Investor protection and the liquidity
of cross-listed securities: Evidence
from the ADR market
Huimin Chung
*Graduate Institute of Finance, National Chiao Tung University, Hsinchu 30050, Taiwan, ROC Received 22 March 2004; accepted 23 March 2005
Available online 14 July 2005
Abstract
Using ÔAmerican depository receiptÕ (ADR) data on various countries, this paper sets out to investigate the relationship between investor protection and firm liquidity. Since weak investor protection leads to greater expropriation by managers, and thus greater asymmetric informa-tion costs, liquidity providers will incur relatively higher costs and will therefore offer higher bid–ask spreads. The empirical results demonstrate that the liquidity costs of poor investor pro-tection were more significant during the period of the Asian financial crisis when the expected agency costs were particularly severe. This issue is further analyzed by investigating whether there is any evidence of increases in the vulnerability of ADRs of firms operating in countries with relatively poor investor protection mechanisms during periods of financial crisis. Ó 2005 Elsevier B.V. All rights reserved.
JEL classification: G10; G30
Keywords: Investor protection; Asymmetric information costs; ADR; Liquidity; Financial crises
0378-4266/$ - see front matter Ó 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2005.03.021
* Tel.: +886 3 5712121x57075; fax: +886 3 5733260.
E-mail address:[email protected]
1. Introduction
This study sets out to investigate the relationship between firm liquidity and the level of protection provided to investors. Since a good investor protection environ-ment will minimize the costs of information asymmetry, and thereby reduce the probability of trading against informed traders, liquidity providers will incur rela-tively lower costs and therefore offer narrower bid–ask spreads. Conversely, a weak-er investor protection environment with worse economic prospects will result in greater expropriation by managers, and thus, higher asymmetric information costs. Conducting effective tests of the relationship between cross-country differences in investor protection mechanisms and the liquidity of equities has proved to be extre-mely difficult because firms operating in distinct investor protection environments also trade in different exchanges. This study attempts to overcome this obstacle by using data on ADRs listed in both the NYSE and the NASDAQ, with the use of ADR data providing a good opportunity to examine the relationship between liquid-ity and investor protection levels.
Since US securities laws require greater disclosure than those required by the ADR listing firmsÕ home capital markets, US listing could provide potential improvements in information disclosure and might mitigate the problem of informa-tion asymmetry.1Coffee (1999), Stulz (1999)andReese and Weisbach (2002), argue that US listing enhances the level of protection for investors and reduces agency costs for the controlling shareholders; however,Siegel (2005)finds that cross-listing in the US did not deter Mexican firm insiders from expropriating corporate re-sources, demonstrating that listed ADRs do not always serve as an effective bonding mechanism for deterring malfeasance.Levine and Schmukler (2005) also report
re-sults that do not support the bonding hypothesis.2 Pineger and Ravichandran
(2004) show that cross-listing choices are much more complicated than the legal bonding hypothesis predicts.
Recent research has revealed the importance of the type of legal system governing an economy, in terms of the quality of the protection afforded to investors within that economy. In an examination of legislation covering the protection of corporate shareholders, ownership concentration and the quality of enforcement of the rele-vant laws in 49 countries around the world,La Porta et al. (1998)show that there are enormous differences in the level of legal protection provided to outside investors across these different countries. The protection of shareholders provided by the legal system of an economy is central to gaining a complete understanding of the patterns of corporate finance in different countries; indeed, investor protection turns out to be particularly crucial because there is extensive expropriation of minority shareholders and creditors by controlling shareholders.
1
Doidge et al. (2004) argued that cross-listing helps to secure the commitment of controlling shareholders to limit their expropriation of minority shareholders and increases the ability of firms to take advantage of growth opportunities.
2
The effects on asset values stemming from protective measures for minority share-holders have also been demonstrated to be significant in many other ways.3Beck et al. (2003) demonstrate that legal origin does have some significance on the financial development of a country, because legal traditions differ in their ability to adjust to changing commercial circumstances.Johnson et al. (2000), in particular, show that measures of the effectiveness of such protection can better explain the extent of exchange rate depreciation and stock market decline in the Asian financial crisis than standard macroeconomic variables. In a comparison of the liquidity of component stocks listed in the Heng Seng Index (HSI) and those of mainland China-related firms
listed in the Stock Exchange of Hong Kong,Brockman and Chung (2003)show that
the HSI constituents exhibit lower bid–ask spreads and greater depth than the stocks of China-related firms. Their results provide support for the assumption that stocks of firms operating in countries with strong investor protection mechanisms have greater liquidity than those of firms operating in poor protection environments.
The number of non-US stocks listed on the US exchanges has recently been on the increase and, as a result, research into the market microstructure of ADRs has re-cently gained much greater attention.Bacidore and Sofianos (2002) find that non-US stocks have higher spreads, less depth and greater transitory volatility than US stocks, and that the higher spreads of the non-US stocks come about mainly as a result of higher information asymmetry and increased adverse selection costs. To our knowledge, however, few studies have attempted to document the impact of country-level investor protection mechanisms on the liquidity of cross-listed secu-rities in the US. Following the research design ofBrockman and Chung (2003), this study aims to examine the hypothesis that the stocks of firms operating in countries with strong investor protection mechanisms have greater liquidity than those of firms operating in poor protection environments.
Clarke and Shastri (2001)return no significant results in their analysis of the effects of insider trading enforcement on ADR liquidity. In this paper, however, we aim to provide a more comprehensive analysis of the relationship between ADR liquidity and investor protection. In particular, we will explicitly analyze the impact of investor protection and the quality of law enforcement on ADR liquidity levels.
We further examine the issue by testing whether the ADRs originating from coun-tries with poor investor protection mechanisms were more vulnerable during the per-iod of the Asian financial crisis. Since weaker investor protection mechanisms and relatively poor economic prospects lead to greater expropriation by managers, and ultimately to greater asymmetric information costs, the optimal course of action for investors would be to sell off their holdings in countries with poor investor pro-tection mechanisms. This is explored by testing whether there was any stronger net selling pressure on the ADRs of those countries with poor investor protection mech-anisms during the period of the Asian financial crisis.
