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Who needs stock exchanges?

Date 14/07/2006

Clem Chambers

Past performance is no guarantee of future returns, or so the theory goes. Yet how many investors and traders really believe that? It is a brave trader that doesn't fall back on stock charts to try and predict the future. While the theory says that the market is a random walk, how many fund managers would keep their jobs if they said they never bothered to look at stock charts because it is theoretically pointless?

So it is perhaps not too ironic to look to the past history of stock exchanges to glimpse the future of the world's bourses. While history might not be a good guide to the future of a stock time series, it illuminates the trends so elusive in stocks themselves and throws light on why exchanges will continue to be pivotal to economies and the peoples of the world.

The first stock exchange was founded in Amsterdam by the world's first multinational; the Dutch East India Company. As such, the Dutch East India Company was the first company to issue stocks and it did so for the very same reason companies IPO today; to raise money to build their business. The Dutch had reached a stage where they needed to reorganise their economy and they did so with a revolutionary idea of public issuance.

The Amsterdam bourse was founded in September 1602 within six months of the company's formation and was an integral component to its success; it grew to an organisation of 50,000 civilian employees, with a private army of 40 warships, 20,000 sailors and 10,000 solders and a mind blowing dividend flow. The whole of Holland was revitalised.

With a market for its stocks and bonds, the Dutch East India Company became probably the most powerful business in the history of the world. It became, to all intents and purposes, a state within a state; just the kind of company fit for a James Bond plot.

It seems highly unlikely that companies will ever again lay siege to markets with troops and gunboats. The first public company was without doubt the mightiest there has ever been.

Yet the key to the success of the Dutch East India Company was that its ownership had been opened up to the public. This enabled the vast sum of 6.5m guilders to be raised. The exchange also allowed the company to issue bonds to finance its short term needs. In this way the first stock exchange was a crucible of modern capitalism. The history of the Dutch East India Company is also a kind of template of what was to happen to companies on stock markets over the years to come.

The company's IPO saw a 'pop' of 15% to its issue price, the first opportunity for investors to stag an IPO in history. It is intriguing to imagine that somewhere in the record there may well be the name of the first stock flipper in history, though it is unlikely that many of the initial shareholders 'stagged' the issue, as the actual concept of stock market trading wasn't yet invented; buying and selling was a manual and laborious affair.

Long-term holders were on to a good investment too, and twenty years later the share price had risen 300%. This might not seem like a particularly stellar return, but during the period the average dividend from the company was a fat 18%. Clearly investors at the time were not so interested in capital

appreciation and looked to income for their returns. Life was short in the 17th century, so investors looked for the sort of returns that today could never be delivered. While P/E ratios weren't yet invented, the P/E of the Dutch East India Company was very low and, though the actual accounts of the company were not transparent, the P/E of the company must have been nearly one when, four years after its foundation, the company paid a record dividend of 75%.

However, the executive board of the company seemed to have been under just as much pressure to make its numbers as any modern group of execs and the company resorted in later years to all kinds of financial engineering to keep up its notional shareholder returns. Cash dividends were increasingly replaced by bonds, and even spices like pepper were used as payment.

Soon shareholders were known as 'pepper sacks', undoubtedly for their ownership of hard-to-dispose-of aromatic payments in lieu of cash.

Then, of course, along came tulip mania - the first of many speculative market bubbles to come. This period, which witnessed tulip bulbs explode in value under the influence of what amounted to options trading, saw the company's stock rise to 1200% of its original issue price. By the late 18th century, after nearly 200 years of operation, the company began to fail and the share price crashed. With 110m guilders of debt, the Dutch East India Company imploded in a way Enron shareholders would recognise. The Dutch state stepped in and took on its debts. While the story of this individual company was over, the history of stock markets was only just beginning.

Meanwhile, in 1698, a John Castaing began to issue a list of stock and commodity prices in Jonathan's Coffee-house. Trading in London had already begun and soon dealers where making such an uproar that they had to be expelled from the Royal Exchange, the traditional centre for commerce in London. The Royal Exchange was a centre for dealing in physical objects, the goods that came and went through the port of London, but stocks were a natural extension of the contracts and bills that passed during transactions.

However, stocks represented a new dynamic. They were a derivative of a new powerful kind and as such it was only to be expected that they would create an explosive atmosphere. New financial instruments are powerful and dangerous things. Most of the most famous and costly booms and busts have been caused by a new instrument being unleashed on a greedy and ignorant audience. It is only after the market has learned an expensive lesson that the long-term application of the instrument turns to the greater good. Somewhere in every bust there lurks an expensive learning curve that, given time, pays handsome returns.

