March 3rd 2012

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Articles from this issue:

CANBERRA OBSERVED: Labor pushes the self-destruct button

QUEENSLAND: Issues facing voters on March 24

EDITORIAL: Beyond the leadership woes: Labor's identity crisis

RURAL AFFAIRS: Huge cost of abolishing national wheat pool

ENVIRONMENT: Rudd's costly carbon capture scheme a dud

ENVIRONMENT: Earth Hour: World Wildlife Fund publicity stunt

INTERNATIONAL AFFAIRS: Western media duped by mirage of Arab Spring

UNITED STATES: Obama's left-wing diplomacy a global failure

STOCK MARKET: From mutual associations to profit-seeking enterprises

CIVILISATION: Has Europe lost its soul?

MARRIAGE: Don't blame gay lobby for decline in marriage

EUTHANASIA: Stacking the deck by suppressing contrary views

CINEMA: Baker Street sleuth's new look

BOOK REVIEW Should America have dropped the Bomb?

BOOK REVIEW A child's imagination is a terrible thing to waste

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From mutual associations to profit-seeking enterprises

by Jeffry Babb

News Weekly, March 3, 2012

Wall Street is not a big street. It would be absolutely impossible for all the people who claim to “work on Wall Street” to actually work there — it’s more a figure of speech, just as many Broadway shows are not actually on Broadway.

One of the most notable things about Wall Street is the headquarters of J.P. Morgan, a rather small building, which faces the New York Stock Exchange. When people talk of Wall Street, they actually mean the New York Stock Exchange, the richest, most powerful and influential capital market in the world.

It is absolutely correct that at one end of Wall Street there is a river and that at the other end there is a church. The exchange was formed beneath the famous buttonwood tree in 1792 when a group of early New Yorkers gathered to trade stocks.

Even in colonial times, New York was the commercial centre of the mid-Atlantic states, its magnificent harbour — the finest in north-eastern America — making it a natural magnet for trade.

Although other exchanges competed with the New York Stock Exchange, none could match it, nor could any other centre compete with New York’s merchants. Philadelphia was for many years a serious threat, but perhaps a joke attributed to W.C. Fields sums up the common New York attitude to Philadelphia: “I went to Philadelphia last Sunday. It was closed.”

However, the New York Stock Exchange has changed. Recently, it has merged with Euronext, a pan-European exchange. A plan to merge with the Deutsche Boerse, based in Frankfurt, was scuttled at the last minute by European Union authorities, who warned that the combined entity would account for almost 80 per cent of trading on international exchanges.

Why is this important? The role of a stock exchange is not to act as a high-priced casino but to raise capital. It exists to raise capital for national development and so that people can raise money to build businesses.

Take Australia, for example. Just over 200 years ago, Australia had nothing that could reasonably be described as civilisation. When the First Fleet arrived in 1788 and New South Wales was proclaimed a British colony at Sydney Cove, there were no roads, buildings, hospitals, factories or banks. They all had to be built.

What’s more, there was no capital. To build Australia, we had to import capital — as we always have done and still do — or generate it ourselves, which we have never been all that good at. Countries such as Britain have had millennia to generate capital. We had nothing but bush. We soon found that the best way to marshal capital was through a stock exchange. Eventually, each state capital had a stock exchange.

Until very recently, almost every stock exchange in the world worked on the same system. The prime role of the stock exchange was to marshal capital for national development. Most stock exchanges were not primarily profit-seeking enterprises.

The exchanges operated by means of “seats”. To trade on the exchange, you bought a seat. When times were good, and everyone wanted a broker, seats were very expensive. When times were bad, and no-one wanted to know about the stock exchange, they were very cheap.

The stock exchange operated as a sort of mutual association. Its prime aim was to raise capital to develop the nation. In Australia, the great mining houses such as the Broken Hill Proprietary and the Collins House group, dominated by the Baillieu family (one of whose members is currently Victoria’s Liberal premier), spread their wealth throughout the community by means of the stock exchange.

How would this in effect work? For most of Australia’s financial history, the major finance houses were based in Collins Street, Melbourne. The Sydney firms were mainly small, retail-based operations. The big Melbourne firms, such as J.B. Were and Potters, had the real financial firepower.

While each state capital had its own exchange, Melbourne was the epicentre. While the Perth exchange was more or less a small room in St Georges Terrace, the Melbourne exchange had a massive chalkboard which was managed by a group of young men called chalkies who would somehow distinguish the “open outcry” calls and then write the quotes in chalk on the board.