The results show that the ADRs of firms operating in countries with better inves-tor protection mechanisms, as well as higher quality law enforcement levels, had
3
both lower asymmetric information costs and higher liquidity. The empirical results demonstrate that the liquidity costs of poor investor protection are more significant during the periods of financial crisis when the expected agency costs are particularly extreme. This paper shows that even after cross-listing, home country investor protection regimes matter in determining information costs and liquidity, thus ques-tioning the extent to which ADR listing firms bond to US laws. Furthermore, the net-selling pressure during the period of the Asian financial crisis (as measured by the daily order imbalance) was stronger for the ADRs of countries providing poor investor protection, indicating the increased vulnerability of liquidity levels for firms where investors are provided with lower levels of protection.
Our results are consistent with the theoretical models of contagion of financial cri-ses, such asKodres and Pritsker (2002), which demonstrate that information asym-metry costs are a major factor in tradersÕ selling off of securities in a number of countries. If poor investor protection is the key to asymmetric information costs, then stocks afforded poor protection will be much more vulnerable to contagion during periods of financial crisis. During the Asian financial crisis, for example, the net-selling pressure on the ADRs of countries with weaker investor protection mechanisms was relatively stronger, providing a clear indication that the asymmetric information costs incurred during a period of financial crisis are much more severe for securities which are afforded relatively poor levels of protection.
The remainder of this paper is organized as follows. Section 2 provides a descrip-tion of the data and the research methodology adopted for this study. The penulti-mate section presents the empirical results, with the final section providing some concluding remarks drawn from this study.
2. Data source and research methodology 2.1. Data source
This study employs intra-day ADR trading data taken from the NYSE Trade and Quote (TAQ) database, whilst the current list of ADRs is obtained from the Bank of
New York website (www.adrbny.com). Similar to Clarke and Shastri (2001) and
Huang and Stoll (1996), we select the ADRs which had an average price in excess of $5.00 to control for the potentially extreme illiquidity. Following Bacidore and Sofianos (2002), we exclude stocks that have average daily number of trades less than two. The sample covers the ADRs of firms operating in 29 different countries and comprises of 204 ADRs traded on the NYSE and NASDAQ from April 1997 on-wards. The period under examination is from 1 July 1997 to 31 December 1997. A brief chronology of the Asian financial crisis is presented inKaminsky and Schmu-kler (1999), which also demonstrate that July–December 1997 was the crisis period for Asian countries only.
We delete all trades and quotes that are out of time sequence, as well as those which involve any errors. We also omit any quotes coming within the following three conditions: (i) where either the bid or the ask price is equal to, or less than, zero; (ii)
where either the bid or the ask depth is equal to, or less than, zero; and (iii) where either the price or volume is equal to, or less than, zero. The NASDAQ market is based on a competing dealer system in which each dealer continually posts firm bid and ask quotes on an electronic screen, and trades are typically double counted.
FollowingWeston (2000), for ADRs traded on the NASDAQ, the trading volume is
divided by two.
FollowingHuang and Stoll (1996), we attempt to further minimize data errors by eliminating quotes with the following characteristics: (i) all quotes with a negative bid–ask spread, or a bid–ask spread of greater than US$4; (ii) all trades and quotes which are either Ôbefore-the-openÕ or Ôafter-the-closeÕ; (iii) all Pttrade prices, where:
j(Pt Pt1)/Pt1j > 0.1; (iv) all atask quotes, wherej(at at1)/at1j > 0.1; and (v)
all btbid quotes, wherej(bt bt1)/bt1j > 0.1.
2.2. Measures of investor protection
We consider the following two measures of shareholder protection in the home country of a cross-listing firm, obtained fromLa Porta et al. (1998).
2.2.1. Anti-director rights
The anti-director rights index is calculated by aggregating the following six impor-tant shareholder rights, as reported inLa Porta et al. (1998). The index is formed by adding a value of 1 where: (i) the country allows shareholders to mail their proxy votes to the firm; (ii) shareholders are not required to deposit their shares prior to the general shareholdersÕ meeting; (iii) cumulative voting or proportional representa-tion of minorities in the board of directors is allowed; (iv) an oppressed minorities mechanism is in place; (v) the minimum capital shareholding which entitles a share-holder to call an extraordinary shareshare-holdersÕ meeting is equal to, or less than, 10% (the sample median); and (vi) shareholders have preemptive rights which can only be waived by a shareholdersÕ vote. The index ranges from zero to six.
2.2.2. Quality of law enforcement
The enforcement of investor protection laws has been shown to be an important factor in the development of an economyÕs equity market. A strong legal enforce-ment system can substitute for weak rules since active and well-functioning courts have the ability to step in and rescue investors abused by the management. In this study, the measure of the quality of law enforcement is the average of the five proxy variables employed inLa Porta et al. (1998): the efficiency of the judicial system, the rule of law, corruption, the risk of expropriation and the risk of contract repudia-tion. The index ranges from 0 to 10.
2.3. Measure of liquidity 2.3.1. Bid–ask spread and depth
The analysis of ADR liquidity covers two dimensions of liquidity: spread and depth. The following measures of trading costs are used in this study with each being
computed by using transaction data. They are then averaged for each security for each month of the sample. The percentage spread of ADR i at time t, Percentage Spreadit, is calculated as (Askit Bidit)/[(Askit+ Bidit)/2], where Askitand Bidit are
the respective intraday ask and bid prices at time t for ADR i.
As noted inStoll (2003), prior research has established that cross-sectional vari-ations in spreads can be explained by economic variables and that the relvari-ationship between the spread of a security and the trading characteristics of that security is one of the strongest and most robust relationships in finance.Demsetz (1968)shows that spreads are positively related to price and volume, whilst Stoll (1978) reports that spreads are positively related to volatility. Using TAQ data on ADRs traded on the NYSE,Clarke and Shastri (2001)find that the ADRs from the emerging mar-kets have higher spreads, greater adverse selection costs and less quote depth than those from the developed market.
