BACK TO THE DRAWING BOARD.
As the mainstream activities of exchanges continues to stagnate, Jannah Patchay, of Agora Global Consultants argues that now is the time to think out of the box.
Equity markets seem to be the natural solution to a fairly simple supply and demand equation. I have a business – you want to make an investment. My business can issue shares. Voila, we have a match and everyone is happy. What additional embellishment could possibly be required for a transaction as simple as this?
As exchanges have evolved over the centuries, the core components of their business model have changed superficially, but are still clearly recognisable. As matchmakers of investor cash supply to enterprise capital demand, they provide a framework for bringing new IPOs to market, a secondary market and access to liquidity for investors, and market data to facilitate the price formation process. However, in most capitalist economies, exchanges are not actually operated as public utilities at all. Consequently many of the activities in which they engage have so far been revenue generating and profitable to them. That is, until now…
The dramatic decline in IPOs and the stagnation of the primary markets has hit exchanges hard, as news headlines frequently inform us. Falling transaction volumes on secondary markets as a result of increased competition between trading venues, increasingly squeezed margins on secondary market data, and many other pressures are making life a little more challenging for the exchange operator.
Regulation has provided a brief reprieve; increased clearing requirements have led many exchanges to explore vertically integrated trading and clearing businesses, either setting up new clearing houses or investing in existing ones. As regulation strengthens, balance sheet strength and increased margin requirements can drive creation of new products (such as Eris Exchange’s swap futures, or ICE’s swap futurisation programme). But what innovation is taking place in the old fashioned Equities market?
Indeed, can anything be done to salvage the traditional primary and secondary stock markets, in light of the dire picture painted above?
In this aggressive world where the constant mantra is “bigger is better”, what innovations can non “premier league” exchanges bring to the market that not only provide them with new revenue streams, but also enable them to fulfil their core function of helping companies gain access to capital?
One thing is certain; doing more of the same simply isn’t going to work. Market conditions have changed, perhaps permanently, and exchanges must adapt their business models if they are to compete in this new landscape.
However, it isn’t all dismal news. There are examples of successful exchange innovation that fulfil investor and issuer needs, which can be found in some unexpected places. A recent industry conference provided several examples from smaller exchanges attempting to find their own path to success whilst also building the economies and markets in which they operate. Interestingly, their ambitions were often not constrained within their own geographic boundaries.
We often hear government ministers preach to businesspeople that small to medium enterprises (SMEs) are the key to economic growth, particularly in times of global recession such as the one we find ourselves in currently. This is true of not only developed markets such as the EU and the US but also of emerging markets, in which the ability to operate a main market hinges on the creation of an SME market to feed into it. Most SME markets have struggled with the issues of good governance and liquidity. On the one hand, many SMEs do not have the capacity to show compliance with onerous listing requirements. On the other hand, good corporate governance, transparency and accountability to investors are absolutely necessary to build investor confidence and therefore liquidity in the market.
Having examined this problem in detail, one of the Caribbean exchanges has set about implementing an SME market that is built on principles of good governance and investor confidence. Each issuer must have an approved “mentor”, whose role is to ensure that the company complies fully with its listing and governance requirements. The exchange has negotiated with its local government to obtain generous tax incentives for companies remaining listed on the market, without suspension, for a minimum period of 15 years, including a full 5-year tax holiday for these companies. Companies failing to meet their listing requirements for the duration are required to repay any tax benefits accrued. There is therefore a powerful financial motivation for companies to list in the first place, to remain listed, and to ensure that their governance standards are high. As investor confidence in the quality of issuers grows, so too will liquidity in this market.
There has also been much recent discussion of the use of crowd-funding as means for exchanges to build IPO pipelines. For the majority of SMEs, funding requirements are in the order of 10,000 – 250,000. These firms are poorly serviced by the current financial market structure – they are too small for even the SME exchanges (and their business models are not yet developed enough for an IPO), and where they are able to obtain corporate financing through bank lending, interest rates are prohibitively high. The traditional sources of private investment – private equity, venture capital and angel investment are either out of their reach or would require giving up control of the direction of their businesses at a crucial stage in development.
Crowd-funding provides a neat solution; companies can obtain funding at low cost from enthusiastic investors, sometimes in exchange for no more than sample products or free services, but increasingly in exchange for equity. An enterprising exchange, seeing a decline in IPOs on the main market, might look to the future and seek to build up a pipeline of SMEs that will one day IPO on first its junior and then main market. Creation of an exchange-hosted and operated crowd-funding platform would provide an ideal incubator and indeed create a whole ecosystem for funding companies from early-stage capital through to IPO and subsequent debt issues. There is also potential to create a range of new tradable instruments for a crowd-financing model, from debt to future income-related payment streams.
The Equities market may never be the same again, but that is not to say that it will not thrive in the future, in ways which we are only beginning to imagine now.©BestExecution | 2013