Effect on stocks due to moving to digital trading, Thesis of Financial Economics

Download Effect on stocks due to moving to digital trading and more Thesis Financial Economics in PDF only on Docsity! Strathmore UNIVERSITY ‘eit EFFECT OF ONLINE TRADING ON RETURNS IN THE STOCK MARKET: IS THERE A POSITIVE PRICE REACTION WHEN STOCKS MOVE FROM FLOOR TO ELECTRONIC TRADING ON THE NAIROBI STOCK EXCHANGE ANDREW KANIA (087733) Submitted in partial fulfillment of the requirements for the Degree of BBS Financial Economics at Strathmore University Strathmore Institute of Mathematical Sciences Strathmore University Nairobi, Kenya June 2018 DECLARATION I declare that this work has not been previously submitted and approved for the award of a degree by this or any other University. To the best of my knowledge and belief, the Research Proposal contains no material previously published or written by another person except where due reference is made in the Research Proposal itself. © No part of this Research Proposal may be reproduced without the permission of the author and Strathmore University Name: Andrew Kania Signature: 0.0000... cee Date: 00... e cece eset eeee This Research Proposal has been submitted for examination with my approval as the Supervisor. Signature: Date 00... coos ceee ee eseee tees eeeneeeeteeeeteeees Strathmore Institute of Mathematical Sciences Strathmore University 1.0 INTRODUCTION 1.1 Background Information Stock Exchanges are accurately named. Essentially, they are organizations where money can be exchanged for securities or securities for money. It is for this reason that they are often referred to as capital markets, since it is in capital that their dealings really consist. The Stock Exchange itself never buys or sells securities but is an association which provides facilities and rules under which its members can deal in securities with each other (Simmons, 2014). The trading of stocks dates back all the way to 1792 where a dozen group of menin New York made it their business to deal in bonds and stocks and has since then been adopted by many countries all over the world as globalization gradually came into effect. Companies in Nairobi, Kenya didn’t fall too far behind the band wagon of indulging in stock exchange since the Nairobi Stock Exchange (NSE) was registered under the Societies Act (1954) as a voluntary association of stockbrokers and charged with the tesponsibility of developing the securities market and regulating trading activities( (Exchange, n.d.). Prior to being officially registered, dealing in shares commenced with trading on a gentleman's agreement with no physical trading floor nor electronic trading platforms. The NSE, over the years, has seen subtle developments in its overall structure and framework as well as the in the systems used in facilitating the trading of stocks. At first the gentleman’s agreement was an acceptable way of dealing of shares since the London Securities Exchange(LSE) recognized NSE as an overseas stock exchange. Then later, after the Nairobi Stock Exchange was officially registered, business was transacted through phone-calls and prices determined through negotiating in the year 1954 up-to 1962. With NSE being official, the next development that it saw was its privatization which meant trading moved from being conducted over a cup of tea toa floor based open outcry system that was located at IPS Building, Kimathi street, Nairobi in 1991. With the open out-cry system being limited in terms of data presentation and order execution, a more efficient process of dealing stocks was introduced in 2004, where Kenya capital markets were automated. The NSE then implemented live trading on its own automated trading systems trading equities, two years later, and the trading hours increased from two hours to three hours of the day. A year later NSE implemented its Wide Area Network platform which meant brokers and investors no longer required a physical presence on the trading floor and which was later come to be known as remote trading. The consequence of remote trading was the extension of trading hours at the bourse from 9:00AM to 3:00PM. The automation also brought about many convenience developments for the investors (both local and foreign) such as the introduction of the NSE ALL-Share Index that provided a comprehensive measure of performance of the stock market and also the first edition of the NSE Smart Youth Investment Challenge to promote stock investments among Kenyan youth. Later the Nairobi Stock Exchange changed its name to Nairobi Securities Exchange and became a member of the Financial Information Service Division of the Software and Information Industry Association (Nairobi Securities Exchange , 2018). From a general perspective the development of a stock market is determined by a number of factors that include market capitalization, liquidity, regulation and trades (Nyamakanga, 2013). Internationally and locally, the main developments in the field are such as advancement in charting tools, especially when they represent growing investment of stocks or portfolios. People dislike having to sort through columns of digits in order to get the information they want. While traders always want the option to view raw data if they want to, the default method of presentation for modern platforms must be charts and graphs. While charts and graphs have been used by traders for decades, advances in technology make them more useful and more intuitive than ever. Even mobile devices now have the processing power onboard