In the analysis of the liquidity of ADRs, following Stoll (2000), the averages of each of the underlying variable are taken across all of the days in each month in order to reduce the errors associated with a single day. So as to control for the factors that might be important in determining the spread, we investigate the follow-ing regression model:
SPit ¼ b0þ b1Log Pitþ b2Log ritþ b3Log Vitþ b4Protiþ b5QLEiþ eit; ð1Þ
where SPitis the monthly average of the percentage spread for ADR i at month t; Pit
is the monthly average trading price; Vitis the monthly average trading volume; and
ritis the standard deviation of the quote midpoint for ADR i in the previous month.
Proti represents anti-director rights, which aggregates six important shareholder
rights for the country where the ADR i firm is operating. QLEi is the quality of
law enforcement in the home country of ADR i.4
This paper calculates the monthly averages, for ADR i, of percentage spread, trade price and trading volume, over the sample period from July 1997 to December 1997. The tests are based on pooled time-series cross-sectional data so as to maxi-mize the number of observations carried out in each test. The specifications assume that errors have a first-order moving-average structure, contemporaneous correla-tion and group-wise heteroskedasticity. A generalizacorrela-tion of the R-squared measure proposed byBuse (1973)is reported. For the sample of observations at T time points on each of N sectional units, the observations are arranged first by cross-sections, and then by time periods within the cross-sections. Since the analysis com-prises of six-monthly data, T corresponds to 6.
As noted by Lee et al. (1993), market liquidity has both a price dimension (the spread) and a quantity dimension (the depth). These dimensions show that liquidity providers are sensitive to changes in information asymmetry risks and use both
4
Our analysis does not encompass the effects of firm-specific governance attributes on the liquidity of ADRs, since no firm-level corporate governance scores are available for the period of the Asian financial crisis. Some firm-level corporate governance scores have been compiled by both Credit Lyonnaisse Asia and Standard and Poor, but whilst they are being increasingly applied to many studies, such asDurnev and Kim (2005), once again, these scores were not available for the period of the Asian financial crisis.
spread and depth to actively manage this risk. If the liquidity provider believes that the probability of some traders possessing superior information has increased for ADRs from countries with lower levels of investor protection, he may respond by increasing the bid–ask spread. Alternatively, the liquidity provider could protect himself by quoting lower depth. We extend the above analysis to ADR depth, whilst
also analyzing Eq. (1) for ADR depth. Following Brockman and Chung (1999),
which argue that dollar depth provides a more relevant measure of liquidity, we de-fine (dollar) depth as the number of shares at the highest bid and lowest ask price multiplied by their respective prices.
2.3.2. Information asymmetry component
In the literature on market microstructure, the bid–ask spread is modelled as aris-ing from three sources: adverse selection, order processaris-ing costs and inventory hold-ing costs due to risk aversion. The adverse-selection component compensates the market-maker for losses incurred on trades against informed traders. If weak inves-tor protection and poor economic prospects lead to greater expropriation by manag-ers, and thus higher asymmetric information costs, these costs may be inversely related to the extent of investor protection.
We go on to investigate the impact of investor protection on the adverse selection
components of the ADR bid–ask spread. Van Ness et al. (2001) compare several
structural models for estimating the adverse selection costs and conclude that no sin-gle model appear to perform better than any other; this paper employs the model of Lin et al. (1995)in this study, since it is the method most often used in practice.
The method of estimating components of effective spread developed byLin et al. (1995) is an extension of the model of Huang and Stoll (1994), which defines the signed effective half spread, zt, as the transaction price at time t, Pt, minus the spread
midpoint, Mt. The signed effective half spread is negative for sell orders and positive
for buy orders. In theLin et al. (1995)framework, the adverse selection and order persistence parameters are estimated from the following regressions:
Mtþ1 Mt¼ kztþ etþ1; and ztþ1 ¼ hztþ gtþ1; ð2Þ
where k is the proportion of the effective spread due to adverse selection, d = (h + 1)/ 2 is the order persistent parameter and et+1 and gt+1are random error terms. It is
important to note that the LSB (Lin et al., 1995) model measures the proportion of the effective spread attributable to adverse selection. Since the previous studies have found that the estimation results of adverse selection costs can vary signifi-cantly from one model to the next, we also employ the GKN (George et al., 1991) model to check the robustness of their decomposition results. George et al. (1991) allow expected returns to be serially dependent and propose the estimation of infor-mation asymmetry component using the following model:
2RDt¼ p0þ p1stðQt Qt1Þ þ Vt; ð3Þ
where RDtis the difference between mid-point return and transaction return at time
t; stis the percentage bid–ask spread; and Qtis a +1/1 buy–sell indicator at time t.
2.3.3. Net buy volume
2.3.3.1. Order imbalance. Information asymmetry is at the root of financial conta-gion in the theoretical model ofKodres and Pritsker (2002). In particular, any small panic-trading signal can become a precipitating factor for investors, leading to an overall loss of confidence and an increase in the perceived risk of holding a range of investments in different equities, with these countries ultimately being pushed into poor equilibrium and financial distress. This research investigates whether the net selling pressure on ADRs from countries with poor investor protection was greater during the period of the Asian financial crisis.
The research design aims to tackle the question of whether ADRs from countries with lower investor protection levels suffer from serious net selling pressure, or panic selling, during episodes of severe financial crisis. FollowingBailey et al. (2000), we analyze this issue by first applying the method proposed by Lee and Ready (1991) to classify the trade, and then calculate the cumulative daily net buying volume dur-ing the period from July to December 1997. This is undertaken first of all by com-paring the transaction price with the prevailing quotes, and then by classifying each transaction as a buyer-initiated or seller-initiated trade.
Our analysis of net-buying pressure adopts the relative measure of order imbal-ance, i.e., the ratio of buyer initiated volume to seller initiated volume. Although Chordia et al. (2002) provide a complete analysis of market order imbalance using time-series data, studies into the cross-sectional determinants of order imbalance are quite sparse. In addition to the volume and volatility variables, followingBailey et al. (2000), the return variable is employed as the control variable in our analysis of the ratio of buyer-initiated volume to seller-initiated volume. Hence, we explore the monthly net-buying pressure for the six-month period from July to December 1997 in the following model to test the relationship between net-buy volume and investor protection during the period of the Asian financial crisis:
ðBUY -V =SELL-V Þit¼ d0þ d1Retitþ d2LogVitþ d3Logritþ d4Protiþ d5QLEiþ eit;
ð4Þ where the dependent variable is the ratio of buyer initiated volume (BUY-V) divided by seller initiated volume (SELL-V) for ADR i in month t. Retitis the average daily return
for a given month, t. Vitis the average daily trading volume in month t. ritis the
vol-atility (standard deviation of return) for ADR i in month t. Protirepresents the
anti-director rights, which aggregate six important shareholder rights for the country in which ADR firm i is operating, and QLEiis the index of the quality of law enforcement.
