How Stock Exchanges Work: Capital, Risk, and Inclusion

Why Both Parties Can Benefit from a Trade

The question is posed: "Why part from your money or your shares if you didn't believe you would come out ahead in the bargain?" If this seemingly reasonable statement is true, why would anybody trade in financial securities? After all, both parties to a trade cannot come out ahead simultaneously. Or can they?

People trade financial securities in order to increase their financial wealth by participating in the future prosperity of a business as an equity holder. Investing is the process of deferring current consumption in exchange for greater consumption in the future. In exchange for not purchasing goods and services today, investors expect to receive a rate of return commensurate with delayed gratification. This calculation is part of the required rate of return that investors demand for deferring consumption. Interest rates play a heavy role in this calculation, as the opportunity cost of deferring consumption is much lower in a low-interest-rate environment than it would be in a high-interest-rate environment. Accordingly, an investor demands a lower required return when interest rates are low.

Yes, both parties can come out ahead simultaneously in a financial transaction. For a company, it benefits from access to the capital needed to maintain a market-leading position, invest in new products, or pay down debt. The investor, particularly a long-term investor, benefits from the potential capital appreciation of his or her shares as the business performs well in the market.

Risk Diversification and Early Stock Exchanges

Ships sailing to the East Indies could make a lot of money or lose everything. The Amsterdam Stock Exchange ameliorated this risk through diversification. By spreading investment across multiple voyages and ventures rather than concentrating it in a single ship or expedition, the exchange allowed market participants to limit their exposure to any one catastrophic loss.

Fairness and Regulatory Integrity in Financial Markets

Fairness, and more importantly financial integrity, is critical in a financial exchange. The capital markets themselves are predicated on integrity. Without it, market participants would be far more reluctant to extend capital to companies in the form of debt or equity.

In America, a lack of integrity combined with mass market euphoria contributed to the stock market crash of 1929. In that instance, consumers lost confidence in the function of the capital markets. This encouraged bank runs as consumers looked to withdraw their capital, and businesses that needed capital to survive received less investment. The resulting economic devastation led to a series of landmark legislation: one act created the Securities and Exchange Commission (SEC) as an oversight agency to maintain the integrity of the financial markets, and another federally insured deposits, providing ample liquidity to the capital markets and preventing future bank runs.

It is therefore important to maintain high standards, rigorous oversight, and meaningful punishments for those who act unethically. These measures ensure the smooth operation of the capital markets. Fairness is not merely a moral imperative — it is a structural necessity for markets to function at all.

How Stock Exchanges Finance Real Investments

Stock exchanges help facilitate the flow of capital from those with excess savings to those in need of additional capital. In exchange for providing this capital, market participants demand a return on investment commensurate with the overall risk associated with the business enterprise. Investors in technology start-ups, for example, will demand a higher required return on their capital than they would with an established firm such as Walmart. Companies then deploy this capital to purchase assets that allow them to generate additional revenues and profits to grow the business.

Stock exchanges facilitate this exchange in several ways. First, companies can elect to offer shares to the public, the proceeds of which can be used to purchase real investments such as factories. Through an IPO (S-1 filing) or secondary offering, a company discloses what the proceeds from the offering will be used for — whether to pay down debt, cover general administrative expenses, or expand operations through the purchase of real assets.

Likewise, a company can issue debt that is often traded on public exchanges. This debt, much like equity, can be raised and used for a variety of purposes including the purchase of real assets. As a recent example, Verizon launched a $25 billion bond sale to be used to pay for 5G spectrum and infrastructure.

Companies are increasingly electing to use debt to finance the acquisition of real assets, taking advantage of the extremely low interest rates prevailing in the market. This allows stable companies such as Verizon to borrow cheaply relative to their risk profile. Low borrowing costs also lower the hurdle rate that a company must achieve to justify an investment. For example, the yield on a Walmart bond maturing in December 2022 was approximately 2.35%, meaning the company needed only to earn a return on those borrowed funds exceeding 2.35% to justify the expenditure.