Making the Most 0f Fragmented Capital Markets


Ron Russo
Ron Russo
Sep 29, 2017 · 9 min read

The U.S. is the most fragmented market in the world, but a fragmented market in a developed economy differs greatly from a fragmented market in a developing economy.

Low market liquidity is a consequence of capital market fragmentation.

Meanwhile, access to information in fragmented capital markets is another major issue.

Capital markets are fragmented on a global scale, from developed markets to emerging economies and all the way to frontier nations. The rise of technology-driven and electronic trading coupled with the evolution of regional regulation — such as the Regulation National Market System (Reg NMS) in the U.S. and Europe’s Markets in Financial Instruments Directive (MiFID) law — has fueled the development of fragmented capital markets.

The U.S. is the most fragmented market in the world, but a fragmented market in a developed economy differs greatly from a fragmented market in a developing economy.

In Africa, where there is a patchwork of rules and regulations as fragmented as the markets themselves, investors are eyeing the greatest investment opportunity they’ve seen in years with the planned combination of regional stock markets.

“In my estimation, Africa is the hottest investment destination right now,” Jonathan Hoenig, founder of asset management firm Capitalistpig Hedge Fund LLC, told GLX (my company) in an interview. “It’s the only true frontier market left. Now that exchanges and pools of capital are linking it with the rest of the world, there’s limitless upside potential for the continent.”

China, whose economy has turned a corner since the country began opening up its borders and capital markets, is experiencing new investment activity as a result of greater cross-border access amid programs connecting mainland China investors with other markets.

“The countries that are emerging are doing so because they haven’t liberalized their economies yet. That’s the problem,” Hoenig said. “China has been a very slow, long process, going back to the early ’90s when they started opening up their markets. The small steps toward economic freedom are what explain their success over the past couple of decades.”

Developed Markets

According to BlackRock (BLK), the world’s largest asset manager, the U.S. is a “complex and highly fragmented market where trade order flow must navigate 13 exchanges, 40-plus dark pools, and a handful of electronic communication networks (ECNS).” This is in stark contrast to before the turn of the century when only a couple of major exchanges — mainly the New York Stock Exchange, the American Stock Exchange, and the Nasdaq Stock Market — were handling trades.

“The U.S. is highly fragmented in the sense that there are a lot of different places to trade — dark pools, exchanges, and ECNs,” Hoenig continued. “But if you look at the actual stocks trading, many trade at sub-penny spreads. So markets are fragmented, but they’re also super efficient, thanks to that competition among trading venues.”

In the U.S., not a single trading venue represents more than one-fifth of total market volume today, according to Voya Investment Management, a New York-based asset management firm. According to this The Wall Street Journal piece, trading on the big board in NYSE-listed stocks was more than slashed in half in the decade leading up to 2015 from 77 percent to 32 percent. This is evidence of a trend toward a fragmented market. There is a similar story at the NASDAQ, where trading volume in stocks listed on the electronic exchange fell from more than 50 percent in 2005 to less than 30 percent in 2014.

Meanwhile in Europe, the implementation of MiFID in 2007 opened the door for greater competition for trading and clearing, as the rule ushered in new trading venues to go head to head with traditional stock exchanges. This resulted in fragmented equity markets and the rise of dark pools across the continent.

Emerging and Frontier Markets

In China, there has been a series of initiatives aimed at connecting mainland investors with investment opportunities in other markets. Shanghai-Hong Kong Stock Connect, a program launched in 2014, was designed to “achieve a breakthrough in mutual market access between the Mainland and Hong Kong.”

As Mark Tinker of AXA Investment Managers explained on CNBC, “This is a way of connecting the rest of the country with the rest of the world.”

While Shanghai-Hong Kong Stock Connect targets retail investors, Shenzhen-Hong Kong Stock Connect — which was launched at the end of 2016 and opened up approximately 100 stocks to mainland investors — is a program designed ramp up participation among institutional investors, including insurance companies and pension schemes, for instance.

Low market liquidity is a consequence of capital market fragmentation. Just compare the number of shares traded on the African stock exchanges to that of the NYSE, for instance. This is not to say that the U.S. market is out of the danger zone of low volatility, evidenced by the flash crash episode that took place in the markets less than a decade ago.

‘Liquidity Is Like Oxygen: You Only Notice It When It Is Gone’

BlackRock cites the above saying in its analysis of the Flash Crash event that rocked the financial markets on May 6, 2010. This is the day that market liquidity was sucked out of the proverbial room, leaving traders and investors scrambling for air. Liquidity rushed back into the markets, which only exacerbated an already-out-of-control situation. The flash crash itself unfolded for slightly more than half an hour, but the effects of the incident are never too far from any trader’s memory.

Paul Richards, managing director and head of market practice and regulatory policy at the International Capital Market Association (ICMA), addressed some of the other risks of capital market fragmentation in a report. According to Richards, the ICMA “has encouraged open and integrated capital markets across national borders for almost 50 years.”

Richards points to the political climate both in Europe and the U.S., observing a “reassertion of national sovereignty and a backlash against globalization by voters who have not benefited from it.” For instance, in the U.S., President Donald J. Trump won the election using the slogan “Make America Great Again,” leading to a push to buy American and return manufacturing jobs back to the country.