We hypothesize that since weak investor protection and poor economic prospects lead to greater expropriation by managers, and thus larger asymmetric information costs, it would be optimal for investors to sell off their securities holdings from coun-tries with poor investor protection mechanisms. Hence, ADRs from councoun-tries where Protiis low will tend to have high net selling pressure, i.e., a small
(BUY-V/SELL-V)it value. In general, positive signs will be observed for d4and d5if ADRs from
countries with poor investor protection mechanisms suffer from serious net selling pressure during a period of financial crisis.
2.3.4. Asymmetric depth
If, during periods of financial crisis, the probability that some traders possess superior information increases for ADRs from countries with lower investor protec-tion levels, the liquidity provider could protect himself by quoting a relatively lower bid depth. We can therefore use asymmetric depth as an alternative measure of net selling pressure, since this measure may have a greater correlation to adverse selec-tion costs than average depth.Huang and Stoll (1994)analyze the effect of depth at the ask to the depth at the bid on quotes returns and price returns. Following Brock-man and Chung (1999), we use dollar depth in the calculation of asymmetric depth (AsyDep), which is defined as the dollar depth at the best bid price divided by the dollar depth at the best ask price.
We calculate the average asymmetric depth for each month for each ADR and explore the following regression model:
AsyDepit ¼ b0þ b1Retitþ b2Log ritþ b3Log Vitþ b4Protiþ b5QLEiþ eit. ð5Þ
The tests are based on pooled time-series cross-sectional regression that assumes that errors have a first-order moving-average structure, contemporaneous correlation and group-wise heteroskedasticity. In general, positive values for b4and b5would
indicate that ADRs from countries with better investor protection mechanisms receive relatively greater submissions of limit orders from the buy side.
3. Empirical results 3.1. Descriptive statistics
Table 1reports the average values of the percentage spread, asymmetric informa-tion costs, mean price, trading volume and volatility; Panel A provides the summary statistics for each legal origin, whilst Panel B provides the summary statistics for each country. The asymmetric information costs are estimated by using the methods proposed byLin et al. (1995).
As demonstrated byLa Porta et al. (1998), legal protections for outside investors vary considerably across countries, with common law countries tending to provide much higher levels of protection than civil law countries; we thus calculate the aver-age percentaver-age spread and asymmetric information costs for ADRs from each legal origin. Preliminary analysis ofTable 1shows that the average percentage spread of ADRs for firms from French civil law countries is higher than that for firms from English common law countries. The average percentage spread for ADRs of firms operating in common law countries is 0.0146, whilst that for ADRs of firms operat-ing in French civil law countries is 0.0162.Table 1also presents the average value of asymmetric information costs for each legal origin, and for each country.
Rather interestingly, Panel A shows that average asymmetric information costs of ADRs from French civil law countries is 0.5955, which is 12% higher than that of firms from English common law countries, whilst Panel B shows that the highest asymmetric information costs is 0.7098 for ADRs from Venezuela, a country which
has an anti-director rights score of 1. Furthermore, the average asymmetric informa-tion costs are in excess of 60% for ADRs from countries with protecinforma-tion scores of 1, such as Germany, Italy, Mexico and Venezuela. In summary, the results from Table 1
Summary statistics, by origin of law and by country
Legal origin/country No. of ADRs Average values across ADRs Percentage spread Information asymmetry costs Price Volume S.D. (daily return) Panel A: By legal origin
England 67 0.0146 0.4742 36.67 92395.33 0.02052 France 112 0.0162 0.5955 32.26 164246.47 0.01937 Germany 17 0.0144 0.5099 44.22 71227.41 0.02146 Scandinavia 8 0.0101 0.4644 37.51 145219.87 0.01790 Panel B: By country Argentina 9 0.0116 0.5868 31.77 239230.11 0.01350 Australia 3 0.0097 0.5569 45.56 23254.36 0.01382 Brazil 2 0.0118 0.5883 29.17 204266.19 0.01182 Chile 19 0.0182 0.6523 25.83 166283.57 0.01669 Denmark 2 0.0120 0.5618 39.95 60243.85 0.01317 France 12 0.0105 0.4461 38.05 81248.82 0.01817 Germany 3 0.0158 0.6108 25.96 87429.49 0.02522 Hong Kong 3 0.0196 0.5773 22.06 74937.25 0.02222 Indonesia 4 0.0228 0.5850 18.66 59319.74 0.03433 Ireland 5 0.0151 0.4947 41.06 71643.79 0.01671 Israel 1 0.0211 0.4322 18.65 7304.55 0.02225 Italy 10 0.0200 0.6310 33.09 116642.24 0.01978 Japan 8 0.0095 0.4411 70.29 29747.49 0.01788 South Korea 3 0.0212 0.5569 18.94 208251.79 0.02577 Mexico 25 0.0234 0.6710 19.13 203065.37 0.02245 Netherlands 17 0.0094 0.5436 55.97 228722.76 0.01860 Norway 2 0.0058 0.6170 55.88 59225.38 0.01574 New Zealand 4 0.0120 0.4500 29.47 35556.82 0.01310 Peru 3 0.0208 0.5456 16.46 155744.44 0.02065 Philippines 1 0.0101 0.6624 34.27 141426.15 0.01522 Portugal 3 0.0107 0.5809 31.59 47182.20 0.02342 South Africa 5 0.0205 0.3767 22.46 47067.45 0.02011 Singapore 2 0.0216 0.4301 14.82 83248.74 0.02928 Spain 6 0.0121 0.5211 44.04 68702.47 0.01545 Sweden 4 0.0113 0.2924 27.11 230705.13 0.02135 Switzerland 2 0.0225 0.5919 15.82 17404.60 0.01895 Taiwan 1 0.0134 0.4202 23.12 51033.08 0.03099 United Kingdom 44 0.0139 0.4718 40.23 119739.38 0.02269 Venezuela 1 0.0072 0.7098 44.07 267447.69 0.01816
Notes: The table contains summary statistics for our sample of ADRs for July–December 1997. Percentage spread, information asymmetry costs, daily trading volume and standard deviation are calculated for each company using the NYSE trade and quote databases. Reported values are the average values for each origin of law or country. Asymmetric information costs are calculated using the method proposed byLin et al. (1995).
