The capital market is the market where long-term securities are issued and traded. The London Stock Exchange is the principal trading market for long-dated securities in the UK (www.londonstockexchange.com).
A stock exchange has two principal economic functions: to enable companies to raise new capital(the primary market), and to facilitate the trading of existing shares(the secondary market) through the negotiation of a price at which title to ownership of a company is transferred between investors. Secondary trading dwarfs the issue of new ordinary shares. In 2004, secondary turnover in UK companies was £2,316 billion by value, involving 2.15 million ‘bargains’ (deals). By contrast, new money raised by UK firms in the same year was only £16 billion.
■ A brief history of the London Stock Exchange
The world’s first joint-stock company – the Muscovy Company – was founded in London in 1553. With the growth in such companies, there arose the need for share- holders to be able to sell their holdings, leading to a growth in brokers acting as inter- mediaries for investors. In 1760, after being ejected from the Royal Exchange for rowdiness, a group of 150 brokers formed a club at Jonathan’s Coffee House to buy and sell shares. By 1773, the club was renamed the Stock Exchange.
The Exchange developed rapidly, playing a major role in financing UK companies during the Industrial Revolution. New technology began to have an impact in 1872, when the Exchange Telegraph tickertape service was introduced.
For over a century, the Exchange continued to expand and become more efficient, but fundamental changes did not occur until 27 October 1986 – ‘Big Bang’ – the most important of which were:
1 All firms became brokers/dealers able to operate in a dual capacity – either buy- ing securities from, or selling them to, clients without the need to deal through a
third party. Firms could also register as market makers committed to making firm bid (buying) and offer (selling) prices at all times.
2 Ownership of member firms by an outside corporation was permitted, enabling member firms to build a large capital base to compete with competition from overseas.
3 Minimum scales of commission were abolished to improve competitiveness.
4 Trading moved from being conducted face-to-face on a single market floor to being performed via computer and telephone from separate dealing rooms. Computer- based systems were introduced to display share price information, such as SEAQ (Stock Exchange Automated Quotations).
The Alternative Investment Market (AIM) was introduced in 1995, to provide a mar- ket that is accessible to both investors and companies from a wide range of backgrounds, including start-ups and established firms. In 2004, AIM celebrated its 1,000th listing. By the end of that year, 1,020 UK and international companies were listed on AIM with total capitalisation of £31.75 billion. The total value of secondary deals on AIM in 2004 was
£18.2 billion, while AIM firms raised £4.6 billion in new issues.
In 1997, the settlement service for exchanging shares and associated payment moved to the CREST electronic settlement system. In the same year, the Stock Exchange Electronic Trading Service (SETS) was launched to bring greater speed and efficiency to the market. Today, the London Stock Exchange is viewed as one of the leading and most competitive places to do business in the world, second only to New York in total market value terms.
The LSE has two tiers. The bigger market is the Main List, providing a quotation for 2,753 companies (as at August 2004). To obtain a full listing, companies have to satis- fy rigorous criteria laid down in the Stock Exchange’s ‘Listing Rules’ (or ‘Yellow Book’). These relate to size of issued capital, financial record, trading history and acceptability of board members. These details are set out in a document called the company’s ‘listing particulars’.
The second tier is the Alternative Investment Market (AIM). It attempts to min- imise the cost of entry and membership by keeping the rules and application process as simple as possible. A nominated adviser firm (typically a stock broker or bank) both introduces the new company to the market and acts as a mentor, ensuring that it complies with market rules. Although the majority of companies are capitalised at between £2 million and £20 million, it also includes start-up operations at one end and companies capitalised at over £200 million at the other. However, the require- ment to observe existing obligations in relation to publication of price-sensitive information and annual and interim accounts remains. The AIM is unlikely to appeal to private investors unless they are prepared to invest in relatively high-risk businesses.
While the vast majority of share trading takes place through the Stock Exchange, it is not the only trading arena. For some years, there has been a small, but active Over- The-Counter (OTC) Market, where organisations trade their shares, usually on a
‘matched bargain’ basis, via an intermediary.
Self-assessment activity 2.2
What type of company would be most likely to trade on:
(a)the Main Securities Market?
(b)the Alternative Investment Market?
(c)The Over-The-Counter Market?
(Answer in Appendix A at the back of the book)
■ Regulation of the market
Investor confidence in the workings of the stock market is paramount if it is to operate effectively. Even in deregulated markets, there is still a requirement to provide strong safeguards against unfair or incompetent trading and to ensure that the market oper- ates as intended. The mechanism for regulating the whole UK financial system was established by the Financial Services Act 1986 (FSA86), which provided a structure based on ‘self-regulation within a statutory framework’.
In 1997, statutory powers were vested in a supervisory body, the Financial Services Authority (FSA), responsible to the Treasury. Its objectives are to sustain confidence in the UK’s financial services industry and monitor, detect and prevent financial crime (www.fsa.gov.uk). This involves the regulation of the financial markets, investment managers and investment advisors.
The FSA also takes on additional responsibilities for monitoring the Bank of England and money markets, building societies and the insurance market. The hope is that, by having a single regulator covering all financial markets, there will be greater efficiency, lower costs, clearer accountability and a single point of service for customer enquiries and complaints.
