Although campaigns to improve the investment climate for venture companies often feature some effort to roll back regulation, a new working paper from a quartet of researchers highlights the possible pitfalls of undermining investor protection and confirms the value of maintaining investor confidence – even for highly speculative stocks.
For the past few years, Canada’s venture market appeared to be in a relentless decline. From 2011 to 2015, the total market capitalization of the companies listed on the Toronto Venture Exchange (TSXV) dropped by more than half to $23.5 billion from $49 billion – and financing activity was down by about two-thirds to $3.3 billion in 2015 from $10.1 billion in 2011.
However, the TSXV appears to be on the rebound this year, as its total market cap climbed by approximately 46% to $35.1 billion year-to-date as of Aug. 31. At the same time, financings rose by 26%, trading volume increased by 18% and trading value rose by 12% compared with the previous year.
Over the same period, the Toronto Stock Exchange (TSX) also saw conditions improve, albeit more modestly. For example, the TSX’s overall market cap rose by 8% and financings rose by 3% year-to-date as of Aug. 31.
So, the TSXV has led the way by a wide margin – a result that comes in the wake of a dedicated effort to rejuvenate the TSXV over the past year.
In late 2015, the TSXV issued a white paper spelling out its plan to revitalize the market and reverse the recent decline in both financing and trading activity. That plan featured a variety of initiatives designed to attract new listings and woo investors, including stepped-up sales efforts, a new market-making program and broad-based approaches, such as advocating for tax breaks for venture investments.
Another major component of the TSXV’s revitalization plan focuses on regulation and reducing the costs of compliance. However, that aspect of the plan stresses curbing the costs of regulation for issuers without reducing the quality of investor protection.
To that end, the TSXV’s plan targets the elimination of administrative inefficiencies and reducing the time needed to carry out transactions, but without undermining investor trust or confidence. New research appears to validate that approach.
According to The Twilight Zone: OTC Regulatory Regimes and Market Quality – a paper co-authored by Aditya Kaul from the University of Alberta; Christian Leuz of the University of Chicago and the U.S. National Bureau of Economic Research; Ingrid Werner from Ohio State University; and Ulf Brüggemann of the Humboldt University of Berlin – reducing regulatory protection to ease compliance costs for small firms also reduces market quality.
The academics’ study, an analysis of trading in the U.S. small-cap, over-the-counter (OTC) markets, found that small-cap stocks that are subject to tougher regulation and more onerous disclosure requirements enjoy higher liquidity and less risk of crashing than their less regulated counterparts.
“Our analysis points to an important trade-off in regulating the OTC market and protecting investors: lowering regulatory requirements (e.g., for disclosure) reduces the compliance burden for smaller firms, but also reduces market quality,” the paper states.
That conclusion follows from an analysis of trading in more than 10,000 U.S. OTC stocks over a 10-year period (from 2001 to 2010).
The companies included in the research sample are similar to the firms that trade on the TSXV. The firms included in the study are primarily micro-cap stocks. The average market value of firms in the U.S. OTC market is about US$52 million, the paper reports, but most have a market value of less than US$20 million. (The average is skewed by a handful of large firms.) By comparison, the latest data on the TSXV indicate that the average market value of the companies listed on that market is about $21 million.
Although the OTC markets often are viewed as being unregulated, they are subject to myriad regulatory regimes – ranging from firms that are registered with the U.S. Securities and Exchange Commission (SEC) and subject to certain SEC rules to firms that come under state oversight, the paper says. There also are differing disclosure standards within the OTC markets themselves, depending on the venue in which a company trades.
The researchers utilized these differences to examine the relationship between regulatory quality and market quality.
“The OTC market generally offers less investor protection than the traditional exchanges. As such, [this situation] provides an opportunity to study the trade-off securities regulators face between their desire to create a viable market for small growth firms and [the regulators’] charter to ensure investor protection and market integrity,” the paper notes. It adds that, overall, “market quality increases with stricter disclosure regulation and regulatory oversight.”
In other words, the research found that firms that provide more extensive disclosure and are subject to stricter state oversight have higher market liquidity and lower crash risk.
Yet, the elevated market quality associated with tougher regulation doesn’t necessarily translate into better portfolio returns, the research found: “In contrast to our market quality results, the information regimes in the OTC market do not appear to be associated with differential return performance.”
Nonetheless, the research established that some investors recognize differences in regulatory standards – and are more willing to trade in markets with higher regulatory standards.
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