88 Pages Posted: 9 Nov 2010 Last revised: 20 Feb 2014
Date Written: November 8, 2010
A strong, sustained recovery will require the formation and growth of new scale companies. These companies, in turn, often require access to equity capital as they grow. Traditionally, this has best been accomplished by the floating of shares in an initial public offering (IPO).
IPOs have been down substantially over the past decade. Many factors have been alleged to have contributed to this trend, among them, the higher regulatory cost of going and remaining public under the Sarbanes–Oxley Act (SOX) of 2002.
But a far more important, and heretofore unrecognized, deterrent to growth company IPOs is the proliferation of new indexed securities - derivatives essentially. Initially, these products took the form of mutual funds; now they are increasingly represented as “exchange traded funds” or ETFs.
We show here that ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future. In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on U.S. exchanges.
That is not all. The proliferation of ETFs also poses unquantifiable but very real systemic risks of the kind that were manifested very briefly during the “Flash Crash” of May 6, 2010. Absent the ETF-related reforms we outline below in this summary, and in more detail in the text, we believe that other flash crashes or small capitalization company “melt ups,” potentially much more severe than the one on May 6, are a virtual certainty.
In setting forth our thesis, we rebut the currently popular critique of so-called “high frequency trading,” or HFT: namely, that it contributed to the flash crash and continues to pose threats to market stability. Likewise, we demonstrate that the charges against algorithmic trading are without foundation.
We reach several specific conclusions and offer several principal recommendations for the SEC in this paper.
We urge the public, regulators, elected officials, and executive branch policy makers to give attention to the subjects we outline in this paper. In the process, we hope to shed some light on some very complicated but important topics that have a direct bearing not only on our capital markets and their performance, but also on the willingness of the new growth companies to go public and thus help power the sustained growth that our economy so sorely needs.
Keywords: etf, htf, exchange traded fund, high-frequency trading, economic recovery, IPO, growth, market
Suggested Citation: Suggested Citation
Bradley, Harold S and Litan, Robert E., Choking the Recovery: Why New Growth Companies Aren't Going Public and Unrecognized Risks of Future Market Disruptions (November 8, 2010). Available at SSRN: https://ssrn.com/abstract=1706174 or http://dx.doi.org/10.2139/ssrn.1706174