Table 1indicate that the average liquidity of ADRs from English common law coun-tries is higher than that of ADRs from French civil law councoun-tries.
We also conduct the analysis for the correlation matrix of various liquidity mea-sures and investor protection variables. The results are omitted for saving space. We find that percentage spread is positively related to information asymmetry costs and is negatively related to depth. Furthermore, percentage spread and information asymmetry costs are negatively related to both of the investor protection variables, quality of law enforcement and anti-director rights. Two other related measures of investor protection, accounting standards and the emerging market dummy are clo-sely related to the quality of law enforcement. As noted byLa Porta et al. (1998), richer countries have a higher quality of law enforcement. We also find that the dummy variable of emerging countries has a negative correlation with the quality of law enforcement. Both accounting standards and the emerging market dummy demonstrate a significant correlation with percentage spread and information asym-metry costs.
3.2. Impacts on liquidity
It is already well documented that important stock characteristics such as price, volatility and volume may have an effect on spread. This issue is examined in this study by using a multivariate regression approach similar to that used by Stoll (2000)andBrockman and Chung (2003).Table 2presents the regression results from the sample data comprising of average liquidity measures and related variables for the ADRs for each month from July to December 1997. We use three multivariate specifications to examine the relationship between shareholder protection levels and ADR liquidity.
In the first regression, in addition to anti-director rights and the quality of law enforcement, three other important variables, the average trade price, the average daily trading volume and the standard deviation of returns, are also used as explanatory variables. Since the analysis covers 204 ADRs and each ADR has six monthly observations, the total number of observations is 1224. The second regression adds a dummy variable, DASIA, which takes a value of 1 if the company is operating in Asia; otherwise 0. This variable aims to control for the cross-sec-tional differences in liquidity that might arise simply because the company is oper-ating in Asia. In the third regression, in order to control for the potential differences in liquidity between the NYSE and NASDAQ, we use a dummy
vari-able, DEXCH, which takes a value of 1 if the ADR is listed in the NASDAQ,
and 0 if it is listed in the NYSE.
We find, from regression(1), that the percentage spread has a negative relation-ship with price and trading volume, but a positive relationrelation-ship with volatility. These results are consistent with the earlier studies, such asStoll (2000) andClarke and Shastri (2001). The regression coefficients for anti-director rights and the quality of law enforcement are0.037 and 0.023, respectively and significant at 5% level, indicating that after controlling for price, trading volume and volatility, the ADRs of companies operating in a good investor protection environment tend to have lower
percentage spreads. The negative relationship is consistent with our theoretical pre-diction that as the rights attached to securities become critical, company managers will act in their own interest; therefore, where there are weak investor protection lev-els and worse economic prospects, there will be greater expropriation by managers, and thus, wider spreads and higher asymmetric information costs.
The results of regression(2)indicate that the ADRs of firms operating in Asia do not have a higher quoted percentage spread than non-Asian ADRs; thus, Asian ADRs did not exhibit lower liquidity levels during the period of the Asia financial crisis. In regression (3), the exchange dummy variable is negatively significant at the 1% level, indicating that there are salient differences between the liquidity levels of ADRs listed in the NYSE and the NASDAQ. In general, we find that after con-trolling for price, volatility, trading volume and stock exchange difference, there are wider spreads amongst the ADRs from weak investor protection countries.
As reported inTable 2, the estimated coefficient of the exchange dummy variable is significant; however, it would seem inappropriate to relate these results to the dif-ference in trading mechanisms, because the relatively small number of NASDAQ ADRs does not represent a good comparable base. More specifically, the sample of 204 ADRs used in this study contains only 42 NASDAQ ADRs.
Table 2
Regression results of percentage spread on firm characteristics and investor protection: July 1997– December 1997
(1) (2) (3)
Coefficient t-Value Coefficient t-Value Coefficient t-Value
Intercept 8.948*** 39.266 8.967*** 38.925 9.549*** 41.390 Log Pa 0.979*** 33.712 0.980*** 33.685 0.987*** 35.124 Log Vb 0.197*** 16.958 0.196*** 16.816 0.217*** 18.922 Log rc 0.226*** 9.599 0.228*** 9.584 0.289*** 12.111
Quality of Law Enforcement 0.023**
1.993 0.024** 2.051 0.005* 1.735 Anti-director Rights 0.037*** 3.151 0.036*** 3.121 0.019* 1.957 DASIAd – – 0.040 0.559 0.042 0.612 DEXCHe – – – – 0.320*** 5.435 Observationsf,g 1224 1224 1224 R2 0.690 0.692 0.714
Notes:***,**, and*indicate significance at the 1%, 5%, and 10% level, respectively.
a
P is the average trade price.
b
V is the average daily trading volume.
c
ris the standard deviation on daily returns for ADRs in the previous month.
d
DASIAis a dummy variable which is equal to 1 for companies operating in Asian countries; otherwise 0.
e
DEXCHis a dummy variable which is equal to 1 for NASDAQ-listed ADRs, and 0 for NYSE-listed ADRs.
f
The tests are based on pooled time-series cross-sectional data so as to maximize the number of observations for each test. The specifications assume that errors have a first-order moving-average structure, contemporaneous correlation and group-wise heteroskedasticity.
g
The sample period is from 1 July 1997 to 31 December 1997 and the dependent variable is the monthly average percentage spread, whilst monthly averages of price, volume and volatility are used as explanatory variables.
