Why we need stock exchange?

This article aims to analyze the changing world of stock exchanges, the historical and current perspective that’s been driving it, why there is need for stock exchange as in why should we care about it
Estimated Reading Time: 8 minutes

Introduction

A stock exchange is a dynamic electronic platform where the market dealings take place in shares, debentures, and bonds issued by the public and private sector enterprises, the government, etc. In simpler words, the stock exchange refers to an organized market where various long-term securities like shares, debentures, and bonds issued by the companies and government and semi-government organizations are sold and purchased. In the words of Husband and Dockerary, “Stock exchanges are privately organized markets which are used to facilitate trading in securities.”[1]

Stock exchange is also popularly known as the Stock Market, Security market, or Share Market, which provides a convenient place to trade securities systematically. The main aim of establishing a stock exchange is to assist, regulate, and control the business of buying and selling securities in the share market. This buying and selling of securities, in short, trading of securities, is done through stock brokers and traders.  

According to the Securities Contracts (Regulations) Act, 1956, the stock exchange is defined as “an association, organization or body of an individual, whether incorporate or not, constituted to assist, regulate, or controlling the business of buying, selling, or to deal in securities.”[2] Stock exchanges in India operate in accordance with the rules and guidelines issued by the Securities and Exchange Board of India (SEBI).

Understanding stock exchange in market terms

The market for long-term securities such as shares, debentures, and bonds is segregated into Primary and Secondary Market. Primary Market, also known as New Issue Market, deals with new issues where the securities are sold for the first time to collect long-term capital. On the other hand, the secondary market deals with buying and selling of the previously issued securities. So, essentially when a security is sold for the first time to collect long-term capital, it is the primary market activity.

Still, when those securities are sold for the second time to collect long-term capital, it is the secondary market activity. It is imperative to note here that secondary market transactions are done through the medium of Stock exchange. This is where the need for stock exchange comes into the picture. Since the primary market’s growth is mainly dependent on the secondary market, economic development is reflected by the stock market’s growth.

Functions of stock exchange

The critical functions performed by a stock exchange are outlined as below:

  1. Stock exchange provides a ready market for the securities, i.e. bonds, shares, and debentures issued by various concerns.
  2. Stock exchange assists in determining the price of various securities.
  3. Further, it effectively mobilises surplus funds of business firms, cooperatives, and individuals for investment in popular securities.
  4. It plays a crucial role in ensuring wider shares ownership.
  5. Stock exchange has a significant contribution to the economic growth of individual companies and the country.
  6. It ensures fair dealings of securities and the safety of funds.
  7. Additionally, it facilitates capital formation in the country by providing an avenue for investment in those securities which yield a higher return.

Following the functions of a stock exchange, let’s see the role it plays in pushing a country’s economy.

Characteristics of a Stock Exchange

The role of a stock exchange is diverse and highly beneficial in the economic development of a country. As mentioned above, apart from playing a central role in the primary and secondary market, stock exchanges play an essential role in developing the economy by gauging and managing economic growth. Some of the main characteristics of stock exchanges are listed as under:

  1. Raises capital for businesses: They help joint-stock companies to raise capital by selling shares to the investors.
  2. Mobilize savings for investment: Stock exchanges help the investing public mobilise their saving to invest in high yielding economic sectors. This results in a higher yield to the concerned individual and the country as well.
  3. Facilitate company expansion: Stock exchanges facilitate joint-stock companies to spread out, expand, and grow by acquisition or fusion.
  4. Profit-sharing: They also help stock investors to get their share in the wealth of profitable businesses.
  5. Corporate governance: Stock exchanges have their set of rules that a company has to abide by to get listed. Therefore, listed public companies are said to have better management records than private companies.
  6. Create investment opportunities for small investors: By buying a small number of shares, even small investors get the opportunity to participate in the growth of large corporations.
  7. Facilitate government in raising capital for development projects: A stock exchange also helps the government raise capital fund for developmental projects through bonds. An investor who buys the issued bonds will lend money to the government, which is considered a safer and secure means and provides tax benefits.
  8. Barometer of the economy: Stock exchanges have a key role in maintaining the stock indices, which are the direct indicators of the current economy’s general trend. They also help in the regulation of the price fluctuations in stock.[3]

The need of stock exchange

Stock market has a more profound relationship in higher future growth in the economy. That is the essential factor why we need stock exchanges. To better understand the necessity aspect, see below-listed factors that suffice the need for stock exchange influence to help in the country’s overall economic growth.

Stock exchange and growth

It is an undisputed fact that stock markets and economic growth are inextricably intertwined with each other. Stock market provides a valuable complementary financing source that is both forgiving and flexible and leads to a higher future level of GDP per capita growth in a country.

Stock exchange and innovation

Stock exchanges play a supportive role in pushing innovations concerning the unique nature of equity. Equity is a significant source of financing for long-term and uncertain business projects so, more equity funding in a business ultimately leads to more innovation.

Stock exchange and productivity

The need for stock exchange can be well-explained in terms of productivity. Innovation is a prime driver of productivity growth as they enable effective delivery of output per hour. And productivity growth is a fundamental factor that increases GDP per capita of a country. Equity has a significant role with higher potential to reignite a company’s productivity growth, and stock exchanges facilitate that growth.

