A cursory survey of literature describing stock markets and exchanges nets an interesting observation: there is a lot written about individuals and institutions who are active participants in these markets but not much about the markets themselves.
Perhaps this is a reflection of an identity crisis that seems to have plagued exchanges since they came to be. At times, they were the creations of private initiative; at others, government launched and sponsored. Additionally, stock markets and exchanges have a wide range of stakeholders and, as such, it is difficult to pigeonhole the industry into a clear-cut category. Apart from listed companies, investors and intermediaries, there are regulatory bodies (self administered or publicly managed), liquidity providers, settlement banks, corporate governance and disclosure issues, and IT systems providers to name a few. The matrix of this industry is multidimensional.
Securities markets touch the lives of everyone these days and, as such, the industry has become a discipline that warrants special attention. But, should the subject be taught at a business school, law school or a government/public policy school? Attempting to answer this question should illuminate the complexity and the multidisciplinary nature of stock markets and exchanges.
This has not stopped the courageous to attempt to describe what is in an exchange. Seven of the best approaches to defining an exchange that I have come across are summarized below (apologies to the writers for not mentioning names):- A basic assumption underpinning any market is that the potential for trade can make people better off; buyers and sellers can create or enhance value by building a well-regulated and well-managed market.
- An exchange is a link between deficit units (people, enterprises and governments that are in need of more funds than they have), and surplus units (those that have more funds than they need at a particular point in time). In doing so, an exchange contributes to the economic development of its host country or region by mobilizing indigenous savings and attracting foreign investments.
- Stock markets and exchanges facilitate the intermediation between savers and investors, thereby helping translate savings into investments. The more efficient this process is, the less the cost of investing. The less the cost of investing, the higher the rate of investment/saving. This, in turn, usually leads to higher rates of economic growth for a given country or region.
- Exchanges and stock markets have the following benefits:
- an active securities market increases the efficiency of investment because of the control imposed on the behavior of companies through continuous adjustments of their share prices in the market;
- an active securities market lowers the cost of equity capital and, as a result, increases investment and economic growth by spreading the risks of long-term projects among many investors; and,
- an active securities market can attract foreign portfolio capital and foreign direct investment, increase domestic resource mobilization, and, as a result, expand the resources available for investment.
- Exchanges fulfill four basic functions. They:
- provide information signaling as to the value of financial instruments, which provides the basis for investment and issuance decisions;
- allow for the storage of wealth via facilitating the creation and trading of savings instruments;
- allow for risk sharing via diversification; and,
- function as a source of capital, both domestic and foreign.
- For emerging and pre-emerging or frontier markets in particular, international portfolio flows tend to decrease the cost of capital by allowing investors to share the risk of projects with others. These flows also seem to lead to permanent increases in valuations. However, developing countries and pre-emerging markets need to prepare to receive and manage such flows (at times called hot monies) in ways that help them avoid the pitfalls and maximize the benefits.
- Critics of exchanges put up the following observations:
- Exchanges are speculative plays. Prices and volatility cannot be explained by the underlying fundamentals. This, in turn, tends to generate adverse effects for capital formation and has a negative impact on the overall economic welfare of a country or region.
- Market discipline cannot be established with ease because of disclosure problems, costly monitoring, inefficient enforcement mechanisms, and a lack of informed investors.
- Exchanges can destabilize an economy by allowing for the rapid inflows and outflows of capital.
How and why a stock market or an exchange thrives is an interesting question and perhaps we need to study the philosophy and history of market formation to come up with good answers. However, it is interesting to note that once the interplay of human activity becomes established in a certain locale, be it geographic or electronic, it is difficult to dislodge without a compelling argument. This is true of all kinds of markets. A gravity centre of sorts emerges and starts attracting liquidity (the bloodline of any market) that is not easily diverted elsewhere.
It is this gravity aspect that deserves special attention. Stock markets and exchanges are not, contrary to the belief of some, typical financial service providers; they cannot and should not be valued like say banks or insurance companies. The gravity center embedded within the functioning of a stock market or an exchange warrants a premium and those who understand this are the investors who will realize the full potential of their investments in this sector.