As a check for robustness, the regression models are also analyzed for ADRs excluding those from UK and Mexico. Since the UK and Mexico are the two countries with the highest number of ADRs, this analysis can help to provide an understanding of whether the results in Table 2are dominated by ADRs originat-ing from either Mexico or the UK. Mexico is ranked in the governance literature as providing relatively weak legal protection for outside investors; indeed, asSiegel (2005)demonstrates, US law enforcement neither prevented nor punished a group of Mexican firm insiders that expropriated corporate resources. In fact, the results
for ADRs excluding those from UK and Mexico are very similar to those inTable
2. Since the results are rather similar, they are omitted for the purpose of space saving.
Our results inTable 2provide further evidence on the effects on the liquidity of equities based upon legal origin, and provide some general support for recent find-ings that cross-country differences in legal origin help to explain variations in finan-cial development. Beck et al. (2003)find that legal origin is important to financial development because legal traditions differ in their ability to adapt efficiently to evolving economic conditions. Indeed, an influential strand of the comparative law literature holds that common law evolves more efficiently since judges respond to unforeseen and changing conditions on a case-by-case basis. Our results demon-strate a relationship between cross-sectional differences in the percentage spread of ADRs and cross-country differences in investor protection.
We also analyze the relationship between investor protection and quote dollar depth of ADRs. As the main results are very similar to those reported in Table 2, the results are omitted for saving space. We find that quote depth has a negative relationship with volatility, but positive relationships with both price and trading volume. The market depth of ADRs also appears to be affected by investor protec-tion levels. The quality of law enforcement does not have any significant impact on depth, which may be due, in part, to the fact that average depth is not perfectly cor-related to asymmetric information costs. However, asymmetry depth, as measured by the ratio of bid-depth to ask-depth, may provide a better measure. This issue is investigated more carefully later in this section.
A good investor protection environment minimizes the costs of information asym-metry and reduces the probability of trading against informed traders. Hence, the above test can be directly analyzed into the asymmetric information costs. The pooled cross-sectional, time series (CSTS) regression results on the relationship be-tween adverse selection costs and ADR characteristics are presented in Table 3, which shows that asymmetric information costs have a negative correlation with trading volume and a positive relationship with volatility. The smaller number of observations for the regression sample of information asymmetry costs is mainly due to the failure of the methods ofLin et al. (1995)andGeorge et al. (1991)to pro-duce reasonable estimates of information asymmetry components for some ADRs. We delete those ADRs with estimates of information asymmetry components which are greater than 1 or less than 0.
As inClarke and Shastri (2001), price is not an important factor in terms of its effects on the asymmetric information components of ADR spreads. The dummy
variable, DASIA, is not significant, indicating that there are no differences between the asymmetric information costs of Asian and non-Asian ADRs.
The GKN method is also applied to calculate the information asymmetry costs for each ADR, with the regression results based on this method being reported in Table 3. As the table shows, these results are the same as those of the LSB method. Furthermore, with all control variables included, the coefficients of the investor pro-tection variables are significant at the 1% level for both of the information asymme-try models. In particular, the estimated coefficient of Ôanti-director rightsÕ is 0.014, indicating that one point increase in the Ôanti-director rightsÕ score represents a 1.4% reduction in the information asymmetry component of the bid–ask spread.
Mitton (2002) provides a comparison within countries between those companies which issue ADRs and those that do not, whereas this study focuses on a compari-son between ADRs from various countries; thus, our results do not necessarily con-tradict those ofMitton (2002).MittonÕs (2002)results show that in certain countries, during the period of the Asian financial crisis, the share prices of companies issuing ADRs were higher than comparable domestic companies with no ADR issues, whereas this paper finds differences in liquidity between ADRs from various countries.
In order to test the robustness of the results, we conduct further empirical studies of the effects on the liquidity of ADRs from accounting standards and the emerging market dummy; the results of these additional regressions are presented inTable 4. The analysis is conducted by performing purely cross-sectional regressions, as op-posed to the pooled cross-sectional, time series (CSTS) regressions reported in the previous sections. The CSTS approach yields more observations, but its estimated coefficients can be more influenced by a few extreme observations. If the proposed relationship between investor protection and liquidity is strong, then it should also Table 3
Regression results of asymmetric information costs on firm characteristics and investor protection during the Asian financial crisis
LSB (1) LSB (2) GKN (1) GKN (2)
Coeff. t-Value Coeff. t-Value Coeff. t-Value Coeff. t-Value
Intercept 0.872*** 14.937 0.897*** 17.490 0.570*** 12.672 0.577*** 15.959 Log P 0.014 1.594 0.007 0.956 0.016 1.493 0.019* 1.896 Log V 0.006* 1.665 0.016*** 4.692 3.543*** 10.071 1.844*** 6.341 Log r 0.868** 2.234 0.835** 2.058 0.030*** 9.942 0.021*** 8.722 Quality of Law Enforcement 0.027*** 7.068 0.019*** 5.417 0.016*** 5.342 0.006** 2.504 Anti-director Rights 0.022*** 5.859 0.014*** 4.034 0.014*** 4.800 0.007*** 2.818 DASIA 0.004 0.186 0.018 0.883 0.097** 2.477 0.088** 2.066 DEXCH – – 0.114*** 3.514 0.120*** 3.125 Observations 1152 1152 1164 1164 R2 0.251 0.305 0.381 0.421
Notes: The sample period is from 1 July 1997 to 31 December 1997, and the dependent variable is adverse selection costs calculating using the method ofLin et al. (1995, LSB)and the GKN method ofGeorge et al. (1991).
show up in purely cross-sectional regressions. Hence, the analysis is further explored for the average percentage spread over the period July 1997–December 1997.
Model(1)ofTable 4presents the results of the purely cross-sectional regressions. The estimated coefficients of the quality of law enforcement and anti-director rights variables are both significant at the 5% level. The t-statistics are computed from the heteroskedasticity robust standard errors followingWhite (1980). The second regres-sion model presented inTable 4presents the results when adding the emerging mar-ket dummy variable, indicating that the quality of law enforcement is no longer significant. This is to be expected since emerging markets tend to have a lower qual-ity of law enforcement; these two variables are highly correlated.