The people who actually did the buying and selling were called operators. They were almost without exception young men, usually from the better private schools.

Participants were highly skilled. I used to trade with Gillon Derham, who among other things, were odd-lots brokers to the exchange.

Before computers made such things far easier, each trade had to be a standard size. If it was below a certain size, it was called an odd lot. If you had an odd lot, for example from a bonus issue, you sold it to the odd-lots broker at a deep discount. He would then amalgamate the odd lots and make a not inconsiderable profit.

Gillon Derham also had a standard brokerage business. Quite often, I would be in the lift at the old Stock Exchange building in Collins Street and I’d meet the Gillon Derham operator just before trading started and he’d say something like, “I’ve got a couple of yours here; I reckon I’ll do them in 15 minutes.” And he was always right.

But things have changed very much since then. Before the stock exchange, like everything else, was “rationalised”, brokerage rates were standardised. The private investor knew exactly what he was paying and the prices were moderate. The average private investor could do well by trading in fairly small amounts, knowing what his margins were.

The rationalisation began when brokerage was deregulated. Now it has reached the point where for private investors the stock market has divided into two halves.

First are the full-service brokers, where you get “advice” and the minimum brokerage is no less than $100, meaning there is no point making a trade under $5,000. These brokers are best for people with very little knowledge of finance and who need the professional advice of an experienced stockbroker.

Quite frankly, unless you are regularly trading big amounts and have great confidence in your broker, you may as well go to an “execution only” institution.

These days, most people dealing in modest amounts go to online brokers. Quotes and execution are almost instantaneous. Advice is almost non-existent; but at least you know what you are getting, and prices are far cheaper than for full-serviced brokers.

For the full-service broker dealing with private clients, overheads are high, research is costly and orders are still thin. Private-client brokers work on a retainer and commission, regardless of the hours they put in. Unless it’s a boom, returns aren’t really all that great.

It seems likely a shift will continue towards institutional brokers handling big clients and full-service private brokers being squeezed by online brokers who are really not much more than order-takers.

If things have changed for the retail investor, things have changed far more significantly for the role of the stock exchange in international and Australian finance.

First, one must understand what the stock exchange sells. Investors rarely call it “the stock exchange”. They call it “the market”. That’s because it’s a market in securities.

Initially, the ASX was the Australian Stock Exchange; now, it’s the Australian Securities Exchange, because it sells other things besides stocks — options, warrants, futures and so on, which are called derivatives.

As we have said, for most of their existence stock exchanges have been mutual associations owned by the seat-holders whose purpose was to raise capital for national development, not maximise profit. That has all changed and it has had profound implications for us all.

Believe it or not, the market leading the transition from “for development” to “for profit” was the Australian Stock Exchange.

The ASX was formed in 1987 from the amalgamation of the six state-based exchanges. The ASX was a mutual association, effectively owned by the stockbrokers who operated on it.

In the late 1990s, the de-mutualisation process began and stockbrokers were issued with stock in the new entity. On October 10, 1998, the ASX became the first stock exchange in the world to list its own stock. This was quite revolutionary; it had never been done before.

The logical outcome was that the ASX had become another enterprise that could be sold and traded. There was, in theory, nothing special about the ASX. This had not escaped the notice of the Singapore Exchange.

The ASX is quite a considerable undertaking. By some measures, it is the sixth biggest securities exchange in the world. In 2010, the Singapore Exchange launched a bid to take over the ASX, which would have created an entity with a combined value of $14 billion.

The Singapore Exchange had been pursuing expansion opportunities in Asia without great success. Singapore itself, being a very small island, does not have great potential for domestic expansion, so undertaking overseas expansion is a natural progression.

Initially, Australian competition authorities cleared the bid. Of course, the various Australian advisers retained by the Singaporeans would have been keen to see the bid succeed, as, apart from anything else, they would have been on substantial success fees.

Eventually, however, Labor Treasurer Wayne Swan woke up to the fact that the Singapore Exchange, which would have ended up totally controlling Australia’s main means of raising capital for national development, was controlled by Temasek, Singapore’s sovereign wealth fund — effectively, the Singapore government itself.

DBS, formerly the Development Bank of Singapore, another government-associated entity, also has a substantial holding in the Singapore Exchange.

On April 8, 2011 Swan killed the bid. Perhaps some businesses are more important than ideology.

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