In Europe, the motto behind the U.K.’s departure from the EU had a similar antiglobalization tone: “Taking back control of national borders, national laws, and national money.” Meanwhile, events such as Brexit stand to threaten the progress of integrated capital markets.

There is a heavy cost associated with capital market fragmentation, one that, according to the ICMA, cannot easily be quantified:

  • Higher user costs as a result of financial institutions needing to keep more capital and liquid assets in order to operate under “divergent regulatory regimes”
  • Risks tied to financial stability if different regulatory bodies lead to “regulatory arbitrage” among them

Meanwhile, access to information in fragmented capital markets is another major issue.

“In Africa, the dissemination of information will be much slower,” said Hoenig. “In the U.S., we have Reg FD, so when a company announces something, it must do so publicly. Everything in Africa is definitely more slow, antiquated, and analog. But that’s where the opportunity is. I think platforms like this bring Western-style reputability that gives people more confidence to invest.”

African capital market regulators are working to merge all stock markets on the continent. The pilot program involves six exchanges — Johannesburg Stock Exchange, Nairobi Securities Exchange, Nigerian Stock Exchange, Stock Exchange of Mauritius, Casablanca Securities Exchange, and Bourse Régionale des Valeurs Mobilières — and will likely start in quarter one of 2018. But the integration of these markets, even for the pilot program, is not a sure thing.

“The legislative roadblocks, as well as capital market objectives in different countries, will make this an uphill task to achieve,” according to Daniel Kuyoh, senior investment analyst at Alpha Africa Asset Managers, as mentioned in The EastAfrican.

In the same article, Eric Munywoki, head of research and business development at Sterling Capital, brought up another concern: “Some exchanges have demutualized while others have not, which would be a factor to consider while drafting the commission-sharing agreement.”

Capital market integration provides a host of benefits to the economy. The ICMA outlines the following features:

  • Less pricey funding for governments and corporations
  • Faster payment transfers across borders
  • More liquidity as a result of the “pooling of cash”

Meanwhile, a further benefit to greater capital market integration, specifically for the EU, is a shared risk via cross-border lending and investment, which would stem the fallout from any country-specific shock, as per the ICMA.

Africa’s pilot program has given renewed hope to investors who are interested in gaining exposure to the region. These six exchanges will be connected electronically so investors can participate in cross-border trading in the equity markets, which is a key benefit of the program. Other benefits have been identified, such as lower trading costs and more options for retail investors.

The program will provide a shot of liquidity to a region that needs it most.

“There’s great benefit in the increasing liquidity in these markets, from cross-linked platforms to increasingly common ETFs, which are opening up African and even sub-Saharan markets to the world,” said Hoenig. “These are growing markets, so there won’t be immediate liquidity.”

Hoenig likens what’s unfolding in Africa to the European markets in the early part of the 1990s.

“Borders became less important, as money was able to more freely seek profit opportunities cross-continent,” he said. “This type of cross-connecting is helpful for everyone, especially institutions. Retail investors aren’t enough. For a market to thrive, you need institutional investors who are willing to invest large sums of money over long periods of time and take activist roles. These types of liquidity programs are a great help.”

There is an even stronger parallel with Latin America: “After the currency crisis of the late 1990s, many Latin American markets were abandoned by U.S. investors,” he said. “But with increasing liquidity, much of it brought on by technical innovation, markets like Brazil really went from being quiet to being very hot. I think you could see the same thing happen in Africa, too.”

Meanwhile, as expected, China’s efforts to open up its capital markets has served as a catalyst to attract capital, including institutional investments. For instance, the People’s Insurance Company of China (PICC) is looking to a pair of capital market programs as a path for investment: the Shanghai-Hong Kong and Shenzhen-Hong Kong stock connect programs. PICC has already doled out between US$1.2 billion and US$1.5 billion in the first half of 2017.

And it’s not just equity market programs drawing capital, as evidenced by US$1 billion in Chinese bonds traded by international investors on the maiden session for the Hong Kong Bond Connect cross-border trading program. The initiative — which supports the opening up of China’s capital markets — grants international investors a way to invest in China’s US$9 trillion bond market through the Hong Kong Exchanges and Clearing, or HKEX.

Hong Kong Chief Executive Carrie Lam Cheng Yuet-ngor is quoted in the South China Morning Post saying:

“Bond Connect marks another new chapter of mutual market access between Hong Kong and the mainland. It is an important milestone for the internationalization of renminbi as it makes it easy for international investors to trade bonds in China. The new Bond Connect and the two stock connects enhance cross-border trading between Hong Kong and the mainland. This strengthens Hong Kong’s role as international financial center.”

Hoenig, meanwhile, is encouraged by these ongoing developments, stating, “It’s become so different in the past decade. There are no more borders when it comes to investing. You can invest in any instrument all over the world in any time zone at very little cost. Institutional and individual investors are ready and happy to scour the globe for the best opportunities. Despite the political headwinds, people are just as interested in investing in China or Africa as they are in General Electric (GE) or Cisco (CSCO).”

You, too, should be equally encouraged. To capitalize on this opportunity, identify the location or types of securities you would like to gain exposure to, and find the mutual fund or ETF that is comprised similarly.

Along the way, make sure you have a clear understanding of the various types of market orders. Consult BlackRock’s detailed descriptions below:

Ron Russo

Written by

Ron Russo

Ron is a serial entrepreneur and the Founder of, and