The privileged and risky world of the stock market

As the sound of gunfire subsided over the battlefield of Waterloo in 1815, news of the Allied victory over Napoleon was carried by relays of couriers to the banker Nathan Rothschild in London. The financier, one of the founders of the Rothschild dynasty, received the news more than 24 hours before it reached the British Prime Minister, Lord Liverpool.

Rothschild knew that the price of British government stocks would soar when the word came through. So he bought large amounts of stock. The price rose over the next four days, and Rothschild added to his already considerable fortune.

Today financial organisations around the globe are linked by electronic communications, and events are known everywhere almost as they happen. The world’s stock markets act almost as one, each of them responding immediately to news from the others.

A dramatic example was the stock market crash of Monday, October 19, 1987, which rippled like a shock wave around the world as each exchange opened for business. The New York exchange had suffered a sharp fall the previous Friday, and a weekend of simmering financial panic followed. The Sydney exchange opened its doors on Monday morning while most of the world was still sleeping. Stockbrokers were deluged with orders to sell, and millions of dollars were wiped off share values. Satellite communications carried the news immediately to the Tokyo exchange, where heavy selling occurred. As the Earth rotated on its axis, bringing opening time to one stock exchange after another, the wave swept around the globe Hong Kong, Singapore, the exchanges of Europe, and back to New York. The value of American companies plunged by more than $500 billion before the end of the day.

`Black Monday’ brought the stock market to the attention of people who normally are barely aware of its existence. How could such enormous losses happen, they asked. How do stock exchanges work?

For three centuries or more, exchanges have been the marketplace where companies – and some governments, too – have gone to raise part of the capital needed to finance their enterprises.

The traditional auction-room frenzy of buying and selling on the trading floors of the exchanges is now yielding to a high-technology hum as dealers become computerised. But basic principles remain unaltered. A stock exchange is the focus for the buying and selling of securities, a blanket term for stocks, shares, bonds and similar documents. They all represent an investment by the person who buys them and a source of funds for the organisation that issues them.

The stock exchange determines, through the free-market process of supply and demand, what any particular security is worth to the holder at any given moment.

Businesses needing extra money to finance their activities have, in free-market economies, two main ways of obtaining it. They can borrow it from a bank for a fixed period or they can raise it by selling a part of themselves in the form of securities to anyone willing to buy.

The second method has an advantage for the business, because the money raised does not necessarily have to be paid back if the company’s ventures fail completely. The buyers of the securities, on the other hand, become entitled to some of the profit if the business thrives, and the securities should rise in value. They hope to receive a better return from that investment than they would by putting their money to other, less risky use.

Being listed on a stock exchange gives a company prestige, which in turn helps in its efforts to raise money. It also has, through the stock exchange, access to the most important pool of potential investors – and their money.

Stock exchanges do not admit a company automatically. They enforce rules to ensure that listed companies give investors full and accurate information about their business, and treat them fairly and lawfully.

It is both expensive and complicated for companies to obtain a listing in top markets such as the New York, Tokyo or London exchanges. In New York, for example, a quoted company must have assets worth at least $16 million.

Most countries have developed secondary markets for smaller companies which wish to offer their securities to the public. These markets apply less strict conditions than the main markets, but are still tightly controlled.

In America the function is fulfilled by the American Stock Exchange (Amex) – also known as ‘The Kerb’ from its street beginnings – and the more recent National Association of Security Dealers’ Automatic Quotation System (NASDAQ). Britain has its Unlisted Securities Market and Third Market, and Tokyo has a two-tier system.