Why are there stock markets, anyway?

proprietorship, partnership and corporation

Starting with the basics, most countries have several forms of business structure.  You can typically either be:

–a proprietorship, that is, an owner/operator, who is solely responsible for running the business, who owns its profits and who is personally liable for any liabilities the business can’t satisfy;

–a partnership, where several entities (the partners) are all mutually responsible for the business in the same way a proprietor is; or

–a corporation, where there is typically a sharp distinction between owners and managers, and where responsibility for the firm’s liabilities is limited to the capital invested in the corporation itself.  Creditors normally don’t have a call on the owners’ other assets.

Corporations have two things going for them:  limited liability and the ability to sell stock in the company easily to a wide range of new owners.

primary and secondary markets

A primary sale of stock is one made by the company itself to an outside buyer.  A secondary sale is one where the seller is someone other than the company.   In other words, it’s a re-sale of stock that was once issued by the company but is now held by someone else.

A primary sale can be done directly by the company, as is commonly done with dividend reinvestment options or direct purchase services, or indirectly through the use of an investment bank.  A secondary transaction can also be done directly, or, as is more usual in most countries, through a publicly accessible secondary market.  This last is what we usual;ly call the “stock market.”

what use is a liquid and transparent secondary market?

From the point of view of a potential holder, the fact that a stock can be bought or sold quickly and relatively cheaply lowers the risk of owning it.  So too does the existence of a regulatory apparatus that mandates full public disclosure, on a regular basis, of relevant information about company operations.  The willingness and ability of the regulators to police the activities of the intermediaries who run the secondary market, to ensure that participants are treated fairly and equitable, is another big plus.

From the stock-issuing company’s viewpoint, the existence of an orderly secondary market lowers its cost of capital, enabling it to compete more effectively, especially with foreign rivals.  You may remember that through the Eighties, American firms complained that they were operationally competitive with their Japanese counterparts, but that the latter enjoyed a significant advantage in terms of cost of capital, which gave them a significant overall advantage.

From the home country’s position, a well-functioning secondary market is in the national interest, for two reasons.  By lowering the overall cost of capital to domestic companies, it encourages their prosperity, and thus economic growth.   It does so in a second way as well, by shifting the flows of capital away from poorly managed firms and putting that money into the hands of managers who are best equipped to use it productively.

That’s the theory–that a country’s stock market is a vital national resource that is instrumental in promoting economic growth.

are we better off now than ten years ago?

It seems to me there are two relevant questions:

–has the SEC done enough to regulate financial intermediaries?, and

–given the close financial connection between Washington and Wall Street, has the government done enough to protect the interests of long-term and individual investors against those of short-term traders?

More on this topic later posts.

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