Weekend Reading #15
A work of friction.
Way back in 1792, 24 stockbrokers signed the now famous Buttonwood Agreement, establishing the seeds of what is today the New York Stock Exchange.
Legend has it they met to trade underneath a buttonwood tree, located at what is now 68 Wall Street. These pioneers were seeking to break free from the auctioneers who made the prices for most markets. In a series of secret meetings, they agreed to deal only amongst themselves, with a one-quarter percent commission.
Centralised liquidity pools gained traction and the arrival of the telegraph (and subsequently the telephone in 1878) sealed New York’s place as the top trading venue in the country, eliminating the need for alternative locations. The limiting factor was no longer information – it was liquidity.
Exchange membership continued to grow to 75 members by 1848, and the subsequent decision to combine all member types into a single membership pool brought the numbering to 1,060 by 1868, with members approving an increase to 1,100 in 1870.
Fast forward to 2005 and the number of members with seats on the exchange still numbered only 1,366. That finally changed post 2005 as the NYSE abandoned its co-operative structure and became a for-profit exchange, with access to the exchange now available for a fee of US$40k/year. Where the stock market in the early 20th century was a largely professional enterprise with little retail participation, today anyone can get access to the US market via more than 3,600 brokers and 630,000 financial entities.
Commissions have collapsed in recent years, but not before an almost century-long boom during which brokers and the exchange were raking in trading fees, miles above the quarter-percent agreed upon under the Buttonwood tree.
Pools of liquidity.
The history of the American stock market shows that demand, supply and technology all play a part in determining the accessibility of a market to participants. In the early days, there was some demand but supply wasn’t organised, allowing auctioneers to earn exorbitant spreads, since they controlled the friction point in the market – pricing. The formation of stock exchanges helped to ease that friction, allowing brokers to capture the value from managing the friction point – their pools of liquidity earned them the pricing power to charge commissions.
Since then, it has been largely a brokers’ game. Despite the plethora of investors (whether funds, corporations or individuals), thanks to changing regulation and perception, access to public markets has been dictated by exchanges running a similar system of limited seats which the NYSE previously operated. Even now, in most markets, especially in Emerging Markets, exchange seats are limited and often can’t be bought. They are thus highly valued. Many local brokers, controlling the choke points of entry and exit from their domestic market, make as much (or even more) profit selling their infrastructure to the global banks as they do commissions on their domestic trading business. Access to capital and liquidity is an asset that, if managed well, can deliver lucrative returns.
That ole devil called rules.
A key facilitator of this incumbency is regulation. Our experience with public markets is that there is immense heterogeneity in regulation. The rules vary from country to country, making it far from simple to execute transactions across borders. This heterogeneity works in favour of the incumbents, and hits both the demand and supply side of capital.
Show any management team seeking to raise capital the paperwork required to file an IPO and you’ll likely get a cringe of disgust as the first reaction. Following that, the thought process goes along the lines of:
1. Can I avoid having to do all this?
2. If not, can I get someone else to do it for me?
Now, if this were a matter of paying a lawyer and banker a couple of thousand (or even tens of thousands) of dollars to get a stack of paperwork done, resulting in a capital raise of a couple of million, that would still be palatable. Yet, the number is much closer to 4-7% of the total IPO value as an underwriter’s fee, plus c. US$4.2m of fees directly attributable to the IPO and listing process. The costs are likely to be even higher in less liquid, less developed markets. For a capital raise of US$100m, this suggests that an average of 10% of total proceeds gets paid away to friction costs. For the investor, these costs indirectly impact them, as issuers aim to recoup some of the costs by pricing their issuance at a higher price, leading to dampened potential returns.
The situation is similar for M&A transactions, especially so if the transaction is cross-border. Multiple sets of regulations meet multiple sets of banks and lawyers, and we see very clearly why the deal-making business is so lucrative.
And let’s not forget tax laws, case in point being the EU, where in spite of ongoing harmonisation of regulatory guidelines and rules, divergent tax rules from each country’s independent fiscal policy have served (and continue to serve) as a friction point protecting national incumbents.
Remove the friction, remove the pricing power.
Constrained market access, layered with onerous regulatory burdens, makes for supernormal profits. Being able to skim 4-7% in underwriting fees as an upfront charge, alongside the additional transactional profits (brokerage, facilitation profits etc), makes doing deals a more profitable business line for investment banks than secondary trading. Any equities salesperson will tell you the miserable story of unbundling and falling commission rates.
Access is what the market pays for, and banks know that, leaving them little incentive to streamline the process. But just as the telegraph and telephone revolutionised stock exchanges, one would’ve expected the rise of the Internet to wreak havoc amongst the franchises of world’s mega investment banks. It hasn’t. The prospect of an easy alternative to preparing regulatory filings on their own (and avoiding the risk of a regulatory mishap) is too compelling for any issuer to refuse.
Not too long ago, we found ourselves in a similar position. Attempting to market a financial product across multiple jurisdictions was a cumbersome process, involving lots of paperwork and hours of consulting with legal/regulatory advisors to make sure we’re on the right side of the law in all countries where we operate. We needed to pay for access, and pay up we did.
