A Brief History and Influence of Capital Markets: From a Massive Boost to Unreasonable Stagnancy

June 08, 2020

There are 60 stock exchanges in the world — 16 with a market capitalization of $1 trillion or more. Since 1980 the total market capitalization of equity-backed securities worldwide rose from US$2.5 trillion to US$68.65 trillion at the end of 2018. As of December 31, 2019, the total market capitalization of all stocks worldwide was approximately US$70.75 trillion. But how capital markets influenced companies and why does it stay stagnant now?

Significance of Capital Markets

In the previous part, we have taken a look at how first companies were born and at the development of corporate law. First, let’s take a look at what is the definition of the capital market.

Capital markets are venues where savings and investments are channeled between the suppliers who have the capital and those who are in need of capital. The entities that have capital include retail and institutional investors while those who seek capital are businesses, governments, and people.

In the broad sense, capital markets provide companies capital that is essential either for existence or further growth of a business. On the other side, it provides investors with an opportunity to increase their own capital.  

All that is required for a capital market to exist is a buyer, a seller, and a financial asset, such as a bond, stock, or contract, that the buyer and seller want to exchange. When most people think of stocks and financial markets, the picture of Wall Street and electronic tickers probably comes to mind.

—  Why a company just doesn’t get a loan for further growth?

Well, you surely can take money from a bank but regular bank lending is not even classed as a capital market transaction. First, regular bank loans are not securitized. Second, lending from banks is more heavily regulated than the capital market. Third, bank depositors tend to be more risk-averse than capital market investors. In general, lending from banks is related to money markets.

Money markets are designed for raising short-term finance, sometimes for loans that are expected to be paid back as early as overnight. In contrast, the "capital markets" are used for the raising of long-term finance, such as the purchase of shares/equities, or for loans that are not expected to be fully paid back for at least a year. Funds borrowed from money markets are typically used for general operating expenses, to provide liquid assets for brief periods.

In the 20th century, most company finance apart from share issues was raised by bank loans. But since the 1980’s there has been an ongoing trend for disintermediation, where large and creditworthy companies have found they effectively have to pay out less interest if they borrow directly from capital markets rather than from banks. According to the Financial Times, capital markets overtook bank lending as the leading source of long-term finance in 2009, which reflects the risk aversion and bank regulation in the wake of the 2008 financial crisis.

However, the tendency to rely on capital markets is more related to the US.  Compared to the United States, companies in the European Union have a greater reliance on bank lending for funding.

Birth of Capital Markets

The first example of a financial market were banks and lenders in early 14th century Europe. These markets operated before the idea of stock, the partial ownership of a company obtained by buying shares. For early banks and moneylenders, the financial markets were all debt-based. They would give loans to governments and individuals, then they would buy, sell, and trade the repayment of the loan.

In the 14th century, just as the Italian Renaissance was beginning, Italy was the economic capital of Western Europe: the Italian States were the top manufacturers of finished woolen products. Simultaneously, the Italian city-states produced the first formal bond markets.

Venice never missed an interest payment, solidifying the credibility of the new instruments. Other Italian city-states such as Florence and Genoa became bond issuers as well, often as a means of paying for warfare. Bonds were traded widely in Italy and beyond, a business facilitated by bankers such as the Medicis.

The war between Venice and Genoa resulted in the suspension of interest payments in the early 1380s, and when the market was restored, it was at a lower interest rate. Venice's bonds traded at steep discounts for decades thereafter. Partnership agreements dividing ownership into shares date back at least to the 13th century, again with Italian city-states in the vanguard. Such arrangements, however, typically extended only to a handful of people and were of limited duration, as with shipping partnerships that applied only to a single sea voyage.

The forefront of commercial innovation eventually shifted from Italy to northern Europe. The Hanseatic League, an alliance of mercantile towns such as Bruges and Antwerp, operated counting houses to expedite trade.

The term "bourse" which would become synonymous with "stock market," arose in Bruges, either from a sign outside a trading center showing one or a few purses (bursa is Latin for bag) or because merchants gathered at the house of a man named Van der Burse; nobody's quite sure.

By the late 1500s, British merchants were experimenting with joint-stock companies intended to operate on an ongoing basis; one such was the Muscovy Company, which sought to wrest trade with Russia away from Hanseatic dominance. The next big step was in Amsterdam. In 1602, the Dutch East India Company was formed as a joint-stock company with shares that were readily tradable. The stock market had begun.

The Dutch East India Company, formed to build up the spice trade, operated as a colonial ruler in what's now Indonesia and beyond, a purview that included conducting military operations against recalcitrant natives and competing for colonial powers. Control of the company was held tightly by its directors, with ordinary shareholders not having much influence on management or even access to the company's accounting statements.

However, shareholders were rewarded well for their investment. The company paid an average dividend of over 16 percent per year from 1602 to 1650. Financial innovation in Amsterdam took many forms. In 1609, investors led by one Isaac Le Maire formed history's first bear syndicate, but their coordinated trading had only a modest impact in driving down share prices, which tended to be robust throughout the 17th century. By the 1620s, the company was expanding its securities issuance with the first use of corporate bonds.

If we take into account, the history of capital markets, the next significant step in the development was in modern history with the eruption of the US capital market and the development of regulation mostly in the US.

Regulation of Capital Markets

Even after more than several centuries from the emergence of capital markets, there was a severe case of lack of investor protection on the market. In the modern era, investors buy, sell, and trade financial assets with a sense of security. If a corporation deceives its investors, there is an avenue through which to seek recompense.

