6th June 2013
The current structure of markets is explosive and posed huge dangers for equity investors. John Kay, visiting Professor of Economics at the LSE, author of the Kay Review and FT columnist has told an Russell Investments annual pension conference in London this week.
Users of capital – companies and investors – have done poorly out of markets for many years, he said, while industry participants “have enjoyed a prosperous decade”.
Few companies raise money in the markets anymore and those that do regard it as a liquidity event for early-stage investors and employees. “The paradox is that stock markets are not a means of putting money into companies, but a means of getting it out,” Kay told the Russell Investments conference.
Investors’ returns suffer from the “extraordinary” chain of intermediation in financial services. In between companies at one end and savers at the other, there are registrars, custodians, nominees, pension fund trustees, insurance companies, investment consultants, platforms, IFAs and so on. “The problem is they all have to be paid,” said Kay. “The amount they take out of the chain in a low return environment can be the totality of what is generated by the chain.”
This situation is unsustainable, Mr Kay warned.
It has been created by a toxic combination of the destruction of trust and poor regulation. Trust has been destroyed as the relationship culture is replaced by a culture based on transactions and trading. Kay said: “Relationships are personal and formed on the basis of trust, whereas transactions and trading exist in an environment of seeking advantage and suspicion. Participants know more about what other traders are doing than about companies these days.”
Kay was doubtful that building trust among the investing public was the answer to the problem. “If the public understood the industry better, they might have less trust and confidence rather than more,” he said.
Meanwhile, wrong-headed regulation now tries to dictate every move by every market participant. This is flawed, he said. “All our experience of regulation of other industries tells us that behavioural regulation just diminishes trust and proliferates complexity.”
The result will inevitably be more and worse crises, he said. The view that systemic crises, such as Tulip Mania, the South Sea Bubble, the Great Depression and the high-tech boom and bust, are inevitable, misses the point that crises are becoming more frequent and larger in amplitude.
“I fear that we will move from crisis to crisis, driven by the disfunctionality of financial services,” said Kay. This threatens not just the financial system but the political system too.
Despite the seeming intractability of the situation, a possible solution does exist. Governments must step in and force a simpler structure onto markets, he said.
“We need a simpler financial system with shorter chains of intermediation. In equity markets this means a world in which there are one or at most two intermediaries between savers and borrowers.
“We do need a financial system. All the evidence says without one, economic growth cannot occur. That does not mean we need ever more trading to create a more prosperous economy though.”