Having been exiled from the Royal Exchange, the stock traders took to the streets and coffee houses. Ironically, in the modern era, the Royal Exchange is now just a collection of trendy boutiques and an expensive wine bar for the once rebuffed stock dealers. This would be a sweet victory was it not for the fact that the market has no long-term memory. This free-form stock

market survived until 1773, nigh on a century, and encompassed the first iteration of the industrial revolution and spanned the UK's first financial boom and bust, 'the South Sea Bubble'.

It wasn't until a further 50 years had passed that the first London Stock Exchange was formed and even then it was initially known as 'the new Jonathan's'; hardly the branding for a national institution. Unsurprisingly it still retained a coffee shop on the floors above the trading area. The re-branded Stock Exchange, with or without the coffee vending, continued to act as a crucible for the British industrial revolution, and all the while the notion of equity was spilling over Europe and into the US.

While fortunes are made and lost, there is nothing respectable or institution-like in the nature of the London Stock Exchange and it is not until 1801 that there is any regulation or formal membership to be seen or had.

While powering the biggest step change in history, many still considered buying and selling shares immoral and downright evil, and as cycles of boom and bust and speculation roiled the stock exchanges of the world there was plenty of evidence that this dim view of stock markets in general must be true. Yet without stock markets and 'Railway Mania', railways would never have been built and while fortunes were being destroyed, new ones were being made.

At about the same moment as John Castaing was publishing his list of financial instruments, stock brokers were meeting under a tree on Wall Street to trade stocks.

Wall Street was a crude defensive wall set up by the Dutch and, for whatever reason, became the point in New York where speculators got together to trade. In 1792 twenty-four stock brokers signed an agreement which constituted the New York Stock & Exchange Board - the original entity that was eventually to become the NYSE.

The Buttonwood agreement, as it was known, can be seen as not only the beginning of the New York Stock Exchange but also as an inevitable event in the development of the US and its rise from continental frontier to superpower. It is hardly surprising that Wall Street was also the genesis of another US icon - the skyscraper - as the concentration of power and money created by financial trading forced buildings that once hugged the ground to be pushed ever higher into the skies.

In the modern era stock trading has lost much of its louche reputation. It is no longer a dangerous, sinful and reprehensible activity guaranteed to ruin a gentleman, but is instead a transparent-regulated industry of the highest propriety. However, for much of its history the trading activity on stock exchanges was as much a conduit for 'animal spirits' as the race track, while today the very basis of a stock market's purpose is the balancing and exploitation of risk.

These animal spirits - as Maynard Keynes termed them - are perfectly illustrated by the battle of Throgmorton Street in London at the turn of the 20th century. In a period famous for its law-abiding rectitude, for its gentlemen in top hats espousing that their word was their bond, and in the time of Queen Victoria when morals and decency were most valued, brokers, who were busily trading gold shares in the street after hours, chose to fight police three days running, rather than be interrupted in their trading. A public brawl one evening might be easily explained as a one-off, but three days of commotion is akin to the sort of uprising generally associated with social revolt. Such is the power of equity.

Many industries have a tendency to concentrate. While some remain atomised, most human activity benefits from scale. In the modern era it is part of government policy to resist this natural gravity, to stop the consolidation of economic activity before it becomes an anti-competitive monopoly. Monopolies are generally considered bad because concentration leads to pricing power and this power works against the benefit of the consumer. In an ideal world the economies of scale delivered by a monopoly would be passed straight to the customer, but in practice it is the tendency of competing companies to operate at near breakeven that delivers the customer benefits that a monopoly can afford to shy away from.

Stock exchanges are natural monopolies because their scale is a direct benefit to their customers. Liquidity is the advantage that traders value most and trading naturally flows to the largest player with the most liquidity. This is a self re-enforcing process. Liquidity is the fuel of any market and the lower the cost of trading the greater the liquidity. The greater the liquidity the lower the costs can be, and more liquidity will be created if the costs are optimal for the customer and the exchange. This loop is the factor that protects the customer from the monopoly, and in practice this appears to be what happens.

In the modern world liquidity is as vital as oxygen. When the London brokers were expelled from the Royal Exchange or arrested in Throgmorton Street for rioting, it was the drive of liquidity that lay behind the outrageous behaviour. Traders, brokers and exchanges themselves live or die by the availability of liquidity, because in the end the market is its liquidity and for once scale is on the side of 'the angels'. The answer to why the world needs stock markets is really a question of why the world needs liquidity. The history of human development is the history of money and the history of money is the history of the development of liquidity.

