Joseph Stiglitz, a Nobel prize recipient in economics well-known for his critical view of the management of globalization and free-markets, once described financial markets as ‘the brain of the entire economic system, the central locus of decision making’. He added that ‘if [financial markets] fail .... the performance of the entire economic system may be impaired’.131
The vital role of financial markets is deemed to arise from the help that these markets provide in increasing the accumulation of savings within a country and transferring these savings to wealth-enhancing investment projects.132 Financial markets execute their functions through both distributing and providing liquidity and credit efficiently to agents in the wider economy.133 Both credit and liquidity are essential not only for the production of goods and services, but also to allow the desire to consume these goods and services to take effect.134 In addition, financial
130 See chapter Two, Part I (b)
131 Stiglitz (n 60)
132 Walter Bagehot, Lombard Street: A Description of the Money Market, (1873), (Orion Editions 1991); Khan (n 21)
133 Hendrik Houthakker and Peter Williamson, The Economic of Financial Markets (OUP 2004) 284
134 Ibid
markets are supposed to help in adjusting any imbalances between the supply and demand sides within an economy; financial markets should be able to provide a self-regulating mechanism that leads, more or less on its own, to its own stability.135 While it has become, to say the least, unfashionable to insist on the self-correcting character of financial markets after the 2007 crisis,136 they are nonetheless the principal means to implement any decision concerning the adjustment of credit and liquidity.
In addition to their influence on credit and liquidity, Levine demonstrates that financial markets provide five services which enhance efficiency, increase productivity and reduce the costs to agents in the economy in addition to their role in increasing savings and the distribution of credit and liquidity.137 Those services are: 1) risk management;138 (2) screening;139 (3) providing information for the prices of events, risks and assets; (4) facilitating transactions, and (5) managing the behaviour of managements.140
Having said that, both the importance and role of financial markets have arguably increased with the spread of market oriented economic policies as the
135 Sebastian Dullien and Christian Kellermann, ‘Good Capitalism… and what would need to change for that’ (2010) 4 Social Europe Journal 26
136 The financial crisis of 2007 left little support for the ability of financial markets to adjust themselves. Alan Greenspan, a veteran supporter of deregulation and the liberation of financial markets, admitted that he had put too much faith in the self-correcting power of free markets, see Edmund Anderws, ‘Greenspan Concedes Error on Regulation’ New York Times (New York, 23 August 2008 < http://www.nytimes.com/2008/10/24/business/economy/24panel.html> accessed 29 June 2011
137 Ibid
138 This service is easily illustrated by the insurance market but is not confined to it. For example, Stiglitz suggests that the real importance of stock market is its function of transferring risks rather than raising capitals (n 60). Furthermore, sophisticated securities markets have developed new tools, for details see Peter Spencer, The Structure and Regulation of Financial Markets (OUP 2002) 75; Peter Haiss and Ljell Sümegi, ‘The Relationship Between Insurance and Economic Growth in Europe: A Theoretical and Empirical Analysis’ (2008) 35 Empirica 405
139 It is argued that in a developed financial system, financial institutions play a major role in fostering innovation not only through providing capital, but also choosing those projects which have better returns; Giancario Bertocco, ‘Finance and development: Is Schumpeter’s analysis still relevant?’
(2008) 32 Journal of Banking & Finance 1174
140 Ross Levine, ‘Financial Functions, Institutions, and Growth’ a chapter in Alison Harwood and Bruce L. R. Smith (eds), Sequencing? Financial Strategies for Developing Countries (Brookings Institution Press 1997)
optimal economic structure throughout the world.141 Since the collapse of the Soviet Union and communism as an economic ideology, state control over the economy has been considered inappropriate, not only among previous communist countries142 but also less developed countries which had previously been dominated by the role of the public sector in providing services and the ownership of productive resources.143 Currently, the market economy structure is still the default economic model in the world; for example, membership of the World Trade Organisation (henceforth WTO) requires adopting a policy based on the market economy orientation.
Consequently, it is of great importance at this time to clarify the importance of financial markets in general, and securities markets in particular, for understanding market oriented policies and the transformation of an economy towards such policies.
