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There was a stock exchange, once upon a time

Date 29/10/2008

Giovanni Bottazzi and Malcolm Galloway Duncan

For most of us, the words ‘stock exchange’ immediately bring to mind certain thoughts and images, but do these still bear any relation to reality? In fact in recent years the financial markets and, in particular, the stock exchange has undergone considerable change in the whole of Europe. A silent cultural revolution is taking place, unsuspected by the majority, promoted by the chosen few and incomprehensible to most. A careful examination of the current situation reveals a series of inconsistencies and concerns. We propose to examine them one by one. Let’s begin with the inconsistencies.

First of all – during the last decade the European Commission in Brussels has compared various financial market models which derive from local traditions and requirements, as well as varying national laws and regulations. There is the Anglo-Saxon model characterised by financial intermediaries operating within a self-governed environment. Then there is the German model, dominated by the ‘universal bank’. Lastly, there is the Napoleonic model of a market governed by the State and based on the concept of a public utility – the model that has functioned since 1808 in the main Italian market in Milan.

In October 2007, the market companies of the London and Italian Exchanges merged. This is an event which would have been unimaginable just a few years ago, all the more so as the marriage was celebrated according to a German ritual, that is using a model which is extraneous to both markets. No consideration was given to the highly regarded tradition of the Anglo-Saxon market, which would have seemed the obvious choice in order to extend its strong points throughout Europe. On the contrary, the German model has been chosen which favours a bank-dominated market, paying no heed to the well known risks already experienced in the past. In fact as long ago as 1925 Italy had judged it opportune to separate short term financial activities, typical of banks, from long term goals, which are characteristic of the stock exchanges. This measure which was likewise adopted in other countries, and above all in the United States, where shortly afterwards it was decided to make a clear distinction between commercial and investment banking.

Secondly – this decision to make a clear distinction between banking activities was based on a consideration which is still extremely valid, even though there is an obvious reluctance to openly admit this home truth. That is that the bank is in natural and ineluctable competition with the stock exchange and a recourse to risk capital. In fact enterprises organised as joint stock companies can finance themselves directly through the stock exchange by means of share issues which are distributed to the public and to both individual and institutional investors. In this manner companies are able to free themselves from the pressure imposed by bank debt and are able to plan their future development over a longer period of time. Naturally, the bank dislikes being substituted as a provider of capital by ‘a do it yourself’ alternative devised by the companies.

However, if stock exchange operators are themselves banks, it is clearly difficult for the stock exchange to act in the most appropriate manner. If, in turn, the stock exchange institution becomes a joint stock company in which the principal shareholders are the banks, it is all too clear what lies ahead for the stock exchange. This is what is indeed proposed by the EU’s Markets in Financial Instruments Directive which came into force on 1 November 2007. The prospect is of a stock exchange company in constant competition with its shareholders which, having at their disposal unlimited financial means, from now on have the ability to organise markets in securities in practically the same terms and conditions as the stock exchanges.

Thirdly – the stock market is affected by a pervasive series of conflicts of interest which hamper the effective construction of a single European financial market. This is not an unavoidable necessity which derives from uncontrollable astral conjunctions; on the contrary it is the natural and clear consequence of the decision to authorise the bank to carry out both capital-providing. This malady cannot be resolved by the creation of so-called ‘Chinese Walls’, artificial barriers to combat interdepartmental communication and operational manoeuvres at levels lower than the command cabin. On the contrary, if the intention is sincere, the problem can only be resolved by preventing whoever is in command from acting in what are two incompatible roles with opposing goals. This is at the heart of the problem.

Fourthly – the general public may not have comprehended nor is at present worried about the changes in course. However, the reality which appears most likely is the decline of the stock exchanges, situated in the major financial centres and well established in the eyes of the general public, even though perhaps not always reflecting the most positive features. Nevertheless their importance within their respective economies was correctly valued in the past. But after having been for years key protagonists of the national economies, stock exchanges now risk being demoted to stand-ins. How long will the general public continue to behave as if nothing had happened?

These factors hardly promise well for the future. On the contrary, they arouse several queries. Here are a few.

Firstly – how come there is this sudden frenzy on the part of the stock exchanges to merge? It would appear, in order to combat the above-mentioned threats. They have thus sacrificed their independence in favour of a single European market. They have lowered their national flags, but, strangely, no-one has tried to hoist a European flag. It will be difficult for the new stock exchange conglomerates to represent or promote the economies of their home countries, as national boundaries no longer count, and neither does distance. For example, the New York Stock Exchange has merged with Euronext which, in turn, is the fruit of the merger of several European market centres around the Paris Bourse. In such stateless and mercenary exchanges, what counts is the available capital, as products displayed in markets other than where the stakeholders reside are in turn invested in places ever more distant and diverse. Owners of capital are ever ready to disinvest here and invest in other regions where short term prospects appear to be more remunerative. This is one of the typical aspects of globalisation: decidedly not the most virtuous or promising for productive activities and for the real economies.

