Report: What are stock exchanges for? And why should we care?
June 2019 • The Purpose of Finance • by by William Wright
This report analyses the changes in the world of stock exchanges, equity markets and the new issue market over the past 50 years. It highlights the vital role that stock exchanges play in the economy, analyses the main drivers of the significant changes over the past few decades – and suggests how we can get exchanges back on track.
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This paper is part of the Purpose of Finance initiative on which New Financial is collaborating with Pension Insurance Corporation. You can find more details of this project here.
Stock exchanges have played a vital role at the heart of the economy helping companies raise capital for more than 200 years. Healthy stock exchanges are crucial to financing growth and innovation. They provide access for companies to a deep pool of capital, enable price discovery, spread risk, help widen and share wealth creation, and they improve transparency, accountability and corporate governance standards. But something is wrong.
The paradox of stock exchanges
In this paper we highlight ‘the paradox of stock exchanges’: on many measures, stock exchanges are bigger, more liquid and more efficient than ever before – but fewer and fewer companies are choosing to be listed on them or to use them to raise capital.
The value of stockmarkets in the UK and US has risen more than six-fold in real terms in the past 50 years and the value of trading in listed companies listed in the UK and US has increased by more than 50 times in real terms.
But the number of companies that are listed on stock exchanges in the UK and US has roughly halved over the past 25 years, the number of new listings has dropped by three quarters, and the amount of capital being raised on stock exchanges has dropped by around two thirds.
We think that without urgent action, there is a risk that this vital engine for raising capital, sharing risk, and widening participation in wealth creation, could be seriously undermined.
The purpose of stock exchanges
The starting point for this paper is the fundamental purpose of stock exchanges, which we define as capital formation and intermediation: stock exchanges provide a centralised marketplace to enable companies that need money to raise capital from investors who have it, and to enable those investors to trade shares in listed companies.
This involves a delicate balance between overlapping and often competing interests of different groups (issuers, investors and intermediaries). This juggling act can be broadly split into primary markets (raising capital) and secondary markets (trading and price discovery).
The main thesis in the paper is that over the past 25 years the pendulum has swung from raising capital to trading (or from primary to secondary markets), creating a bifurcation between a hyper-efficient market for capital raising and trading for the biggest companies at the top end, and a less efficient and less active market for smaller companies at the other.
A structural shift?
There is no single factor behind the decline in listed companies and new issues, but we highlight three broad drivers:
The growth of alternative sources of capital
- Growth in pools of private equity, venture capital, SWFs
- Growth in corporate bonds (compounded by low interest rates and tax benefits)
- Too much cash
The cost and burden of being listed
- More governance, disclosure & regulation
- More public scrutiny
- High cost of listing (and an antiquated new issue process)
Big shifts in the finance industry
- The increase in scale, speed and complexity across the industry
- The changing economics of smaller company broking and investing
- The changing model of the stock exchange industry
Why should we care?
The fate of stock exchanges has a big impact beyond the world of the financial markets in at least three ways:
Growth, investment & innovation
Stock exchanges play a valuable role in financing growth and investment. Equity is a unique form of financing that is ideally suited to support long-term investment with an uncertain outcome. Equity encourages innovation and improvements in productivity that are required to drive economic growth.
Widening wealth creation
Public equity markets are a mechanism to reduce inequality and an engine for the wider participation in wealth creation through people’s pensions and direct investments. The shift from public to private capital over the past few decades means that high growth and high returns from venture capital and private equity-backed companies are increasingly limited to those investors who able to invest in private markets – such as wealthy individual investors and the shrinking number of people lucky enough to be part of a defined benefit pension scheme. Millions of individuals coming into contact with the stockmarket for the first time through auto-enrolment pensions are being excluded from this growth opportunity.
Standards & accountability
And third, stock exchanges play an important role setting standards, providing transparency and accountability, and supporting the social licence for businesses across the economy.
What can we do about it?
There is no silver bullet to reverse the structural decline in equity markets over the past few decades. It will require all market participants to work together to address three main areas:
- reforming the tax treatment of equity finance
- encouraging more investment in equity markets by asset owners;
- reducing the disclosure gap between privately-held and public companies
- developing a less onerous regulatory framework for smaller companies
- rationalisation and consolidation of exchanges and market infrastructure
- introducing more effective competition between exchanges
- investing in corporate services to support listed companies
- modernising the IPO process
- encouraging more direct retail interest in equity;
- creating industry-wide initiatives to support investing in smaller companies and helping to fund the ecosystem around them.