to deliver the fast, high-resolution graphics needed for e-trading software. (Trading Development Platfrom FinTech, 2018) One of the most-powerful benefits that advances in technology offer online trading is speed and volume of stocks exchanged. Most online trading companies make continuous strives toward improving the speed of order routing and execution. Fast low-latency trading platforms not only avoid taxing the user’s patience, they avoid costing them money. In the world of modern gigabit networks, time is, indeed, money. Every second in an e-trade transaction can cost a trader thousands-of-dollars. And latency issues can affect both data feeds and presentation, and order execution. Common sources of latency include market, or exchange servers; brokerage servers; internet connectivity; and client hardware and software. While each of those systems inherently exhibits a certain amount of latency, it is the job of the developer to ensure that the platform is not the source of undue delay (Trading Development Platfrom FinTech, 2018). With the advent of FinTech we find more innovative ways to access the stock markets as well as to keep track of the information on the stock exchange. More sophisticated operating systems and more efficient process are being developed day by day. One of the major developments to have caught on include algotrading. Algorithm trading is the first fully-integrated algorithmic trading software solution which allows for automation of complex, quantitative trading strategies in Equity, Forex and Derivative markets (AlgoTrader, 2018). Additionally, the next major change revolves around Artificial Intelligence assisted trading. “ML has been evolving in the last 15 years, and deep learning is definitely a new breakthrough technology and helping people to manage lots of data sources and come up with new patterns to help estimate trading, ideas, and make better investing decisions; I think that’s also why you see so many big firms investing in this area, and also you see Apple just acquired a ML company in Seattle, Turi...so not only on Wall Street, but also the traditional big tech companies are moving into this space...” (Lu, 2018). Further understanding of the improvements or non-improvements in the stock market due to such a monumental structural change such as converting from open outcry systems to electronic trading system could help us understand and possibly model what could happen if further prodigious changes occur in the Nairobi stock exchange and what to expect and where to expect it. There have been several automation policies that have been undertaken by the NSE. Though these automation changes may have improved certain aspects of the market, itis still unclear whether translated to better returns in the market. Therefore, it’s 2.0 LITERATURE REVIEW 2.1 Introduction This chapter reviews the theoretical framework behind price determination in the markets and its relation to automation in exchange markets. The literature related to the automation process in the Nairobi Stock Exchange is documented as well accompanied with the different views behind the automation process and the various advantages and disadvantages of the various the associated systems. Literature on related exchanges will also primarily feature in this segment to serve as areference point for the Nairobi Stock Exchange. 2.1 Automation in the Nairobi Stock Exchange In the 1930s dealing in shares begun based on a gentleman’s agreement with no particular defined physical trading floor. The London Stock Exchange(LSE) officials accepted to recognize the setting up of the Nairobi Stock Exchange as an overseas stock exchange (1953). Transactions were consummated via face-to-face negotiation based on a handshake agreement firm between the oncoming shareholder and the firm with the agreed negotiated price with defined relevant conditions. This is more time consuming and hence inherently takes longer to implement. The NSE was then listed as a private company limited by shares. Share trading moved from being conducted one on one, to the floor based open outcry system located at the IPS building (Nairobi Securities Exchange , 2018). Open-outery has a very straightforward market structure. Traders, all present at a central location, publicly announce bids and offers. Ifa trader finds a bid or offer attractive, the trader simply hits the bid or takes the offer. The transaction price is then reported to the entire trading community (Phelps, 1994). Open outcry allows for floor traders to understand the emotions of the other traders on the floor when orders are being called in. This intangible information is essential for many of the traders on the floor. Being able to see a trader’s greed or fear offers much more than watching a chart on your computer. 