From the days when brokers gathered under a Buttonwood tree in lower Manhattan, stock markets have been central to a healthy functioning economy. But these days, they seem kind of sick.
Initial public stock offerings (IPOs) have been in steep decline as companies put off going public. And who can blame them? The financial costs of being a public company have risen. And the market’s obsession with quarterly earnings makes it hard for business leaders to invest for the long term and stay true to their missions.
Meanwhile, many mom & pop investors feel they are pawns in a market that seems to favor insiders, speculators and high speed traders.
Suddenly, fixing the markets is taking on new urgency. Last week, the SEC approved a new stock exchange designed to thwart high frequency traders, while in Silicon Valley a prominent entrepreneur revealed plans to create a stock market that encourages long-term thinking and value creation.
There are also legislative efforts at the national and state level to create new kinds of exchanges. Together, these efforts may someday restore our public markets to their intended role: to encourage capital formation and give investors a fair marketplace to buy and sell their shares.
Here’s a roundup of regulatory and entrepreneurial efforts to create a better system of raising capital and maintaining liquid markets:
High frequency traders have become a parasitic and destabilizing force on the markets. These private outfits pay rich sums to “co-locate” their trading servers at major stock exchanges to shave fractions of a second off their trades—they then use that extra time to outrun investors and capture profits from small discrepancies in stock quotes. More than two-thirds of all stock trades were executed by high-speed traders at their height during the financial crisis, netting big profits at the expense of other investors.
On Friday, IEX, the stock trading system created by Brad Katsuyama and featured in Michael Lewis’ hit book, Flash Boys, received regulatory approval from the SEC to operate as a stock exchange, putting it on par with NASDAQ and the NYSE. Lewis’s riveting prose (he could make securities laws fun to read about) drew mainstream attention to the esoteric issue of high frequency trading that encapsulated the public’s growing unease with the public markets.
In 1940, investors held stocks for an average of seven years; by 2007, that was down to seven months. Factor in high frequency trading, and some estimates have put it as low as 11 seconds.
Katsuyama designed IEX specifically to counter these robo-traders. His big innovation was rather simple: introducing a “speed bump” of 350 milliseconds to neutralize the advantage that high frequency traders have and thwart their front running. IEX had been operating as a “dark pool” while its application to become a full-fledged exchange went through the approval process. Despite heavy lobbying from incumbents such as the NYSE and NASDAQ, the SEC green-lighted IEX last Friday.
Status: IEX will be open to all public trades starting in September.
Long-Term Stock Exchange
In the old days, hot growth companies like Microsoft and Intel pursued IPOs early in their growth cycles. They raised growth capital and their public shareholders benefited as they went on to become some of the most successful companies on the planet. These days, Silicon Valley companies are likely to go public kicking and screaming, if they do at all. Their value is created in the private market and captured by a handful of early angel and venture investors. An IPO, if it does happen, is often just a way for those early investors to cash out to a gullible public.
Worse, once they are public, a company’s managers become slaves to the quarterly earnings cycle, which encourages financial management over research and long term investment.
That frustrated Eric Ries, a Silicon Valley entrepreneur and author of The Lean Startup. In a piece published on Medium last week, he introduced his solution: the Long Term Stock Exchange, which he describes as “a new public securities exchange designed to promote long-term value creation.”
The number of companies listed on US stock exchanges has declined from 9,000 to roughly 5,000, according to David Weild of Weild & Co. And the US has fallen from first place to 12th in terms of small IPOs.
The exchange will achieve its mission in three ways: by requiring that companies that list on it not tie executive compensation to short-term stock performance, by increasing transparency and company reporting, and by rewarding long-term shareholders with greater voting rights.
Status: Ries will have to get regulatory approval for his LTSE.
Ever since the passage of the JOBS Act in 2012, Congress has been mulling ways to create liquidity for small investors who, thanks to the law, may now invest in private companies. When an investor buys shares in a company through the new crowdfunding exemptions, those shares are typically restricted for up to a year. And even after the lockup period expires, the shares may or may not be listed on a stock exchange, making it difficult for an investor to sell them if they need their money back.
For the small growth companies raising money this way, the major exchanges are out of reach. Some issuers, such as Elio Motors, an electric car maker that raised from the public through Regulation A+, have listed on the OTC market, which deals in the shares of smaller companies. But legislators are proposing a new kind of market.
The costs of going public have risen. While $10 million IPOs were commonplace 25 years ago, the typical stock offering soared to around $140 million in recent years.
In May 2015, the House Financial Services Committee first proposed the Main Street Growth Act, which allow the creation of exchanges that could facilitate buying and selling of shares in companies that have raised money under exemptions from federal securities laws. The bill resurfaced earlier this year in the same committee. As described in the bill, venture exchanges would operate on a national scale yet be exempted from federal National Market System (NMS) and Alternative Trading System (ATS) rules, making them less expensive to operate than a full blown stock exchange.
Status: The bill is still pending full House approval, and from there would move on to the Senate.
Local Stock Markets
The US once had dozens of local stock markets that served local companies and investors. Research has shown that these long-forgotten exchanges were an important driver in their local economies. But with the advent of telecommunications, the local markets lost ground to the powerful New York Stock Exchange. One by one they merged or closed.
The concept of a local stock market is being revisited as states adopt that allow investment crowdfunding within state borders. As with the JOBS Act, those intrastate laws raise the issue of liquidity: how can investors sell their shares if they need to?
Michigan is experimenting with an answer. The Michigan Investment Markets bill, passed in October 2014 on the heels of the state’s MILE crowdfunding law, allows for the creation of local stock markets and provides a regulatory framework they can operate within. The markets would be regulated at the state level as broker-dealers, and would deal solely with Michigan-based investors and securities.
Status: Although there has been interest, so far no one has stepped up to create a market under the Michigan law. A similar bill has been introduced in Texas but did not make it onto the agenda in the last legislative session, pushing it off until 2017 (the Texas legislature meets every two years).