At first glance, with markets at all-time highs, this might seem a silly question to ask, but a look beyond the glitter of the index peaks suggests that some troubling trends continue to undermine the foundational role that stock markets should play in capitalism. This point of view is explored in a recent article by Arjuna Sittampalam (a researcher at EDHEC-Risk Institute and editor of the  Investment Management Review).

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Sittampalam looks at the negative impact that High Frequency Trading (HFT) is having on small and mid-cap stocks. As the author notes:

The obstacles to trading in smaller stocks are partly attributed to the shrinkage in the number of dealers catering to this market. These dealers are themselves finding life difficult, because of insufficient volumes in these companies and cut-throat competition in the bigger ones, where the large dealers with economies of scale have the advantage. These trading problems undercut the second major purpose of the stock market, which is to provide liquidity.

Even more problematic, notes Sittampalam, the ability for new companies to raise capital via IPO’s continues to decrease. He believes that several factors are contributing to this problem:

The decline in IPOs has sparked an intense debate among academics, policy-makers and industry experts as to whether serious structural factors underlie it. According to the IPO taskforce set up in the US, it now needs over nine years from the start-up stage to go public, compared with less than five years in the early ‘80s.

Several problems and causes have been suggested.

  • Exchanges that used to be mutually owned by stockbrokers, and were more or less functioning as utilities, are now owned by shareholders, with the focus turning to maximising profits.
  • Accordingly, exchanges have moved to HFT and derivatives. For example, NYSE Euronext earned only $334m from company listings and a much higher figure of $675m from derivatives in the year to September 2011.
  • Bankers are now focusing on mandates from bigger companies and reducing their services to smaller ones.
  • High costs of flotation and regulation are also being blamed.
  • Investors are fed up with paying too much for IPOs, many of which have fallen in price since launch in the past few years, with increasing distrust between companies, including their advisers, and investors.
  • Private equity groups are being assigned some of the blame, as they try to extract high prices for companies stripped of their growth potential and burdened with excessive leverage.

Sittampalam’s conclusion is that stock markets, focused as they are on  making more money for those who already have it, are failing in their most basic and most important roles:

The stock market is decreasingly fit for purpose in terms of its intended functions. These are twofold, raising capital from investors and providing liquidity for the latter after purchase, in order to encourage them in the first function.

Once again, it’s tempting to cast these worries aside, but to do so would be wrong. Capital markets are supposed to be just that and not dark alleys where gamblers take chances with other people’s money. The latter has always existed, of course, but never before has it been the driving force of the markets, which, one could argue, is the situation today. Perhaps the most optimistic scenario is that alternative markets such as AIM and Plus in the UK will step in the fill the entrepreneurial gap that the large markets are creating, but this will be a tough road to take with today’s complex regulatory environment. Indeed, a smart move would be for regulators to encourage the birth of smaller markets in the US —  markets focused less to moving money and more on making it. In espousing the need for markets to return to their basic role, Sittampalam is correct and his views deserve careful consideration by regulators and investors alike.

Read more: http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2012-06-15.1506

 

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Posted by Carlos Alvarenga

Carlos Alvarenga is the Executive Director of World 50 ThinkLabs and an Adjunct Professor at the University of Maryland's Smith School of Business.

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