Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Capital Market Structure (Contd)

Liquidity

The condition of market liquidity can be considered as one of the factors affecting the price discovery function and market efficiency. A liquid market is defined as a market where a large volume of trades can be accommodated without any significant effects on price. Liquidity on the Indian stock exchanges has improved significantly due to sharp increase in trading volumes, which grew at an average annual rate of 75.8 per cent during the latter half of the 'nineties (Table 4.6). The growth of liquidity is also evident from the two ratios, viz., traded value ratio and turnover ratio, which are commonly used to measure the liquidity.

The traded value ratio is measured as the total value traded divided by GDP. The turnover ratio is measured by the value of total shares traded divided by market capitalisation. Whereas the traded value ratio captures trading in relation to the size of the economy, the turnover ratio captures trading in relation to the size of the stock market.

An analysis of these two ratios in the Indian stock market suggests that liquidity has increased in the recent years. The traded value ratio, which was 23.2 per cent during 1993-94, declined to 15.7 per cent during 1994-95, but increased sharply thereafter to 58.1 per cent by 1998-99. A sharp improvement has also taken place in the turnover ratio. The ratio, which was 50.9 per cent during 1993-94, declined to 34.4 per cent in the following year, but increased gradually thereafter to as high as 215.1 per cent during 1999-2000 (Table 4.7).

Transaction costs have a significant bearing on returns as they can substantially affect the notional gains from investments. Transaction costs also impact volumes and volatility as reduction in trading cost could induce the investor to trade more frequently leading to increased volumes. The empirical evidence suggests that increased trading volumes by increasing liquidity result in reduction in volatility. Transaction costs, apart from including explicit cost, such as, brokerage fees, etc. also include some implicit components, such as, market impact cost (cost of degradation in price suffered due to execution of large orders), clearing and settlement cost arising due to counter party risk, paper work cost and bad delivery, etc. In addition, in a trading mechanism which involves market makers, trading cost also includes bid and ask spread.

Despite the growing popularity of stock markets during the 'eighties and the first half of the 'nineties, the transaction costs were high due to physical movement of papers, bad deliveries due to existence of securities in physical form, less transparent method of trading, involvement of a chain of brokers for executing transactions in the largest stock exchange, etc. Changes in the market microstructure, such as, automated trading, dematerialisation, increased liquidity, guarantee of trades and increased competition in the supply of brokerage services and resultant reduction in brokerage fees have brought about a significant reduction in the transaction cost. According to the estimates, there has been a decline in average transaction cost for all investors in the past few years. The transaction cost on India's equity market declined to 0.6 per cent of selling/buying price in 1999 from 4.75 per cent in 1994. The transaction cost in India now compares well with that in the best markets of the world (Table 4.8). The reduction in the transaction cost is an excellent signal of improvement in the overall market efficiency and market growth.