Capital Markets and Unintended Consequences

Sep 24th, 2012 | By | Category: General Comments
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Marc Cuban wrote a blog post a few days ago offering some suggestions for restructuring US equity markets. For those of you who are unfamiliar with Cuban he is a successful internet entrepreneur and owner of the Dallas Mavericks. The premise of Cuban’s blog was that over the years “Wall Street” has lost its way and has devolved into a bunch of computers that do nothing in the service of “Wall Street’s” original purpose. The “original purpose” according to Cuban is assisting private companies in the raising of capital.

Cuban uses “Wall Street” as a synonym for secondary capital markets which is a bit confusing. Generally, when the media refers to Wall Street they are referring to investment banks, which have several different businesses one of which is the raising of capital for new and existing businesses. But they have several other major lines of business  including allocating their own capital via trading and investments, advising clients on the allocation of their capital and advising clients on mergers/acquisitions and other restructurings.

The actual businesses Cuban was referring to in his post which he believes are in desperate need of reform are secondary equity markets (NYSE and NASDAQ). These markets serve to provide liquidity for primary capital markets. In order to have a robust secondary market you need to encourage as many traders and investors to participate as possible. If you do this then transaction costs will decrease and liquidity will increase leading to stocks trading at higher valuations. This is evidenced by the fact that publicly traded firms trade at much higher multiples than their privately held peers. This type of robust secondary market encourages more of the primary allocators of capital such as investment banks, private equity firms, and hedge funds to invest equity capital with new and existing businesses.

So this brings us back to Cuban’s original point which is he would like to have secondary equity markets focus on serving the purpose of facilitating the raising of capital for private businesses. This of course is exactly what they are designed to do. The exchanges have become far more liquid with lower transaction costs in the last decade. And because of this large investors are more willing to allocate capital to private businesses. They know that US markets are the most liquid equity markets in the world and that they can exit large positions with relative ease. Also, firms that become public via an IPO receive more capital in these offerings because of the higher valuations afforded firms that trade on the secondary market (see Facebook).

Cuban basically shoves aside these basic tenets of how our markets function and suggests that firms will more easily raise capital if there is an additional transaction tax placed on any trader or investor who holds a position for less than one hour. Common sense tells us exactly how this idea will play out in practice. The HFT programs that make markets in the thousands of US equities will widen their quotes because of the increased costs of making markets, which will effectively pass along this tax to investors. Manual traders may decide to trade less often as their transaction costs are higher, which will further lower liquidity. The net result will be a downward shift in the valuations of publicly traded companies, which will make it more difficult for companies to raise capital via initial public offerings. That is what is referred to as “unintended consequences”. Cuban’s goal is to help private companies raise capital but he proposes something which would undoubtedly cause the opposite and harm a bunch of others along the way.

His second idea is to eliminate all capital gains taxes on stocks that are held for more than one year. This might actually increase liquidity as traders and investors with longer time frames could decide to allocate more money to secondary markets. So I guess one out of two ain’t that bad.

The US markets have changed a lot in the 16 years that I have traded professionally. It is very easy to get caught up in the hoopla that surrounds HFTs and flash crashes and then go off half cocked suggesting new market structures that may cause more harm than good. My partner Mike Bellafiore was asked about this topic last month while in Singapore and offered his thoughts here. Hopefully cooler heads will prevail in the coming months and years and sensible rules and regulations will be passed that encourage more robust markets, so that the US will maintain its lead as the strongest and most stable markets in he world.

Steven Spencer is the co-founder of SMB Capital and SMB University and has traded professionally for 16 years. His email is sspencer@smbcap.com.

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