In an attempt to enhance London’s reputation for clean and fair markets, the FSA has introduced new powers, effective from 2000, to deal with insider dealing and attempts to distort prices. It is a criminal offence to undertake ‘investment business’
without due authorisation. A Recognised Investment Exchange (RIE), of which the London Stock Exchange is one, may also receive authorisation. Recognition exempts an exchange (but not its members) from needing authorisation for any activity consti- tuting investment business.
The Stock Exchange discharges its responsibilities by:
■ vetting new applicants for membership
■ monitoring members’ compliance with its rules
■ providing services to aid trading and settlement of members’ business
■ supervising settlement activity and management of settlement risk
■ investigating suspected abuse of its markets.
Market abuse includes three strands:
(a) Market distortion – acting in such a manner as to force up a company’s share price.
(b) Misuse of information – e.g. buying or selling shares on the basis of privileged information.
(c) Creating false information – e.g. putting false information on to a website.
FSA86 also gave the Exchange responsibility for regulating both the admission of companies to the Official List and their ongoing compliance with the listing require- ments. Companies violating the Exchange’s rules of conduct can have their listings removed.
Other bodies also keep a watchful eye on the workings of capital markets. These include the Bank of England (www.bankofengland.co.uk), the Competition Commission (CC), the Panel on Takeovers and Mergers, the Office of Fair Trading, the press and various government departments.
Self-assessment activity 2.3
To what extent does an effective primary capital market depend on a healthy secondary market?
(Answer in Appendix A at the back of the book)
■ Share ownership in the UK
Back in 1963, over half (54 per cent) of all UK equities were held by private individu- als. This proportion had dropped to 14.9 per cent by the end of 2003 (www.statistics.
gov.uk). Today, share ownership is dominated by financial institutions (the pension funds, insurance groups and investment and unit trusts). Together, including both UK and foreign institutions, they own around 80 per cent of the value of UK traded com- panies. These impersonal bodies, acting for millions of pensioners and employees, pol- icyholders and small investors, have vast power to influence the market and the companies they invest in. Institutional investors employ a variety of investment strate- gies, from passive index-tracking funds, which seek to reflect movements in the stock market, to actively managed funds.
Institutional investors have important responsibilities, and this can create a dilem- ma: on the one hand, they are expected to speak out against corporate management policies and decisions that are deemed unacceptable environmentally, ethically or economically. But public opposition to the management could well adversely affect share price. Institutions therefore have a conflict between their responsibilities as major shareholders and their investment role as managers seeking to outperform the markets.
A further indication of changing patterns of share ownership is the proportion of the adult population that holds shares. Successive governments have promoted a
‘share-owning democracy’, particularly through privatisation programmes. However, individuals tend to hold small, undiversified portfolios – over half of private investors hold just one security – which exposes them to a greater degree of risk than from investing in a diversified investment portfolio.
■ Towards a European stock market
The European Union is meant to be about removing barriers and providing easier access to capital markets. Until recently, this was still a pipe dream, with some 30 stock exchanges within the EU, most of which had different regulations. With the introduc- tion of a single currency, there will undoubtedly be strong pressure towards a single capital market. But does this mean a single European stock exchange, with one set of rules for share listing and trading?
Euronext was formed in 2000 as a result of the merger of the Amsterdam, Brussels and Paris stock exchanges. As the first pan-European stock exchange, it has already under- taken further mergers with other smaller exchanges in Europe (e.g. LIFFE, Lisbon), which is exerting more pressure on the London and Frankfurt exchanges. These two exchanges attempted, but failed, to merge in 2000. The New York Stock Exchange is eas- ily the largest in terms of market value, while Nasdaq, the US exchange for young growth companies, has the most companies listed.
However, the London market lists the greatest number of foreign companies. At year-end 2004, there were some 450 foreign firms listed on the main market, the major- ity from the USA, Western Europe and the Commonwealth countries, but including representation from Russia, Hungary and China.
The box below gives the examples of Inion, a Finnish Company, maker of biodegrad- able plates for mending broken bones. Inion announced plans to list in London in 2004, Its market value at floatation was £72 million.
Inion plans £30m public offering
Inion, a Finnish medical devices company, is planning to raise £30m in an initial pub- lic offering on the London Stock Exchange.
The indicative price range for the flota- tion has been set at between 113p and 136p a share, giving a market capitalisa- tion of between £80m and £90m.
The company, which makes biodegrad- able polymer implants, was set up in 1999 by senior researchers from Bionics, a Nasdaq-listed Finnish implants company.
Auvo Kaikkonen, chief executive, said listing alongside other medical technology companies in London would ensure better
liquidity than floating on the Helsinki Stock Exchange, which is dominated by Nokia.
‘We wanted a market where there was an experienced analyst and investor commu- nity,’ he said.
Inion’s products include biodegradable screws, plates and meshes to stabilise bro- ken and damaged bones while they heal.
Inion incurred a pre-tax loss of approxi- mately ;3m (£2.1m) on revenues of ;2.4m in the first half of 2004. Mr Kaikkonen said it would break even when revenues reached ;20m.
Source: Financial Times, 10 November 2004.