The invention of money, the first and still greatest derivative, was as great an invention as fire or the wheel. A liquid proxy of value opened the world for human expansion; with it trade and cities grew. It has always been thought, since their invention, that the growing size of cities could not be supportable. From Athens to modern mega-cities, the question has been how can these sterile places be fed and provisioned. Surely cities would become too big to be supported by their hinterlands and at some point collapse. But as they grew, money and markets enabled them to be sustained. Money meant there would be food enough to feed the concentrated human activity. Be it the Agora in ancient times or the financial exchanges of today, markets remain the pivots of our economies.

Today the world will trade its wealth through derivatives; so that while someone somewhere will continue to swap a chicken for a sack of corn, 99.99% of the world will depend on the trading of one kind of derivative or other through an exchange for our very existence. Corporations will continue to be, as the East India Company was in the 17th century, the agents of economics and progress. As such, the stock exchange is critical to the economies of the world.

The market, as no one likes to believe, is always right and while it is easy to laugh at stock market booms and busts, they most often signal the birth of a new chapter in our economic history. It is easy, for example, to look back at the dotcom boom and see only the rise and fall of ridiculously overvalued companies with blue sky ideas and no business plan to sustain

them. However, today the survivors of that pure equity-fueled boom are reshaping the economic and social landscape of the world that we live in. Without stock markets there would be no eBay or Amazon or Vodafone, no huge drug companies, no Google. Where would GE be without its publicly traded equity? Would fading giants like GM even still be making cars without the liquidity for its equity?

In short, the modern world relies on market liquidity in the same way that Rome relied on water carried to it by its aqueducts. It is interesting to note that Rome's great history was brought to a rapid and desolate end when the Ostrogoths simply destroyed the aqueducts and in one blow made the city uninhabitable for the best part of 1000 years. In the modern world market liquidity is no less vital and it is no surprise that those who would hurt our way of life, first strike at our markets. Market liquidity provides the efficiency necessary to run the modern world, and stock markets provide the capital at a price necessary to power the world's growing economies.

The human world is no longer a natural and organic place. It simply cannot support itself without its vast mechanical infrastructure that acts on many levels as the lever to provide the more-for-less that keeps six billion people alive. So with economic growth it is no surprise that stock exchanges are more and more liquid and that more and more money is pouring around the bourses of the world. Stock market liquidity is as necessary for our daily well-being as oil pumped from the ground. Without the world's stock markets there would be less and it would cost more: be that drugs, oil, food or a telephone call. Money still makes the world go round, and it does so to a significant extent by lapping the circuit of the world's stock markets.

This process can only grow. In a world that is seeing perhaps three billion people climbing from poverty to what we in the western world recognise as a reasonable standard of living, the pace of economic activity can only accelerate. In the same way as we can look back at the 20th century and see the economic activities in our countries as almost unrecognisably small, so in a decade or two we will look back at current levels of activity and marvel at its limitations. Soon headlines will only mention trillions where before news was measured in billions, and soon enough we will start seeing in the press a quadrillion as a unit of money and we will have forgotten how, as recently as the 80s, millions were still considered a significant order of magnitude. This growth will see stock markets trading at levels that we can only imagine today.

While a Nasdaq TotalView screen looking onto the frenetic trading of Google gives us an idea of what the future holds, it is hard to truly understand the step change this will bring about. Trading is still an activity that can be judged by the eye, it is still only exceptional companies or exceptional times when trading activities turn into sub-second price moves; or moments of liquidity faster than the human eye can appreciate. But even now, trading can turn from trade-by-trade activity into a fluid stochastic phase where, like electrons, the price takes on a velocity at which only a trade print can determine to the human observer what price was dealt. Inevitably, markets will trade faster than the human eye at all times and transactions will be crossed at para-human speeds, and this will drive yet more progress.

People will still come to the bourses with their animal spirit and back their hunches with their hard-earned capital. There will be booms and busts and scandals. The regulators will regulate, the lawyers will sue, the speculators will trade and promoters will promote. Stocks will go up and down, fortunes will be made and lost and they will declare that this time everything will be different but it won't be. Who will need stock markets then? Everyone; because without the markets, as surely as in Rome after the barbarians felled the aqueducts, we would all starve.

Clem Chambers is CEO of stocks and investment website ADVFN ( Clem wrote a stock column for Wired from 2000 to 2001 and is currently a columnist for many publications, including UK national newspapers The Business and The Scotsman. He is also a regular contributor for a number of UK and US financial publications, and makes frequent appearances on the BBC, CNBC Europe and SKY.