In many countries, capital markets are often served by multiple stock exchanges, typically with one national or dominant exchange and several regional or satellite exchanges. While multiple exchanges create a competitive landscape, they also lead to fragmented liquidity and diseconomies in operations. This paper examines the role of the Lahore Stock Exchange (LSE) in comparison with the country's dominant exchange, the Karachi Stock Exchange (KSE), in four areas: (i) market efficiency in processing information, (ii) transaction costs, (iii) contribution to price discovery, and (iv) market integration. A comparative analysis of the exchange performance indicates the two exchanges to be at par in terms of informational efficiency and transaction costs. There is evidence of informational linkages and interdependencies between the two exchanges; the LSE appears to contribute to price discovery and competes to an appreciable extent. Against the background of proposals to merge the country's three stock exchanges, a major consideration in evaluating public policy is the relative performance of the LSE and its viability as an effective competitor. Eliminating inter-exchange competition by merging the stock exchanges is predicted to lead to higher transaction costs, lower incentives for regulatory compliance, and diminished motivation for promoting capital market development.
Keywords: Stock exchange, demutualization, market efficiency, transaction costs, price discovery, market integration, dually listed stocks, satellite and dominant exchanges.
JEL Classification: G14, G15, G38.
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I. Introduction and Overview
Capital markets in many countries are often served by multiple stock exchanges. When markets are imperfectly integrated, prices in one exchange usually adjust to those in the other with some time delay. This has been termed by Garbade and Silber (1979) as a dominant-satellite market relationship; the former is a satellite and the latter is dominant. While multiple exchanges create a competitive landscape, they can also lead to fragmented liquidity and diseconomies in operations. A key consideration in evaluating public policy toward the structure of the exchange industry is the relative role of satellite exchanges in the country's capital markets, particularly in creating a competitive environment.
There are three stock exchanges in Pakistan: Karachi, Lahore, and Islamabad. The Karachi Stock exchange (KSE) dominates all trading activity, while the Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE) account for a smaller share of the total volume. This study examines the role of the LSE relative to the KSE in its basic function as a stock exchange. Its performance is assessed in terms of relative efficiency in processing information (market efficiency), cost of intermediation (transaction costs), role in price discovery, and the extent of market integration through the flow of information.
The study was conducted against the background of ongoing efforts to demutualize the country's three stock exchanges. Currently, they are structured as mutual nonprofit companies owned by members who have the exclusive right to trade on the exchanges. The proposed restructuring will convert the exchanges to shareholder-owned for-profit corporations. Subsequently, the three exchanges may be consolidated into one corporate entity. An assessment of the LSE's relative role should provide insight into whether or not public interest is best served by the contemplated consolidation of the three stock exchanges.
The remainder of this section will provide an overview of the three stock exchanges and we examine various issues relating to the performance of the stock exchanges. Section II presents a review of the literature, and Section III provides empirical evidence of the LSE's performance, describes the data and econometric methodology used, and records the results achieved. …