Notwithstanding the existence of different forms of market economy,144 they share a core concept of minimising the influence of non-economic factors that could influence the allocation of resources through market forces.145 To that end, the pricing mechanisms provided by markets are assumed to be the best available means to channel goods and services to their most highly valued use in the most efficient way.
141 Statistically, there has been evidence to support the notion that policies in accordance with the market economy model are a step towards both economic development and modernisation; see Felix Rioja and Neven Valev, ‘Finance and the Sources of Growth at Various Stages of Economic Development’ (2004) 42 Economic Inquiry 127; Ross Levine, ‘Finance and Growth: Theory and
Evidence’ (2004) NBER Working Paper, Paper No. W10766/2004
<http://www.nber.org/papers/w10766> accessed 29 June 2011
142 Phillip Arestis and Panicos Demetriades, ‘Financial Development and Economic Growth: Assessing the Evidence’ (1997) 107 The Economic Journal 783; Wendy Carlina and Collin Mayer, ‘Finance, Investment, and Growth’ (2003) 69 Journal of Financial Economics 191
143 The unsatisfactory results of other social models have encouraged developing countries to seek alternative models. See Said El-Naggar, ‘Privatization and Structural Adjustment: The Basic Issues’ in Said El-Naggar (edt), Privatization and Structural Adjustment in the Arab Countries (IMF 1989); Ron Dore, ‘Stock Market Capitalism and its Diffusion’ (2002) 7 New Political Economy 115
144 For example, there is the Anglo-Saxon, the German and the Japanese models. For further discussion see Dore, ibid
145 Hans Blommestein and Michael Spencer, ‘The Role of Financial Institutions in the Transition to a Market Economy’ in Gerard Caprio, David Folkerts-Landau and Timothy David Lane (eds), Building Sound Finance in Emerging Market Economies, (IMF and World Bank 1994) 143
Stout captures the relations between price, efficiency and increased prosperity, noting that:
‘A free market relies on a willingness to pay, as measured in monetary terms, to determine how highly individual consumers value particular goods. A good is presumed to be worth most to the consumer who will pay the highest price for it.
Market distortions may shift price from the equilibrium that would be set by supply and demand in a perfect market. Whether these distortions are the result of price controls (such as minimum wage laws), monopoly, or the slow incorporation of information concerning value, they are assumed to produce sub-optimal allocations of resources. These diminish the total wealth available to be distributed and reduce social welfare’.146
Thus, it can be argued that a competitive private sector should be able to both gather savings at a market rate of interest and allocate capital to the most efficient private sector projects,147 given that allocative decisions are rationed by price and borrower insolvency.148 It is therefore plausible to suggest that the most important aspect of financial markets in a market economy model is the process of price discovery for the provision of credit and payment of interest.
In addition to the pricing of credit and liquidity, financial markets are also used increasingly as a means to transfer the ownership of resources not only from states to the private sector, but also between agents in the private sector itself. This is
146 Lynn Stout, ‘The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation’ (1988) 87 Mich. L. Rev. 613, at footnote 155
147 Mohamed A. El-Erian and Sgamsuddin Tareq, ‘Economic Reform in the Arab Countries: A Review of Structural Issues’ in Said El-Naggar (edt), Economic Development of the Arab Countries: Selected Issues (International Monetary Fund 1993) 33
148 Blommestein and Spencer (n 145)
done mostly through an initial public offer of state owned enterprise or raising capital by companies and private agents.149
It should be noted that any careful investigation of the function of stock markets must distinguish between two types of markets: (i) primary markets in which the securities are issued and offered to the public and where privatisation is taking place, and (ii) secondary markets in which those securities are traded among investors, which is the main focus of this thesis.150
The primary markets are these where newly issued securities are sold to investors, whether national or international. The proceeds generated from the primary market go from subscribers to the organizations that issued the securities.151 Thus, it is reasonable to maintain that these markets cause savings and wealth to move from savers to producers, therefore yielding economic rewards.
However, the economic benefits of secondary capital markets are not as clearly straightforward as those in primary markets. Critically, exchanges in secondary markets do not move savings or wealth to producers or wealth enhancing projects. Secondary markets are those where sellers of existing securities meet buyers to exchange ownership only, and thus no new securities are created.152 One question that needs to be asked, consequently, is whether or not there are economic benefits from secondary markets given their abstention from the process of the allocation of resources between producers and savers ascribed to financial markets in general and primary securities markets in particular.
