The Stock Exchange Does Two Things, and You Cannot Keep One Without the Other

Ask a defender of the stock exchange what it is for and you will get a good answer. Ask a critic and you will get a different good answer. Both are right, and the interesting fact is that they are describing the same machine.

The First Function

The exchange is a device for collecting money from many people who have some and directing it to enterprises that need it. A company that wants to build a factory sells a claim on its future profits to thousands of strangers, and the strangers, who could never have found the company on their own, get a share of something productive. This is genuinely good. It is how railways, electrical grids and semiconductor fabs got built, and no planned alternative has done it as well.

The liquidity is part of the good. Because you can sell your share tomorrow, you are willing to buy it today. Without a secondary market nobody would hand money to a company for thirty years with no way out, and the primary market would dry up.

The Second Function

The same machine is a device for moving wealth from the unorganised to the organised.

On one side of every trade there are people who do this for a living: firms with analysts, lawyers, direct lines to management, and machines that see the order flow before you do. On the other side there are people who bought a fund because a colleague did, or who sold in a panic because the news said to. Every transaction between the two sides is a transfer, and it runs in one direction on average. Not on every trade, but over years, from the side that treats the market as a hobby to the side that treats it as a job.

This is not a scandal about any particular firm. It is what a marketplace does when participants are unequal in information and patience. The exchange does not care who is on which side; it clears the trades.

Why You Cannot Separate Them

Here is the point I want to make, and I think it is usually missed by both camps.

The critic wants the first function without the second: raise capital, but stop the professionals feeding on the amateurs. The defender wants to talk about the first function and treat the second as an abuse to be regulated away.

Neither is available. The second function is the first function seen from the other side. The liquidity that makes people willing to invest is the same liquidity that lets the organised trade against the unorganised every second of every day. The price discovery that allocates capital well is done by exactly the people who profit from being better at it than you. Take away the professionals and the market gets less liquid and worse at pricing, which harms the first function. Take away the amateurs and the professionals have nobody to be better than.

So the exchange is not a good institution with a bad habit. It is one thing with two faces, and the faces are the same shape.

A Modest Proposal

If the two functions cannot be separated, they can perhaps be rebalanced, and I want to float one lever.

Require that a share, once bought, be held for a minimum period. Say half a year.

Think about what this does. The first function is barely touched: a company can still raise capital, an investor can still get out, only not tomorrow. Anyone who buys a share because they believe in the enterprise is unaffected; six months is nothing to them.

The second function is hit hard. Almost everything the organised do to the unorganised depends on speed: front-running, momentum, trading the news before it is absorbed, the whole apparatus I have described elsewhere. A six-month floor makes most of it impossible. You cannot skim a trade you must sit in for half a year. You have to actually be right about the company.

There are real costs. Liquidity falls, and with it some willingness to invest. Hedging becomes harder. Firms that live on market-making would shrink or leave. I do not pretend these are small.

But notice the shape of the trade-off. Every cost falls on the second function, and only a residue reaches the first. That is what you would expect from a rule that raises the price of speed and leaves the price of judgement alone. If the exchange must do both things, a rule that taxes the one we dislike while sparing the one we want is about the best that can be done.

What I Am Not Saying

I am not saying the exchange should be abolished, and I am not saying the second function is theft. People who are better informed and more patient earning more than people who are not is how any market works, and it is how the pricing gets done.

I am saying that we should stop describing the exchange as a capital-raising institution with a regrettable casino attached. The casino is the capital raising. Pretending otherwise is why every reform aims at the wrong target and why the professionals are always, somehow, unaffected.