History and Future of Capital Markets — Will Company Benefit From Going Public in 2021?

Kirill Zheleznov, Enty CEO
Nov 5, 2020 · 15 min read

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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 the 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 the 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.
— So, that's cool and all but 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. 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.

The 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 a 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, particularly individual investors, buy, sell, and trade financial assets with a certain 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 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.

    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 SEC

    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.

    Outdated Rules and Long-awaited Change

    So, the current capital markets use mostly the same old 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. However, it's obvious that such overprotective behavior hurts the market as well.

    On the other hand, we see that technology is ready to take the capital market to the new era. The ICO boom has also demonstrated that technology can significantly improve the whole financial market. It has also proven that a lack of knowledge and a lack of proper regulation can damage a lot of investors badly. However, asset price on traditional markets is ruled by speculation and odd factors as well.
    With that in mind, it's fair to say that now the financial industry started a movement towards the reduction of intermediaries and P2P offerings of their assets. With proper regulation in hand, investors from over the world are able to support the best businesses in a convenient way. Just imagine 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 in P2P models it can be reduced to the issuer, investor, issuance platform in between, and one regulator that can be executed in a form of a technological solution. The number of intermediaries is severely reduced, which allows for a significant issuance cost reduction, saves great amounts of time. The latest and greatest example of such model was demonstrated by Carta. The platform is planning to launch a private share trading platform that is expected to be an alternative to leading stock exchanges as fast-growing tech companies increasingly decide against initial public offerings.

    So which other new initiatives we have seen on the capital market?

    A Direct Public Offering (DPO), also known as a direct listing is a way for a company to go public by selling existing shares instead of offering new ones. A company does not work with an investment bank to underwrite the issuing of stock. While forgoing the safety net of an underwriter provides a company with a quicker, less expensive way to raise capital, the opening stock price will be completely subject to market demand and potential market swings.

    Going public via a DPO is traditionally faster and cheaper than going public via an IPO. In a traditional IPO, one or more investment banks serve to underwrite the issuing stock. In this role, they manage several aspects for an IPO that add cost to the business and time to go public, but also security to the process. When a company goes public via an IPO, the underwriters distribute shares among select brokerages who then impose restrictions on who is allowed to participate in the IPO. This can make it hard for all investors to gain access to IPOs.

    With DPOs, there is an even playing field, with stocks being listed on the market for everyone to access and trade. The availability of shares is dependent upon early investors, while the price is dependent upon market demand. This makes a DPO a potentially riskier route than an IPO as there could be more volatility and market swings. The DPO model still operates by the same old rules but with a significant improvement.

    Long-Term Stock Exchange
    The IPO is like a wedding. The IPO process is, what kind of wedding planner do you hire? What kind of wedding do you want to have? But being a public company is you're now married to the public markets for the rest of your life. People have mostly focused on the IPO process — it's like making the wedding more efficient. That's not the problem. The problem is we have to live like this forever.
    Eric Ries
    Long-Term Stock Exchange CEO
    Another problem of the capital market is the fact that today's public companies are too focused on things that revolve around short-term stock price increases — beating quarterly projections by Wall Street analysts, shrinking extraneous budgets for research and development to cut costs, and tangling with activist investors who want to nip and tuck to create extra margins. This makes becoming a public company less than attractive.

    With that in mind, we have seen the new paradigm in the form of long-term stock exchange. LTSE supports companies that are built to last and investors who measure their horizons in decades and value companies accordingly. The aim of founders lies in creating a public market that supports investment, experimentation, and scaling that companies can use to find continuous success. Investors in LTSE-listed firms are asked to commit to the long term — they could disclose to the company that they are planning to be long-term shareholders.

    Security (Equity) Token Offerings

    So, another method that was projected to change the way companies raise funds is security token offering. The main idea behind the concept is to combine current regulation with the concept of ICO, therefore reducing investment barriers and opening liquidity for issued assets.
    In its current form, STO offers traditional security in the form of a token. It opens the opportunity for businesses to raise funds by offering digital security to investors in a regulatory-compliant manner.

    As for the issuer, the process is much cheaper than an initial public offering or equity crowdfunding, and the legal setup is faster than traditional methods. Additionally, all compliance features are already built-in in the code. For investors, this fundraising method lowers entry barriers while keeping investor protection mechanisms in place. Just like any existing traditional market instruments, tokenized securities may grant rights in digital or physical assets ownership, profit-sharing, or financial commitments.

    Artem Tolkachev
    Tokenomica CEO
    However, up to this day, there is still no secondary for these assets, as regulation slows down the process. As a concept, STO really looks like something that may revolutionize the market but in reality, most STO platforms have already pivoted to operate on other markets.

    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. Along with that, the market limits companies' growth, as they have to focus on quarterly reports and capitalization rather than real profits. While capitalization and profits simply don't go along with each other.

    We believe that companies need to aim towards direct listings and raise funds through other new paradigms such as private equity crowdfunding, etc. There is a wide range of ways to sell companies' shares before going public and the growth of the secondaries market only proves that. As a platform that helps companies manage their back-office operations, we are also aiming to help them make the best choice when it comes to raising funds or going public. In the next and the final part of our series, I would like to share my vision on how Enty aims to make processes more efficient for modern companies.
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