main contribution tothe Czech Republic adopted a liberal the development of the capital marketapproach to the regulatory and disclosure infrastructure was to create a system whererequirements for firms included in the pro- ownership of shares was recorded in a cen-gram. Shares of 1,500 enterprises were tral, computerized share registry. Paper cer-offered in one initial public offering (where tificates were not used. This registrycitizens could use vouchers to buy shares) records any transfers of ownership and pro-


Table 4. Stock Exchanges in Central and Eastern Europe

Bratislava Ljublijana StockWarsaw Stock Budapest Stock Prague Stock Stock Stock Zagreb Stock Exchange of

Name Exchange Exchange Exchange Exchange Exchange Exchange Lithuania

Ownership Treasury plus Member banks 38 banks and Ministry of 45 including 24 banks, 2 insur- Ministry of28 banks and brokers Finance and government ance companies, Finance, banks,brokers central bank and central bank i oil comapny, investment, and

and 7 brokers other companies

Membership 49 brokers, 84 banks and 28 permanant 20 banks and 17 banks, 21 62 members1 bank brokers and 16 temporary 43 brokers brokers, 2 insur- with a right to

banks and brokers ance companies trade

Public companies 53 39 More than t,ooo More than 600 40 1,750

Traded 50 35 More than i,ooo, More than 600 17 38 102companies 37 listed

Capitalization $4 billion $1.7 billion $14 billion $2 billion $210 million $500 million $76 million for102 companies,$800 million for1,750 companies

Trading system Order-driven call Daily open outcry Call auction five Electronic contin- Twice a week Open outcry and Order-driven callauction five days and electronic days a week uous trading and open outrcy, elec- electronic trading market one daya week trading call auction tronic trading a week

other days

Clearing and Central share Central depository Subsidiary of the Organized by the To be created Informal Centralsettlement registry and cleaning exchange exchange depository

agency (Keler Ltd.)

Other securities Treasury bonds Government bonds Government and Government and Government andtraded T-bills, vouchers company bonds company bonds company bonds

Regulatory Securities Securities Ministry of Ministry of Finance Securities Securities com-authority commission commission Finance (a securities commission mission planned

and exchangecommission isplanned)

Other Member of the ioo other Trading also Trading also About go percentInternational companies traded occurs on RMS occurs on Brati- of trading isFederation of on over-the- system. About slava Options off-marketStock Exchanges counter market 80 percent of Exchange and RMS

trading is off- system. About 80market percent of trading

is off-market

Source: Publications of the exchanges, questionnaires provided by exchange officials, and author estimates.

vides each enterprise and fund with an up- pete with each other. The government hasto-date list of its shareholders. only recently required that prices of trades

Various securities markets emerged. made by the large funds outside the orga-These include the Prague Stock Exchange, nized exchanges be disclosed to the public.with restrictive rules of entry for both secu- In this way small investors know what therities and intermediaries; the RMS system, large, more sophisticated investors thinkwhich uses the infrastructure developed for the shares are worth.the voucher auctions and can be used bysmall investors without the assistance of Polandbrokers; and direct trading between large,sophisticated investors, such as investment In Poland, creation of capital markets infra-funds. structure and gradual privatization through

The government has adopted a hands- initial public offerings were seen as an inte-off approach to regulation and has allowed grated process. Offerings of medium-sizethe various markets and exchanges to com- and large companies to the public through


the stock market were assumed to be the region. Officials attempting to create capi-main method of privatization. The regula- tal markets must overcome a number oftion of the public offerings and trading on problems not found in other countries.the secondary market copied the high stan- First is the huge number of shareholders.dards of Western countries. Transparency Second is the country's large geographicand prudent behavior were the primary size and poor communications systems,objectives of privatization and secondary which mean that markets will likely be frag-trade design. mented or regional. Third is the relatively

