Date of publication
11 July 2013
List of all OECD Corporate Governance Working Papers
OECD Corporate Governance Working Papers, No. 10
By David Weild, Edward Kim & Lisa Newport*
This study provides critical observations on the state of key global equity markets, with substantive suggestions to improve their efficiency and effectiveness in facilitating capital formation. It examines the structure of markets and the characteristics that make some more successful than others, with success defined as providing the most fertile ground for capital raising, effective allocation of capital, job creation and, ultimately, a stronger macroeconomy.
Stock markets in the United States are a particular focus of this report, highlighting structural and regulatory changes that have been exceptionally harmful to capital formation, as well as recent progress that is being made to improve market structure.
It offers compelling evidence that the primary determinant of long-term sustainability
of IPO markets and, as a consequence, an important driver of economic growth, is the
relative size of aftermarket economic incentives. Low aftermarket incentives (defined as tick sizes that are less than 1% of share price for sub USD 500 million market value stocks) and low numbers of small public companies lead to low levels of IPO activity. Broker-dealers, who are the facilitators of capital formation, must have adequate incentives in order to support small company IPO activity. The combination of higher tick sizes and larger numbers of small public companies, on a gross domestic product (GDP) weighted basis, combine to sustain the critical mass infrastructure and services required to support a vibrant domestic IPO market.
The study also finds that GDP growth rates alone are, surprisingly, not a major determinant of small company IPO activity. Thus, stock markets that provide significant economic incentives to support small companies and associated infrastructure in the aftermarket will create higher rates of capital formation that, in turn, will generate jobs, economic growth and tax receipts.
In the same way that a city’s infrastructure cannot be maintained without adequate
capital to support it, an equity market must also be supported with adequate economic
incentives in order to maintain vibrancy. The most striking example of how the lack of such incentives can impact a market is the United States. What was once the greatest capital formation engine in the world has been reduced to a shadow of its former productivity, because of the elimination of nearly all of the economics that once fueled the growth of its ecosystem.
Structural and regulatory changes that began with the new Order Handling Rules in
1997 and Regulation Alternative Trading Systems (ATS) in 1998 were the key blows that were the most damaging to the new issue market in the U.S., particularly for small company IPOs. These changes set in motion a dramatic shrinkage in trading spreads and tick sizes in all stocks. While this was, on its face, good news for investors, the ultimate consequences of smaller spreads and tick sizes was manifest in a stark decline in the number of companies going public. Ultimately, there is a paradox at work here: policymakers intent on saving investors’ money through lower transaction costs can do more harm than good by undermining the very infrastructure and services required to support economic growth. Public company listings, which peaked in the U.S. in 1997 with 8 823 exchange-listed companies, have nearly been cut in half to only 4 916 companies at the end of 2012 — a decline of 44.3%. In fact, since the peak, the U.S. has suffered 15 consecutive years of lost listings.
The U.S. stock markets are essentially governed by a one-size-fits-all regulatory
framework, with one-cent tick sizes for every stock, regardless of share price, market
capitalization or liquidity. While we are encouraged by the passing of the JOBS Act in April 2012, the U.S. Securities and Exchange Commission, alongside Congress, has much work still to do in order to reverse the damage that has been done.
While the IPO decline is most extreme in the U.S., the world supply of IPOs has also
suffered a material decline with the proliferation of electronic markets. Work by the OECD shows that the global number of IPOs has declined from over 2 000 per year in the early 1990s to less than 750 IPOs in 2012. Two thirds of this decline comes from outside of the U.S.
Hedge funds and other hyper trading institutions have become the dominant force in
the one-cent tick size market, at the expense of long-term fundamental investors and
liquidity providers (intermediaries). When trading interests overwhelm fundamental investor interests, price distortions occur, the marketing of individual stocks is displaced by derivatives (including exchange traded funds) and capital formation and allocation become less effective. In turn, economic cycles are made more extreme and long-term economic growth may be stunted.
One-size-fits-all is a poor basis for regulation. Large cap stocks are inherently liquid
and benefit from the interest of many investors looking to buy and sell the stocks at the same time. By contrast, small cap stocks typically are less liquid, with asymmetrical or one-sided order-book markets. Unlike their large cap brethren, small cap stocks require broker-dealers to support liquidity, sales and equity research in order to sustain active markets. One-size-fits-all stock market structures will underperform markets that are optimized separately to meet the needs of large cap and small cap stocks and their respective constituencies.
* The authors would like to thank the partners of Grant Thornton LLP for their longstanding support of the authors’ research into how capital markets structure impacts capital formation, without which, the JOBS Act in the United States could not have become reality. Grant Thornton’s support has allowed us to inform the discussion on “tick sizes” and electronic markets structure in the United States by helping to focus attention on how smaller and smaller trading increments may harm small capitalization stocks and the growth economy, while increasing “short-termism” in large capitalization stocks.