Distribution and access to our end markets was a costly bottleneck, as it is for others, but it didn’t make sense being held hostage by the threat of bureaucracy. So we thought, why not build our own distribution infrastructure?
Move slow, break things.
What we’re about to say goes against the grain of everything that we’ve been taught so far. In order to improve the connectivity between capital and opportunity, we must embrace regulation, not avoid it.
What are the underlying principles behind regulation? Look at any country’s financial markets regulator and you’ll find their values and aims all circle around 3 things:
1. Facilitating productive competition
2. Maintaining market integrity
3. Ensuring fair investor treatment
Shorthand – making sure everyone behaves and has a good time trading the markets while keeping abusive bullies out.
Unlike bankers overheard in the pub nicknaming their compliance officers as ‘business prevention officers’, we see regulatory compliance not only as a defence against legal liabilities, but as a fundamental principle for ensuring that business is conducted properly. Investors, inherently at risk of information asymmetry vis-à-vis vendors, are duly protected, giving them the confidence to deal in the market.
We don’t believe we will successfully define a one-size-fits-all solution to regulatory friction. Rules and regulatory requirements will continue to be country-specific. But the principles behind regulatory compliance are, in our view, consistent with the three values we’ve identified above.
And just as in fundamental analysis, where a good stock is good regardless of which angle you look, we believe the principles of regulation hold for the majority of jurisdictions around the world. They share the same ‘why’, the difference is in the ‘how’. Even so, we don’t think the ‘how’ varies as much as we are led to believe. We are able to systematically judge if a deal is compliant with the rules given a set of fundamental principles and data.
As a business we aim to use emerging technologies to find new ways of reducing friction while fulfilling the fundamental aims of regulation.
Back to first principles.
The road is long, and the perils of a regulatory misstep are potentially fatal, but our starting point is simple – it is likely that what makes a deal compliant in one jurisdiction also makes it so in another, with some slight country-specific variations. If we are able to define the common points around the required disclosures in all of our key target markets, working in tandem with regulators, then we will be able to move through the deal process much more quickly and efficiently.
Solve the friction, reduce the costs.
At our disposal is all of the new technology which has been developed, but which has – perhaps intentionally – not been applied to the most painful bottleneck in the financial markets. From the Internet to natural language processing to distributed ledgers to digital identities. Like the early founders of the NYSE proved, the incumbents, regardless of how entrenched they are, can be overthrown, especially if new mindset and technologies are properly harnessed.
The opportunity we see lies outside listed markets, in the private domain where the limiting factors are many – pricing, liquidity, information and even awareness there are deals to be done. The irony is that despite the connectivity we enjoy today, the interface of capital and opportunity is limited across geographical boundaries – thanks to an aversion to regulatory requirements that borders on demonisation.
'I don't do paperwork.'
Petulant as that argument may sound, it forms the basis for the aforementioned friction – and profit accrual to the incumbent financial services industry.
It’s counterintuitive that given the technology we have available to us, automating the process of filling in disclosures and applications still feels a long way off.
So we’re taking a shot at it, if only for our own benefit. We recognise that regulations are there to protect and assist, rather than impede. Working with our partners, and going back to first principles, the plan is to map out the overlaps in regulatory requirements across the world.
And if we are successful, then we’ll do for dealmaking, whether in public or private markets, in whatever asset class, what the pioneers of the NYSE did to the auctioneers and what direct market access did in turn to the NYSE – democratise the market and change the face of access.
Because the current face of access is wearing a smile of dangerous complacency.
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What we're doing.
In recent weeks we’ve been kept very busy by markets. We’re currently in the process of getting our fund structure set up, after which we will be launching our hedge fund and long only product. In the meantime, we’re keeping in touch with markets by trading PA, visiting friends in EM and doing bottom-up analysis on a long list of stocks that will form the backbone of our investment portfolio. Eugene has been burning the midnight oil (and reducing the life expectancy of his already well-worn keyboard) with detailed notes on a range of EM names, some of which are household names, some of which are frankly pretty obscure. Whilst our thought leadership and blog content is available to all, our stock-specific notes will only be accessible to investors in our funds. We think this is really important.
What we're reading.
We remain fascinated by America's difficult relationship with China, and how that might impact other countries who are forced to choose between competing ideologies. This we call 'The Great Game', and it's a core investment theme for us. So, it was with some interest that we clocked this article penned by Stephen Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist. 'America’s False Narrative on China' is a bold, opinionated op-ed from a seasoned operator who has seen first-hand the enormous opportunities that come through bridging the gap between East and West. His conclusion? 'There are strong grounds to believe that an insecure US – afflicted with macroeconomic imbalances of its own making and fearful of the consequences of its own retreat from global leadership – has embraced a false narrative on China.’
What we're listening to.
This week, like a LOT of other people, we've been gripped by Game Of Thrones. Episode 3 of the 8th and final season was epic, and the 'Night King' theme – composed by Ramin Djawadi – appeared at a pivotal moment in the story and provided the perfect musical backdrop to the action. We don't want to spoil it for those who haven’t seen Season 8 of the show, but suffice to say this was one of greatest television experiences of our lives!