Since many studies have employed accounting standards as an alternative mea-sure of investor protection, we also examine the effects of accounting standards on the liquidity of ADRs. The related results are given in models(3) and (4)of Table
4, which shows that accounting standards has a negative relationship with ADR
liquidity; however, the result is not significant, even at the 10% level. Furthermore, when the variable, Ôquality of law enforcementÕ, is added, the accounting standard variable has little impact on ADR liquidity. This is consistent with Johnson et al. (2000), which demonstrate that the rating of accounting standards has little effect in terms of explaining the exchange rate depreciation during the 1997–1998 financial crisis period.
3.3. Results for the post-financial crisis period
In order to determine whether our results may be sensitive to the sample period under examination, our test is extended to cover analysis of the post-Asian financial
Table 4
Relationship between percentage spread, accounting standards and trading characteristics, July–December 1997
(1) (2) (3) (4)
Coefficient t-Value Coefficient t-Value Coefficient t-Value Coefficient t-Value Intercept 8.583*** 16.122 7.862*** 12.649 8.400*** 15.523 8.585*** 15.580 Log P 0.958*** 15.112 0.948*** 15.041 0.998*** 16.848 0.959*** 14.991 Log V 0.195*** 8.316 0.202*** 8.633 0.188*** 8.105 0.195*** 8.294 Log ra 0.140*** 2.501 0.132** 2.368 0.126** 2.255 0.140** 2.492 Quality of Law Enforcement 0.056** 2.220 0.020 0.459 0.056* 1.739 Anti-director Rights 0.055** 2.358 0.062*** 2.668 0.056** 2.379 0.055** 2.317 DEMERb 0.298** 2.188 Acc Stdc 0.006 1.616 0.002 0.115 Observationsd 204 204 204 204 R2 0.760 0.766 0.757 0.761
Notes:***,**, and*indicate significance at the 1%, 5%, and 10% level, respectively. a ris the standard deviation on daily returns for ADRs.
b DEMERis a dummy variable which is equal to 1 for companies operating in Asian countries; otherwise 0. c ÔAcc StdÕ is the rating of accounting standards reported inLa Porta et al. (1998).
d Total number of observations is 204. The dependent variable is the average percentage spread over the period July
crisis, so as to provide some reasonable assurances that the current results do not dis-appear as soon as we focus on a period in which there is no financial distress. We therefore present further results on the impact of investor protection on ADR liquid-ity for the post-financial crisis period from February 1999 to December 2001.5
In this extended study, to ensure that the huge intraday data is more manageable, we analyze the intra-day data of the closing half hour (3:30–4:00 pm), employing the same data filtering method as was described in Section 2. The average percentage spread and information asymmetry costs are calculated for the period from February 1999 to December 2001. The analysis for the post-financial crisis period is conducted by performing purely cross-sectional regressions and the results are presented in Table 5which shows that the effects on the liquidity of equities from price, volatility and trading volume are the same as those presented inTable 2. The smaller number of observations for the information cost regression is due to the failure of the Lin et al. (1995) method to produce reasonable estimates for information asymmetry costs in some cases. Although the estimated coefficients of the anti-director rights and quality of law enforcement variables remain negative throughout this period, the coefficient of the former is no longer significant, whilst that of the latter is signif-icant only at the 10% level.
The effects of the anti-director rights and quality of law enforcement variables are somewhat stronger on information asymmetry costs than on percentage spreads, whilst the results in Panel B ofTable 5reveal that asymmetric information costs will tend to be higher in relatively poor investor protection environments because weak investor protection mechanisms lead to higher asymmetric information costs.
A comparison of the results in Tables 2 and 5shows that the liquidity costs of poor investor protection are more significant during periods of financial crisis. Since poor economic prospects during financial crisis periods will tend to lead to greater expropriation by managers, and thus greater asymmetric information costs, the im-pact of investor protection on the liquidity of equities may be more significant when expected agency costs are particularly severe.6 Since this analysis covers only the closing half-hour intra-day data, we also conduct the same analysis using full day intra-day data for the year 2000; since the results are rather similar, they are omitted for the purpose of space saving.
Although US listing may bring improvements in information disclosure, and thereby reduce the problem of asymmetric information, our results show that there are significant cross-country differences in ADR information asymmetry costs. The results indicate a clear link between ADR liquidity levels and external governance mechanisms, measured by the extent to which the laws of the ADRÕs home country
5
Since the financial crisis in Brazil was observed in January 1999, our analysis of the post-financial crisis period starts from February 1999.
6
For the period of 1999–2001, the relationship between the investor protection variables and ADR liquidity might be weaker due to the improvement in corporate governance in recent years. For example, Taiwan revised their corporate laws in recent years. See alsoDenis and McConnell (2003, p. 26)for the recent improvement in investor protection and convergence in corporate governance system around the world.
can protect investor rights, and the extent to which those laws are enforced. Our analysis of the data for the periods both during and after the financial crisis indicates that the relationship is stronger for the financial crisis period when expected mana-gerial agency costs are higher.
3.4. Net-buying pressure during the period of the financial crisis
We further analyze the relationship between investor protection and firm liquidity by investigating whether net-selling pressure was any stronger on ADRs from coun-tries with poor investor protection mechanisms during the period of the Asian finan-cial crisis. The results for net buying volume are presented in Table 6, where the Table 5
Regression results of percentage spread and asymmetric information costs on firm characteristics and investor protection: 1999–2001
(1) (2)
Coefficient t-Value Coefficient t-Value
Panel A: Percentage spread
Intercept 10.469*** 26.074 9.871*** 21.867 Log Pa 0.522*** 13.490 0.519*** 13.530 Log Vb 0.305*** 19.918 0.297*** 19.252 Log rc 1.158*** 12.824 1.003*** 9.528
Quality of Law Enforcement 0.036* 1.727 0.046** 2.220
Anti-director Rights 0.011 0.795 0.004 1.106
DEXCHd 0.205*** 2.796
Observations 346 346
R2 0.740 0.745
Panel B: Asymmetric information costs
Intercept 0.603 1.485 1.362*** 7.816 Log P 0.001 0.045 0.003 0.188 Log V 0.039*** 3.884 0.049*** 7.834 Log r 0.182 1.377 0.164 1.227
Quality of Law Enforcement 0.035***
3.661 0.017** 2.218 Anti-director Rights 0.015** 1.983 0.012 1.354 DEXCH 0.051 0.834 Observationse 321 321 R2 0.262 0.392
Notes:***,**, and*indicate significance at the 1%, 5%, and 10% level, respectively. a P is the average trade price.