In order to achieve that, officials had to work on the specific legal framework that would regulate the actions of all players on the market. As the US capital market is the largest in the world, we would like to go over the emergence and development of regulation.

In the beginning of 20th century, Investing was quickly becoming the national sport in the US, as all classes of people began to enjoy higher disposable incomes and finding new places to put their money. In theory, these new investors were protected by the Blue Sky Laws (first enacted in Kansas in 1911).

These state laws were meant to protect investors from worthless securities issued by unscrupulous companies and pumped by promoters. They are basic disclosure laws that require a company to provide a prospectus in which the promoters (sellers/issuers) state how much interest they are getting and why (the Blue Sky Laws are still in effect today). Then, the investor is left to decide whether to buy. Although this disclosure was helpful to investors, there were no laws to prevent issuers from selling security with unfair terms as long as they "informed" potential investors about it.

Black Tuesday
With so many uninformed investors jumping into the market, the situation was ripe for high-level manipulation. Brokers, market-makers, owners, and even bankers began trading shares between themselves to drive prices higher and higher before unloading the shares on the ravenous public. The American public was amazingly resilient in their optimistic craze, but catching too many of these stock grenades eventually turned the market, and, on October 29, 1929, the Great Depression made its dreaded debut with Black Tuesday.

The Securities Exchange Act was signed on June 6th, 1934, and created the Securities and Exchange Commission (SEC). It was President Roosevelt's response to the original problem with the Blue Sky Laws, which he saw as a lack of enforcement. The crash had shattered investor confidence, and several more acts were passed to rebuild it. These included the Public Utility Holding Company Act (1935), the Trust Indenture Act (1939), the Investment Advisors Act (1940), and the Investment Company Act (1940). The enforcement of all of these acts was left to the SEC.

First, the SEC demanded more disclosure and set strict reporting schedules. All companies offering securities to the public had to register and regularly file with the SEC. The SEC also cleared the way for civil charges to be brought against companies and individuals found guilty of fraud and other security violations. Both of these innovations were well received by investors who were hesitantly returning to the market following WWII, the primary mover that restarted the economy.

Although the SEC has been an extremely important shield for protecting investors, there are fears that both its power and love of tighter regulations will eventually harm the market. And harm was done already really. Stock Brokers, Depository And Depository Participants, Banks, Clearing Corporations, Transfer Agents form a complicated structure that increases the cost and time to raise capital for companies. Moreover, most of them can be easily replaced by technology and act as a monopoly on the market. The situation is almost the same in the EU.

With that in mind, the biggest challenge for the SEC lies in protecting investors from bad investments by making sure they have accurate information and not to simply take all power to themselves and act as a tyrant.

Taking the experience of the US, most jurisdictions have created similar regulations to capital markets. Ever since there been little to no changes to the regulation of capital markets. While the world around us changed completely.

Conclusion: Outdated Rules and a Massive Room for Improvement

So, the current capital markets use mostly outdated rules and regulations. Numbers of intermediaries and a lack of technological advancements hurt most market players (except intermediaries). It’s understandable why regulators are so protective, they simply don’t want the new market fall to occur. Additionally, the ICO boom of 2017, has proven that lack of knowledge and lack of proper regulation can damage a whole lot of investors badly.

But on the other hand, the ICO boom has also demonstrated that technology can significantly improve the whole financial market. With proper regulation in hand, investors from over the world are able to support the best businesses in a convenient way.

Built-in compliance with statutory regulations allows to ensure even better protection of all parties concerned. Blockchain technology and smart contracts make it possible to include ownership and regulation directly into a token meaning that the smart contract will be able to execute, regulate, and govern the token. For one thing, blockchain brings disintermediation: for you to become a shareholder, your regular share has to pass through the hands of brokers, transfer agents, clearing firms, custodians, and whatnot — at least 7 intermediaries in total. While it can be just the issuer and the investor with the issuance platform in between: the number of intermediaries is severely reduced, which allows for a significant issuance cost reduction and saves great amounts of time.

Speaking of time, which is always of the essence for the holder of any financial asset: as an investor, you want to have the ability to purchase or get rid of any given security as fast as possible. Now that’s where smart securities really stack up against regular instruments: the latter take T+2 (trade date plus two) business days to settle, whereas the former takes minutes. And, unlike NASDAQ, decentralized exchanges don’t close for the weekend, they’re available 24/7. On the financial market, where each second counts, this means a lot.

Finally, let’s not forget that certain classes of traditional assets suffer from illiquidity, partly due to not being listed on secondary markets. Take, for instance, crowd investing, where people invest in unlisted early-stage companies — shares in those are not traded on NYSE, nor on NASDAQ, nor on any other secondary market. The same goes for private equity: the lack of secondary markets for these assets is attributed to high risks associated with them. Tokenomica aims to bring liquidity to these previously illiquid assets by building a secondary trading facility for them: by virtue of disintermediation and programmable compliance, they could be easily traded on secondary markets as smart securities.

So what does this all mean?

For sure, capital markets have provided a massive boost for companies, allowing them to grow further, attracting more funds in order to grow. Additionally, capital markets made businesses truly international.

However, the overprotectiveness of regulators limits further growth. Almost all regulators are aiming to find a better and faster horse, while the whole world is using airplanes. For sure, in time the necessary change will come. But today, thousands of great businesses might not come to life simply due to the inefficiencies of today’s market.

In the next part, of our series, we will focus on how technologies already improved the operational efficiency of businesses, what still can be improved, and how advanced technology exists in the same realm with useless paperwork.