Market openness and market quality in gold markets

• Author: Dong Zhang,Caihong Xu
• DOI: http://doi.org/10.1002/fut.21969
• Date: 01 March 2019
• Published date: 01 March 2019

Received: 5 April 2017

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Accepted: 9 September 2018

DOI: 10.1002/fut.21969

RESEARCH ARTICLE

Market openness and market quality in gold markets

Caihong Xu

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Dong Zhang

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1

Stockholm Business School, Stockholm

University, Stockholm, Sweden

2

Finansinspektionen, Stockholm, Sweden

Correspondence

Caihong Xu, Stockholm Business School,

Stockholm University, 106 91 Stockholm,

Sweden.

Email: cxu@sbs.su.se

Funding information

The Jan Wallander and Tom Hedelius

Foundation and the Tore Browaldh

Foundation, Grant/Award Numbers:

W2014–0443:1, P2015‐0089:1

Abstract

This paper studies the impact of market openness on market quality in gold

markets, by investigating the openness event that occurred when the Shanghai

Gold Exchange (SGE) launched an international board (SGEI) for foreign

investors in China. Investors prefer to trade on the SGE than the SGEI, probably

due to the SGE’s higher liquidity. In addition, using the New York Mercantile

Exchange (COMEX) gold futures as the benchmark, we show the SGE

experiences a significant increase in liquidity without a concomitant increase in

volatility. Moreover, the SGE’s contribution to international gold price discovery

increases after the openness event.

KEYWORDS

foreign investors, gold markets, market openness, market quality, price discovery

JEL CLASSIFICATION

G14, G18

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INTRODUCTION

Whether or not to open the financial markets to foreign investors is one of the most important decisions to be made by

policy makers in emerging markets. An open market allows foreign investors to trade the assets in that market.

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Bekaert and Harvey (2000) and Henry (2000), among others, argue that market openness, referred to as market

liberalization in their papers, can decrease the cost of equity, and improve corporate governance, transparency, and the

volume of aggregated investment. However, market openness exposes the economy to risks associated with

uncertainties in international capital flows (hot money), and may fuel inflation (Kim & Singal, 2000; Kose & Prasad,

2012; Mehrez & Kaufmann, 2000).

Previous literature mainly investigates the effect of stock markets’openness on the cost of equity and/or market

efficiency. However, no study has been carried out on the gold market. One of the most important benefits of entering

emerging stock markets, for foreign investors, comes from hedging and/or diversifying their risk exposure. However,

gold is a single universal asset which does not differ greatly across countries. The benefits for investors of hedging and

diversification through trading in different gold markets are limited compared to those obtained by trading stocks

across countries. Moreover, in contrast to individual stocks, information that affects the value of gold results from vastly

different sources, for example, gold mines, jewelry and investment demand, central bank actions, and macroeconomic

conditions (Hauptfleisch, Putniņš, & Lucey, 2016). Therefore, previous evidence of the effect of market openness on

stock markets may not be applicable to the case of gold market openness.

This study investigates how market openness affects market quality in gold markets, by examining the unique

market structure change that has occurred in the Chinese gold market. China is currently the largest gold consumer

J Futures Markets. 2019;39:384–401.wileyonlinelibrary.com/journal/fut384

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© 2018 Wiley Periodicals, Inc.

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A completely open market also allows domestic investors to participate in foreign markets. This paper does not focus on this aspect.

and producer in the world. The Chinese gold market is the third largest in terms of gold‐related trading, behind the

largest trading center, the London over‐the‐counter (OTC) physical gold market, and the second largest, the New York

Mercantile Exchange (COMEX) gold futures (World Gold Council, 2017). In China, the Shanghai Gold Exchange (SGE)

facilitates trading of spot gold contracts and spot deferred contracts whereas the Shanghai Futures Exchange (SHFE)

facilitates gold futures trading. The SGE is now the world’s largest physical spot exchange for gold and the SHFE gold

futures are the second‐most‐traded gold futures (World Gold Council, 2017).

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To promote the internationalization of the Chinese gold market and improve its clout in global gold pricing, the SGE

launched an international board (the SGEI) to allow foreign investors to trade gold in China, on September 18, 2014.

Before the openness event, foreign investors were not allowed to trade directly on the SGE.