Contrary to these early expectations, weak judicial system, which makes it diffi-sales to workers and managers have proba- cult for the government to enforce laws reg-bly been the most important method of pri- ulating capital markets.vatization. These sales were made by Mass privatization strongly favoredliquidating enterprises. A disturbing aspect workers and managers and has largely Though theof this method of privatization is that work- resulted in insider ownership. On average, Warsaw exchangeers may own enterprises collectively rather workers retain 50 percent of the equity,than individually. This could result in some managers 10 percent, and only 20 percent is perhaps the mostof the problems encountered in worker- of shares are held by outside investors developed in theowned enterprises in the former Yugoslavia (another 20 percent remains in state hands region, fewand some other countries of the region. and is being auctioned off). companies

Three years after the Warsaw Stock One concern is that managers may try to areExchange was established, only about fifty require that worker ownership be collective traded because ofcompanies' stocks are being traded-mainly rather than individual so that managers can the slow pace ofbecause of a slow privatization program and, maintain control. Thus there may be lim-perhaps, overly ambitious disclosure and ited tradability of company shares. This privatizatonfiduciary standards. Market trade is domi- could change, however, if workers insist onnated by short-term speculators. The War- selling shares to outsiders or if enterprisessaw Stock Exchange is currently the only face financial difficulties and have to turn tomarket that trades shares publicly. It is open banks or other large investors to provideto all licensed brokerage houses. new capital. Equity investors providing new

Market architecture may be changed and capital will insist on control over the com-volume of trade increased by the imple- pany and the right to sell their shares.mentation of the long-delayed mass priva- Greater outside ownership and control andtization program. This program envisages increased tradability of shares will be thethe creation of fifteen national investment price paid by insiders to survive (Blasifunds whose shares will be traded on the 1994).Warsaw Exchange. The assets of the funds On the institutional side, tradability haswould be the stock of about 500 companies, been hampered because each enterpriseaccounting for about 25 percent of Polish controls its own share registry. Some man-industry. These funds are also expected to agers have been accused of using the reg-sell shares of the individual companies in istry to block transfer of ownership totheir portfolio on the Warsaw Exchange. investors not favored by management. InAn over-the-counter market will probably any event, it is costly for a purchaser ofbe created to handle the large increase in shares to physically visit the enterprises tothe number of shares traded. register the transfer of ownership. More-

over, because no paper certificates areRussia issued, it may be difficult for a purchaser to

prove ownership.About 24,000 medium-size and large Russ- Recent decrees require firms to use inde-ian enterprises have been converted into pendent share registrars and depositories.joint-stock companies; some 16,000 of Though compliance is uncertain, this willthem have been transferred to private own- make it easier for insiders to sell shares andership through mass privatization. This is for outside investors (foreigners, banks,far more than in any other country in the funds, other enterprises) to buy.


Secondary trading of shares is decentral- meeting of shareholders. A new companyized, and only a little is carried out on the law is still under preparation. A more com-100 or so organized exchanges. Trading will plete discussion of recent developments inprobably consolidate in a smaller number of the Russian capital markets can be found in

Tbousands of regional exchanges, but a single national Morgenstern (1994) and Leeds and Har-

Russian companies exchange is unlikely. man (1994).Most trading is carried out off-market, Establishing regulations and rules of fair

have been mainly by brokers trying to assemble large trading by market intermediaries such as

privatized, but blocks of shares in particular companies. stock exchanges, brokers, and investment

trading is mostly These brokers typically buy from workers funds will also take time, but bankingwho received shares as part of mass privati- reforms have proceeded much more rapidlyon injonnzai zation. The brokers are often acting for than elsewhere in Eastern Europe (Pohl

markets betwen large outside investors or for managers who and Claessens 1994). Self-regulatory orga-

insiders and large wish to consolidate control over enter- nizations are likely to playa more importantinvestorsseeking prises. role in establishing and enforcing the rules

investors seek1ng One unresolved issue is the clarification of the market than in the Czech Republic

control of property rights of new shareholders, par- and Poland. Mendelson and Peake (1993)ticularly their ability to sell their shares and discuss the major choices.to exercise ownership rights in the general


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