Secondly –such stock exchange aggregations are now sustained by major shareholdings acquired by hedge and sovereign funds, in both cases institutions with enormous capital at their disposal. In the latter case, many belong to countries which have not adopted democratic ways of life. So far their investments have had merely investment objectives, and they have even declined to vote at assemblies of companies in which they have invested. But one may ask what may occur in the future. Will they act differently, benefiting from our democratic customs? This is hardly an aspect to overlook, even by the intermediaries. If we compare a stock market to a large maritime port, its correct functioning can not be left to its most frequent utilisers, that is the sailors: in fact they are often responsible for the decline of the same ports.

Thirdly – it is sufficient to look with a critical eye at the tendencies which have been noted during the last decade and, more recently, within national boundaries in order to have an idea of possible future scenarios. After a long period in which European stock exchanges had a low profile, as the greater part of market turnover took place within the banking community, the stock exchange has flourished in terms of market volume and in the market value of listed companies. However, more recently the attention of the market has been somewhat diverted, and begun to represent ever more the interests of the intermediaries rather than those of the company issuers. In fact, share issues have not increased at the same rhythm as market turnover. Trading in the more speculative shares has increased at a rate far greater than other stocks, and asset management company profits have also risen at an enviable rate.

Fourthly – the rising profits of stock exchange management companies may have led users of the stock market services to think them excessively expensive and encouraged the same intermediaries to substitute themselves for the bourse so that, as market operators, they would save on commissions which, as market managers, they would earn directly. To counteract these initiatives it would have been sufficient for the stock exchanges to give equal hearing to all market categories including company issuers and investors, as was done by the Stockholm Stock Exchange on its privatisation in 1992. Unfortunately, the bourses did not realise the danger in time and allowed the situation to deteriorate. The MiFID directive represents a return to the past: market concentration is no longer required. On the contrary, market operators are given the opportunity to open parallel markets to the stock exchanges. Thus the number of markets increases, diminishing the stock exchanges, and the number of domestic intermediaries will probably likewise diminish under the high costs of the investments needed to bring their structures in line with the new reality, and the presence of international market institutions will become ever more aggressive. It is the complete opposite of what was expected to occur, both by the technocrats in Brussels and in the short-sighted plans of the principal market operators.

These changes do not appear to promise an improvement in terms of confidence in the market operators and clarity in the regulations and market transparency. Those are the essential conditions in order to guarantee a generally well balanced financial market and, in particular, the stock market. In fact the silent market revolution already under way risks breaking the mechanism. We have recently seen how a loss of confidence among market operators, triggered by a lack of stability in another part of the world, can set off a series of market shocks capable of shaking the global market arena. Nevertheless, any move in favour of major clarity is unlikely to come from all-round market operators, who do not like having to point out the difference between listed securities and structured debt which is not listed, even though at times given some form of authenticity by ratings. They are reluctant to admit that only an effective and ample market can guarantee their liquidity at all times. Recent creaking and turbulences experienced in trans-Atlantic markets are evidence of inconsistencies of this nature.

The delicacy of the current moment cannot be underestimated. Innovative finance has in recent years built up an immense house of cards, built on a much smaller base of effective economic activities and therefore by definition extremely unstable. According to an International Monetary Fund estimate, in autumn 2007 world financial activities not only surpassed the correspondent national domestic products by some eleven times, but in addition were principally based on derivative products which, for the greater part, are not listed in any stock exchange.

It appears that the relevant authorities are not sufficiently aware of the imminent danger, notwithstanding the preceding stockmarket crises which have occurred in ever shorter periods of time; 1987 and 1989; 1998 and 2000-2001; 2007 and…? That is in spite of the fact that each event highlighted an imbalance caused by the presence of conflicts of interest which had surfaced after a period of incubation and which were thus clearly evident to everyone.

Bearing in mind that the financial markets are ever more linked at world level, it would appear that the moment has arrived to boost international watchdogs, by strengthening the links among national statutory organisations until now based on an associative basis, creating a kind of UN for the capital markets. This would assure more rapid reactions in times of crisis. In this way, the same authorities could carry out preventive intervention, carefully monitoring any imbalances at their outset and, at the same time, propose measures in order to prevent future events of the same nature.

Clearly the monitoring of this enormous arena cannot be left to market players, like the habitual sailors in the ports, who are chiefly responsible for the present disorder…

Giovanni Bottazzi was a member of the management of Borsa Italiana from 1974 to 1994. Malcolm Galloway Duncan was Head of International Relations at Borsa Italiana from 1972 to 1994 and an advisor to the European Commission (DGXV) from 1981 to 1984.This article is a summary of a detailed study in Rivista Aiaf, the journal of the Association of Italian Financial Analysts (AIAF).