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After the event, three new

international spot gold contracts became available for foreign members of the SGEI. In addition, foreign participants

were able to gain trading rights over most of the gold contracts listed on the SGE by registering as exchange members of

the SGEI. As stated by O’Hara (2003), financial markets have two important functions: Liquidity provision and price

discovery. Therefore, we focus our analysis of the impact of the opening of the gold market on market quality in terms

of both liquidity and price discovery.

This paper contributes to the literature in the following ways. First, we are able to study two different channels of

market openness due to the unique market mechanism of the SGE. The first openness channel is that the SGE

introduced three new contracts on the SGEI. We document that the SGEI gained some trading volume after the

openness event but lost trading interest from investors around 10 months later, probably due to low liquidity on the

SGEI. The second openness channel is that the SGE now allows foreign members to trade the gold contracts listed on

the SGE. The openness event has made it possible for foreign participants to register as members of the SGEI and trade

gold contracts listed on both the SGEI and SGE. In addition, domestic members can also trade on both the SGE and

SGEI. Using the world’s largest gold futures market—COMEX gold futures—as the benchmark, we show that the SGE

becomes more liquid (smaller bid–ask spread) and more active (larger trading volume and greater number of trades and

quotes), without a concomitant increase in volatility, after the opening. This result indicates that investors prefer to

trade on the SGE than the SGEI, due to the fact that the liquidity is much higher on the former, which means a

potentially lower price impact, shorter execution waiting times, and lower trading cost of crossing the bid–ask spread.

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Another possible reason is that the SGEI only offers spot contracts, while the SGE provides both spot contracts and spot

deferred contracts. The built‐in leverage of the spot deferred contracts (margin trading) on the SGE might be more

attractive for investors who trade gold as a financial asset. In addition, only the spot deferred contracts on the SGE can

be used as a hedging tool for investors’spot gold exposure. Hence, traders who enter the market for hedging purposes

will only trade the spot deferred contracts on the SGE.

The second contribution is that we extend the literature on the effect of market opening by studying the effect on

market quality in gold markets. All the previous literature on the impact of market openness examines stock markets,

such as Bekaert and Harvey (2000), Henry (2000), and Cajueiro, Gogas, and Tabak (2009). In addition, we examine the

effects of market openness on market quality in terms of liquidity, market activities, and price discovery. To our

knowledge, no study has investigated the effect of market openness on the price discovery process before.

The third contribution is that we add to the literature on gold price discovery by investigating whether opening the

market to foreign investors improves the price discovery share of that market. There have been many studies that have

examined which gold markets play a major role in gold price discovery, such as Xu and Fung (2005), Lin, Chiang, and

Chen (2008), Lucey, Larkin, and O’Connor (2013), Fuangkasem, Chunhachinda, and Nathaphan (2014) and

Hauptfleisch et al. (2016). Our paper documents that the SGE contributes more to the price discovery process due to the

market opening, after controlling for other factors that may affect price discovery, such as liquidity, volatility, trading

volumes and numbers of small, medium, and large trades. With the opening up of the market to foreign participants,

the gold price on the SGE becomes more efficient in incorporating information than previously, compared to COMEX.

Lastly, this study provides policy implications about market openness in emerging markets and in commodity

markets. Regarding how the market structure might be designed to facilitate market openness, despite the fact that the

SGEI was introduced to facilitate trading in gold contracts for foreign investors, the latter prefer to trade on the SGE.

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See https://www.gold.org/what‐we‐do/gold‐market‐structure/global‐gold‐market.

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Qualified foreign institutional investors (QFII) were able to invest on the SGE under certain circumstances. QFII’s investment activities were subject to restrictions in terms of the maximum

accumulated investment quota, and the minimum wait time before funds could be transferred from China to abroad.

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As shown in Table 2, the daily average trading volume on the SGEI during our sample period is 4,332kg. Table 2 also demonstrates that the bid–ask spread is 203 basis point (bps) on the SGEI and

2.82bps on the SGE. The gold price is 42.5 USD/g as of May 2018. The daily cost difference between crossing the bid–ask spread on the SGE and on the SGEI is [(203 (bps) –2.82 (bps)]× 4332 (kg)

×1000 × 42.5 (USD/g), which is approximately 3.686 million USD.

XU AND ZHANG

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