Stock exchange and investment

There is growing evidence that the companies listed on the stock exchange invest more often than privately-held companies in their business. A high proportion of public companies’ investment goes on long term projects, specifically, R&D sector. Since private companies invest more minor, the trend can cause potential economic damage to equity markets.[4]

Stock exchange and wealth sharing

Stock exchange is a unique form of investment and encourages broader participation in wealth creation. However, since new companies often take their time to decide whether to list at all their growth and returns become limited to wealthy and capable investors who can invest in private markets. This could limit the wealth-sharing perspective of the stock exchanges that seeks to increase the return from equity markets.

Stock exchange and transparency

Stock exchange principles are dedicated to a transparent business system for the listed companies, providing listings and disclosure standards. While many would argue that privately-held companies’ affairs should remain private, it becomes challenging as such companies expand into a broader range of politically sensitive sectors like care homes, infrastructure, and healthcare. Therefore, lower levels of scrutiny may be scheduled to privately-held companies, but this reduces the business world’s transparency level.

Stock exchange and standards

Besides providing a market place for capital raising and trading, stock exchanges also play a crucial role in quality control for listed companies via set listing standards. They monitor the listed companies with market surveillance and their compliance with corporate governance standards. The disclosure and governance standards set by the exchanges work as guidance to provide a superior benchmark for valuations and best market practices.

Contribution of Stock exchanges in corporate governance

Corporate governance is broadly referred to as the rules, process, or law that operates, regulates, and controls business activities. The main objective of corporate governance is to maximize shareholders’ wealth in line with other stakeholders’ interests.[5]

Stock exchanges are established promoters of corporate governance practices for listed companies. The primary and direct contribution of stock exchanges in corporate governance has been traditionally through listing and disclosures standards and monitoring compliance.  However, this regulatory function of stock exchanges has been enlarged with the promulgation of OECD Principles of Corporate Governance, to incorporate corporate governance concerns. Since then, stock exchanges have significantly contributed to corporate governance recommendations and encouraged its practice to be applied by listed companies. The role of stock exchanges in corporate governance as per the Organization for Economic Co-operation and Development (OECD) is briefed as given below[6]:

Exchanges act as a significant source of corporate governance-related regulations by encouraging transparency and discouraging illegal or irregular practices. The exchanges’ regulatory function is mainly exercised in the context of an existing legal framework. They act as a representative authority on behalf of security regulators. The security regulators have delegated exchanges power to introduce and enforce legal regulations on the listed companies, but the power is subject to national legal frameworks’ limitations.

Notably, the principal security regulations and relevant laws comprise corporate governance rules for listed companies, so stock exchanges’ contribution becomes complementary. They have a further shared responsibility to monitor ongoing disclosure standards and prevent fraudulent or other abusive practices. Stock exchanges are committed to reporting market integrity or disclosure requirements breaches by MOUs with market regulators or subject to similar regulatory or statutory obligations. They monitor compliance of companies as per the legislation and subsidiary regulation.

Considering the competence and need of stock exchanges to enhance listed companies’ corporate governance, in the absence of or weak enforcement standards set by the statutory regulators, concerns will arise. Exchanges face incentives to establish and maintain the high regulatory standards. This incentive might weaken because of weak enforcement rules at hand as exchanges weigh the risk of deterring listings altogether or losing the listing to competing market places.

Conclusion

Stock exchanges are a social good and a barometer of developing the economy in a country and the growing market and companies in it. The paradox of stock exchange is more significant, deeper, and more efficient than ever before; however, only fewer companies opt to get listed on them and use stock exchanges as a medium to raise capital.

There has been a significant increase in cost and burden of being a listed company regarding disclosure requirements and corporate governance, holding back companies to list them on a stock exchange. The changing profile of listed companies and the arising issues may limit the wealth-sharing in the highest potential companies. This would pave a danger for the stock market that would be circumscribed only with more extensive and older companies and fewer to join in future. Nonetheless, the supportive role and need for stock exchanges in setting business standards, providing transparency, and widening the economy is well-supported across the world.


[1] Rahul Garg, Stock Exchanges and their Role in India, IJMSSR, Vol. 3, No. 2, (2014), last assessed Jan 11th 2021, at

https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.428.9469&rep=rep1&type=pdf.

[2] The Securities Contracts (Regulation) Act, 1956, sec. 2.

[3] Role of stock exchanges, last assessed Jan 11th 2021, at http://www.stock-trading-infocentre.com/role-ofstock-exchanges.html. Access on 05-12-2013

[4] What are stock exchanges for and why should we care?, last assessed Jan 11th 2021, at https://www.pensioncorporation.com/media/163140/24238_the-purpose-of-stock-exchanges_web_v2.pdf.

[5] Secondary Market Department, Corporatization and Demutualization of stock Exchange,(30 January 2003), www.sebi.gov.in.

[6] The Role of Stock Exchanges in Corporate Governance, last assessed Jan 11th 2021, at https://www.oecd.org/daf/fin/financial-markets/43169104.pdf.

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