It could be argued that the vital role of secondary securities markets is considered to be their support for primary markets. It is evident that a liquid
149 Bernardo Bortolotti and Domenico Siniscalco, The Challenges of Privatization: An International Analysis (OUP 2004) 59
150 Hudson, Securities Law (n 129) paras 1-36, 1-37
151 David Coates, Models of Capitalism: Debating Strengths and Weaknesses (Edward Elgar 2002) 242
152 Ibid
secondary market for shares or securities encourages the involvement of citizens in the primary market and ensures the efficient distribution of ownership after a privatisation programme.153 Secondary markets do so by raising the confidence of savers and investors to subscribe in a primary offering, through providing a means to transfer risk and available liquidity pursuant to the subscription process.154 It is claimed that, by offering subscribers to securities a forum for exchange, secondary markets effectively supply subscribers in primary markets with the opportunity to
‘alter their investment horizon’.155 To that end, it is claimed that it is the high level of liquidity which permits buyers and sellers to transact quickly and without substantial changes in price, which increases confidence in the financial instruments.156 Bernstein notes that, ‘paradoxical as it may seem, the easier the exit from ownership of a corporation, the more attractive its ownership becomes’.157 Therefore, it could be argued that the principal function of secondary securities markets is to increase the confidence in securities offered to investors through the availability of a means to transform long-term investment into liquid funds.
In addition to supporting primary markets, it has been argued that effective secondary securities markets increase the wealth within the economy by reducing the price of credit through the provision of liquidity. A large volume of published studies describing the role of secondary capital markets, namely for stock, has emphasised the important function of liquidity in increasing efficiency by reducing the costs of
153 Bernardo Bortolotti and others, ‘Privatization and Stock Market Liquidity’ (2007) 31 Journal of Banking and Finance 297
154 Blommestein and Spencer (n 145) 154. For the secondary market for bonds, see Katinka Barysch, Heinemann Friedrich and Max Steiger, ‘Bonds Markets in Advanced Transition: A Synopsis of the Visegrád Bond Markets’ ch. in Ronald MacDonald and Rod Cross (eds), Central Europe Towards Monetary Union: Macroeconomic Underpinnings and Financial Reputation (Kluwer 2000)
155 David Coates, Models of Capitalism: Debating Strengths and Weaknesses (Edward Elgar 2002) 242
156 Ibid
157 Peter Bernstein, ‘Liquidity, Stock Markets and Market Makers’ (1987) 16 Financial Management 54, 55
capital.158 By reducing the volatility in prices of stocks and other securities, these financial instruments become marketable and easy to transfer; 159 eventually facilitating the usage of those securities as collateral which in turn generates additional capital in an economy.160
Interestingly, the role of secondary markets is far clearer with regards to the role of financial markets in generating information about the price of risks, assets, management or events as pointed out by Levine. This price information generated by secondary securities markets is asserted to work as a guide to decisions about the allocation of capital within an economy.161 For instance, it helps to assess management performance, gives indications of the pricing of new issues in the primary market and reflects the cost of capital within an economy.162
In short, it is thus reasonable to suggest that secondary securities markets are able to enhance the social welfare not only in transferring the ownerships of productive resources to the private sector within a market economy, but also in supporting economic growth and wealth creation. Given their economic importance and size, it could be argued that there is a public interest in maintaining the efficient functioning of secondary securities markets. Having said that, it should be emphasised that modern securities markets are extremely complex and vary widely in the substantive securities traded in them, and the next section attempts to provide an understanding of the different kinds of these markets.
158 For example, a study by Levine shows that market liquidity – the ability to buy and sell securities easily - exhibits a stronger connection to long term growth; see Levine (n 15)
159 Richard Teweles and Edward Bradley, The Stock Market (7th ed, Wiley 1998) 102
160 Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (Black Swan 2001)
161 Joseph Stiglitz, ‘Capital Market Liberalization, Economic Growth, and Instability’ (2000) 28 World Development 1075, 1079
162 Richard Herring and Anthony Santomero, ‘What Is Optimal Financial Regulation’ ch. in Benton Gup (edt), The New Financial Architecture: Banking Regulation in the 21st Century (Quorum 2000)