10 Many traders will key off of the "noise" in the pits to determine the volatility in the markets at a specific price point. There are a few services on the web that offer this live feed from the pits (Open Outcry, 2011). Long after this with the advent of the electronic age, an electronic trading platform was introduced into stock market trading. This happened much earlier in international exchanges than for the Nairobi Stock Exchange. In 2004 the process of clearing and settlement became fully electronic for the first time. This was closely followed by the introduction of the live trading platform which was capable of trading equities and immobilized corporate bonds and treasury bonds (Nairobi Securities Exchange , 2018). They were deployed to replace or complement traditional, open-outcry markets. This begun with an electronic matching system which is a set of computer terminals connected via high-speed communication lines to a central host computer. Bids, offers and trade requests are entered into the remote terminal and sent to the central host. Only the host computer has complete market information (Phelps, 1994). To date the current computer system over which transactions are entered, routed, executed and cleared electronically with little or no human intervention (Stoll, 2006) Electronic trading has a number of advantages: e Automatic. Once an order is submitted, trade execution proceeds without human intervention according to price/time priority, unlike traditional markets, where orders might be held by dealers. e Anonymous. The identity of traders is not revealed, which can be of importance to certain traders. e Low cost. electronic platforms earn income by charging a fee to market orders, while they pay for orders that supply liquidity. e Fast. Execution and confirmation are electronic and occur in less than a second. e Programmable to offer complex orders. For example, electronic platforms can offer contingent trades where the price is adjusted for changes in index prices or in the prices of other stocks. (Stoll, 2006) 11 Despite this we still require use of floor trading techniques or principles especially for stocks that aren’t as active. This is because they still provide liquidity for these stocks of which is still a lucrative venture, as the shares still participate in the market. Marcel and Bruce argue that the trading environment and the trade-matching algorithm embedded in electronic matching systems fail to capture the key features of open-outcry markets, which account for open outcry's success and high liquidity. While electronic matching systems offer valuable technology, we need accurate measures of what can be achieved and what can be lost before replacing open outcry with an electronic matching system (Phelps, 1994). Itis therefore important to properly research on various factors or indicators that would properly depict what impact this advancement in technology has on overall returns on the exchange. This could be used to serve as a base model depiction of what technological advancements in stock exchanges could mean for future returns the various stakeholders in the market. 2.2 Theoretical Framework One of the foremost theories behind asset pricing include the efficient market hypothesis which states that the prices contain all relevant information about the stock it represents and is a result of complete unimpeded market forces of demand and supply. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of obtaining the information is negligible. Based on this hypothesis, automation definitely affects major aspects of this theory. Major aspects that automation improves include lower transactions costs, faster execution of trades as well and enhancement of liquidity in the market for relatively mote active stocks. Computerized trading systems can improve liquidity in secondary markets by lowering trading costs (spreads, fees, brokerage, commissions paid by investors). High transparency provided by automation reduces information asymmetry in the faced by market participants (Jain, 2005). 12 3.0 RESEARCH METHODOLOGY Research design Population and Sampling Data Collection Data analysis 15 4.0 References AlgoTrader. (2018). Retrieved from AlgoTrader: https://www.algotrader.com Amihud, Y. a. (1986). Asset pricing and the bid-ask spread. Journal of Financial Economics, 223-249. Easley, D. a. (2004). Information and the cost of capital. Journal of Finance, 1553- 1583. Exchange, N. S. (n.d.). History of National Securities Exchnage. Retrieved from https://www.nse.co.ke/nse/history-of-nse.html Franke, G. a. (2000). Information diffusion in electronic and floor trading . Journal and Empirical Finance, 455-478. Jain, P. K. (2005). Financial Market Design and the Equity Premium: Electronic versus Floor Trading. The Journal of Finance, 2955-2985. Lu, A. (2018). Interview Highlights on Artificial Intelligence in Stock Trading and Finance. (TechEmergence, Interviewer) Mburu, R. M. (2016). EXCHANGE, RELEVANCE OF PROGRESSIVE TECHNOLOGY AT THE SECURITIES EXCHANGE: CASE STUDY OF THE NAIROBI SECURITIES. Nairobi: United States International University. Mwangi Michael, M. (2013). THE EFFECT OF AUTOMATION ON STOCK MARKET TRADE VOLUME AT THE NAIROBI SECURITIES EXCHANGE. Nairobi: University of Nairobi. Nairobi Securities Exchange . (2018, June). History of NSE. Retrieved from Nairobi Securities Exchange : https://www.nse.co.ke/nse/history-of-nse.html Nyamakanga, R. (2013). RELATIONSHIP BETWEEN STOCK MARKET DEVELOPMENT AND ECONOMIC GROWTH IN KENYA. Nairobi: School of Business University of Nairobi. O'Hara, M. (2003). Liquidity and price discovery. Journal of Finance, 1335-1354. Open Outcry. (2011). Retrieved from MySMP: http://www.mysmp.com/futures/open-outery.html Phelps, M. N. (1994). Electronic Trading, Market Structure and Liquidity. In Financial Analysts Journal, Vol. 50, No. 1 (Jan. - Feb., 1994), pp. 39-50 (pp. 39-50). CFA Institute. Simmons, E. H. (2014). Mechanics of the Stock Exchange. The North American Review, 287-292. Stoll, H. R. (2006). Electronic Trading in Stock Markets. The Journal of Economic Perspectives, 153-174. Trading Development Platfrom FinTech. (2018). Retrieved from Ignite: https://Aigniteoutsourcing.com/publications/trading-platform-development- trends-fintech/ 16 17