bV is the average daily trading volume.
cris the standard deviation on daily returns for ADRs.
dDEXCHis a dummy variable which is equal to 1 for NASDAQ-listed ADRs, and 0 for NYSE-listed
ADRs.
eThe sample period is from 1 February 1999 to 31 December 2001, and the dependent variables in
Panels A and B are the average percentage spread and adverse selection costs, respectively. The t-statistics are computed from the heteroskedasticity robust standard errors followingWhite (1980).
dependent variable is the buy-to-sell volume ratio, calculated as the total buy-volume divided by the total sell-volume at month t. We add the explanatory variables Reti
and Viin order to control for the potential effect of trade initiation being dependent
on return and volume. Since the coefficient of Retiis positive, this demonstrates that
trades tend to be initiated by buyers when the average return on ADR i is high. Since the dependent variable in first regression model ofTable 6is the buy-volume versus the sell-volume ratio, positive coefficients on the investor protection variables would reveal higher buying pressure on ADRs with good protection levels. Our re-sults indicate that the coefficient of anti-director rights is positive; hence, ADRs orig-inating from countries with poor investor protection mechanisms tended to suffer from serious net-selling pressure during the period of the Asian financial crisis. The results support our hypothesis that during such periods of financial distress, net-selling pressure will tend to be observed for the ADRs of firms operating in poor investor-protection countries.
The second regression model in Table 6 presents the regression results for the dependent variable, asymmetric depth, which is calculated as the dollar depth at the bid price divided by the dollar depth at the ask price. The estimated coefficient of the dummy variable, DASIA, is negative, which indicates the provision of lower bid-depth for Asian ADRs. The relative submission of best buy-order to best
Table 6
Regression results of net-buying pressure and asymmetric depth on firm characteristics and investor protection
Net-buying pressure Asymmetric depth
Coefficient t-Value Coefficient t-Value
Intercept 0.298 0.833 0.944** 2.335 Reta 5.989** 1.974 20.800*** 4.246 Log Vb 0.080* 1.828 0.054 1.571 Log rc 0.080*** 3.048 0.040* 1.891
Quality of Law Enforcement 0.030* 1.756 0.035* 1.902
Anti-director Rights 0.065*** 2.813 0.053** 2.501
DASIAd 0.067 0.633 0.305** 2.390
DEXCHe 0.133 1.087 0.309*** 3.772
Observationsf 1224 1224
R2 0.063 0.157
Notes:***,**, and*indicate significance at the 1%, 5%, and 10% level, respectively.
a
Ret is the average daily return.
b
V is the average daily trading volume.
c
ris the standard deviation on daily returns for ADRs.
d
DASIAis a dummy variable which is equal to 1 for companies operating in Asian countries; otherwise 0.
e
DEXCHis a dummy variable which is equal to 1 for NASDAQ-listed ADRs, and 0 for NYSE-listed ADRs.
f
The sample period is from July 1997 to December 1997, and the dependent variables are the net-buying pressure and asymmetric depth, respectively. The net-buying pressure is calculated as the ratio of buyer initiated trading volume to seller initiated trading volume. Asymmetry depth is defined as the dollar depth at the bid side divided by the dollar depth at the ask side.
sell–order in the limit order book is positively related to the return, whilst trading volume is negatively related to asymmetric depth. The results show that the coeffi-cients of the quality of law enforcement and anti-director rights variables are both positive, which suggests the receipt of a relatively greater level of submissions of limit orders from the buy side for ADRs from countries with good investor protection mechanisms.
The relative bid depth provided by liquidity suppliers seems to be lower for ADRs operating in countries with poor investor protection mechanisms. The results thus provide evidence to suggest that ADRs originating from poor investor protection countries receive a higher portion of their limit orders from the selling side, which would also suggest that selling pressure in crisis periods might be higher for ADRs that are afforded poorer levels of investor protection.
4. Conclusions
This paper links ADR liquidity levels to external governance mechanisms, which are measured by the extent to which a countryÕs laws protect investor rights, and the extent to which those laws are enforced. Asymmetric information costs will tend to be higher in relatively poor investor protection environments because weak investor protection mechanisms and poor economic prospects lead to greater expropriation by managers, and thus higher asymmetric information costs. In an attempt to over-come the problem of the tendency of firms from distinct investor protection environ-ments trading in different exchanges, this study investigates the relationship between investor protection levels and firm liquidity by using data on ADRs. The aim is to provide empirical analysis of the relationship between the liquidity of cross-listed securities and country-level investor protection mechanisms.
Despite the fact that US listing may provide potential improvements in the area of information disclosure, and thus mitigate the problem of information asymmetry, our results reveal that the ADRs of firms operating in good investor protection environ-ments tend to have both lower information asymmetry costs and higher liquidity levels. This finding questions the bonding hypothesis that legal protections provided by cross-listing are effective enough to cause firms to change their governance struc-ture. The liquidity costs from poor investor protection are more significant during peri-ods of financial crisis, when the expected agency costs are particularly severe. Our results further show that ADRs with poor investor protection receive a higher portion of their limit orders from the selling side. The supply of bid depth relative to ask depth, by dealers or market-makers, is positively related to investor protection levels, indicat-ing that sellindicat-ing pressure durindicat-ing a crisis period seems to be higher for ADRs originatindicat-ing from countries with relatively weak investor protection mechanisms.
Our results also suggest a need for improvement in corporate governance around the world towards a more effective mechanism in protecting minority shareholders. Furthermore, as microstructure data becomes more available for emerging markets, in order to further analyze this issue, future research can compare liquidity of ADRs to that of comparable domestic companies that did not list as ADRs.
Acknowledgements
The author would like to acknowledge the constructive comments offered by two anonymous referees, Robin Chou, and the seminar participants at European Finan-cial Management Association 2004 Annual Meeting, National Taiwan University, National Tsing Hua University, and National Kaohsiung First University of Science and Technology. The financial support of the National Science Council of Taiwan is also gratefully acknowledged.
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