Retail investors can spur vibrant capital markets

thumb_khuhhojgfsrgf15afbc2513121d
Photo source: Courtesy

By gatuyu j

This essay was first published in the Business Daily

Having deep capital markets is a reliable mechanism to unlock new pools of capital and ensure efficient allocation of resources in the economy. However, establishing vibrant capital markets is a drawn-out process requiring a mix of financial instruments, stable regulatory framework, market infrastructure, and a critical mass of market participants.

The Kenyan capital markets is underdeveloped relative to economy’s potential. The trading at the Nairobi Securities Exchange (NSE) is characterised by low liquidity in both equity and fixed incomes segments. The turnover ratio averages at five percent with some counters running for weeks without an activity.

Ordinarily, efficient markets should have well-balanced supply and demand sides of capital. In the past, policy measures have majorly focussed on the promoting demand side of the markets, on creating new instruments and encouraging issuers, without equivalent efforts to spur the supply side markets especially in relation to broadening the investor base.

A constant supply of capital is a critical pillar for securities market. A way of nurturing it is by ensuring every class of investors is able to get their desired outcome from the markets. Investors, both retail or institutional, are either “buy and hold investors”, “buy and trade investors”, “active investors”, and “private market investors”.

However, there has been a tendency to encourage the “buy and hold” investors and discourage active traders or speculators, on account of discouraging short termism approach to the markets. This view is unfortunate. Stable capital markets needs all groupings of investors irrespective of their anticipated outcome. The vilified speculators, for instance, provide liquidity to the markets and improve the quality of pricing.

Thus, the next frontier in deepening Kenya’s capital markets is widening the investor base. Currently, the main class of investors are institutional and foreign investors, and participation of retail investors is limited. Institutional and foreign investors bring in capital and skills to the market. However, in the case of foreign investors, their dominant participation in small markets may have de-stabilising effects. They pose a ‘sudden stop’ risk, where capital inflows are quickly reversed as a result of changes in the domestic or international risk environment, resulting into sell-offs and markets meltdown.

To broaden demand side of the markets, participation of local retail investors has to be encouraged. There have been reports of Kenyans recently being duped into sham investments. Sad, as these tales are, some lessons can be learnt. A number of citizens are on the lookout for attractive investments opportunities, a gap the capital markets should tap.

A hindrance for entry of retail investors in Kenya capital markets result from market illiquidity, high transaction costs and market power of brokers. These impediments need to be addressed.

Of these, a transactions cost is a major one. The brokerage fee for a trade transaction at NSE is two percent of amount involved. A buy and sell of equities results into transaction costs of four percent.

To this extent, for an investor to break even, a traded stock has to generate a return of about five percent, which is not easy to actualise in short runs. These transactions costs are detrimental.

This makes a case for introducing the direct market access mechanisms to enable retail investors directly interact with the order book of the exchange without having to pass through a broker-dealer. Stock brokerage is a disrupted practice. Trading has moved from traditional open outcry on trading floors to decentralised electronic, screen-based trading, where investors can trade for themselves rather than handing orders over to brokers for execution.

The law should not require it be mandatory that traders must access order book through brokers. Instead, stockbrokers should justify their continued relevance through value addition for traders to engage them.

Transaction costs

Adopting direct market access mechanism would certainly lower transaction costs, because only the technology is being paid for and not the usual order management. This would give traders more control over the final execution and the ability to exploit liquidity and price opportunities.

Another way to improve market liquidity is by reducing the trading cycle from the current settlement of three days (T+3) to same day settlement (T+0). Such will encourage more retail traders, especially the speculators, and increase trading volumes and facilitate more price discovery. The NSE should be able to demonstrate similar efficiency showcased by online sports betting firms.

Related, promoting margin trading would equally improve market liquidity to benefit of retail investors. Margin trading would enable investors increase their purchasing/selling power. The regulations to operationalize margin trading have been made, but the product is yet to be operationalized.

Lastly, the regulators must maintain a tempo of robust protection of investors by guarding against fraudulent practices which kill market confidence. A recent energised effort by Capital Markets Authority on allegations of insider trading in dealing with KenolKobil shares is encouraging.

Nevertheless, more is needed in legal reforms, especially in protecting minority investors especially against lock-in from protracted takeovers. To attract retail investors, above the liquidity of investments and attractiveness of returns, the safety of their invested money has to be assured. This combines with proactive investors’ education, especially on evidence-based, sensible investment strategy.