Ideas
Professor John Kay

Taking stock of exchanges’ stock-in-trade ... some thought provoking ideas from Professor John Kay

Burgess COMMENTARY

Peter Burgess

Welcome to the Financial Times, news and analysis for global decision makers. Taking stock of exchanges’ stock-in-trade

An invitation to a lunch on the topic of responsible investment appeared to offer sandwiches along with the usual worthy but predictable truisms that investing with a sense of responsibility about the broader consequences of one’s impact may not only be ethical but could offer financial advantages too.

Instead it provided substantial food for thought about the entire basis of the financial system, alongside the inevitable sandwiches.

The speakers were Saker Nusseibeh, chief executive of Hermes Fund Managers, and Professor John Kay, author of the Kay Report on UK equity markets and long-term decision making (and weekly columnist for the Financial Times).

Rather than the disquisition on the opportunities available for investors in alternative energy sources or the challenges of ensuring a human rights-compliant supply chain, Mr Nusseibeh and Prof Kay were considering how one might redesign the system of company ownership to better serve the purposes of society.

Prof Kay suggested that public equity markets are no longer fit for purpose, or rather that the purpose they were created to fulfil no longer exists. While late-19th century capitalists were trying to raise capital to build railroads or mines, enterprises that required large sums of capital up front, the more typical new company today is a technology business that requires comparatively little capital outlay. It is more likely to be using its initial public offering to allow the original investors to realise their profits or even exit the business.

With the rise of collective investing, via pension funds and investment funds, it is no longer the case that stocks are broadly held by individuals.

Prof Kay’s suggestion was that pension funds wishing to invest more responsibly for the benefit of their members should bypass the public markets and invest directly in companies. It would make executives more directly accountable to shareholders. It should also allow those executives to focus on long-term returns, since their pension fund owners would care less about the quarterly returns than intermediary managers do.

These are no doubt desirable outcomes, and might even be the result of direct investment for some pension funds, but it is questionable whether all investors would see positive results from eschewing public markets, and even more so that the system as a whole would be improved by removing public stock exchanges from the chain.

In the space of a 90 minute long lunch with two speakers and time for questions, it was of course impossible for this theory to be elaborated, but it certainly demanded careful consideration. Are we simply in thrall to an empty monument that makes things worse rather than better? Or do public markets still have a useful function, even if it is not that for which they were originally envisioned? Is it possible to come up with a better system?

It is clear there are problems with the system – not just because of the financial crisis, which could be seen simply as a larger than usual correction, but because so many parties can extract such high surpluses from the invested savings of the population. Stock exchanges, high-frequency traders, arbitrage hedge funds – even the mainstream asset manager is doing well out of the business.

Making some of this rent seeking impossible would be good, and direct investment would bypass some of it, but there is no guarantee any surplus rescued from one rent seeker would be passed on to investors. Because most people do not have any great choice about whether they save, either through pensions or insurance, there is no clear reason any surplus needs to be returned to them to persuade them they should continue to do so.

The argument that stock exchanges no longer serve their original purpose may be reasonable, but it does not follow they do not serve any purpose. A recent surge in flotations indicates there is a demand for their service, even if it is not raising capital for new enterprises. Instead, The stock market provides an exit for private equity investors, chosen when it is possible to get a better price there than a trade sale; it offers a way for entrepreneurs to monetise the enterprise and gives them capital to start the next business; and it allows companies to create transparent stock reward schemes for employees, giving them a stake in the business and an interest in its continued success.

The strongest argument for the continuation of public markets is that it gives investors a way to scrutinise the companies listed and creates a standard for transparency and accountability that informs practice even among private companies. Without the standards demanded by listing authorities, many companies might well continue to provide the requisite information, possibly even better information about their individual companies than the standard format. However, without a standardised format for reporting, it would be difficult for investors to compare companies and there would be no certainty that the companies were reporting all relevant information. Regulation, particularly of banks, would become even more complex and demanding than it already is and competition would be virtually impossible to manage.

As Prof Kay suggested, it is certainly right to examine our assumptions that things such as transparency and price discovery are unalloyed goods, but it is equally important to consider how alternative systems might develop in the absence of such assumptions.

My instinct is that the current system of public markets, deeply flawed though it may be, is nevertheless better than any alternative. To paraphrase Winston Churchill, it is the worst of all systems, apart from all those other systems that have from time to time been tried.

Copyright The Financial Times Limited 2014.