The Alternative of Private Regulation: The London Stock Exchange's Alternative Investment Market as a Model

What are the necessary conditions for strong and trustworthy stock markets? Most people assume that markets require a strong set of government rules and regulations to eliminate problems associated with transparency and fraud. Commonly overlooked is the fact that stock exchanges did, and to a large extent still do, provide a set of private rules and regulations. One modern stock exchange that relies heavily on private rather than government regulation is the London Stock Exchange’s Alternative Investment Market (AIM). Founded in 1995, AIM is an exchange-regulated market in which private regulators, called nominated advisers or nomads, oversee individual firms and decide whether they can list their shares. This system of private regulation reduces regulatory barriers and has attracted many new firms. But rather than engaging in a race to the bottom” in which anything goes, the private regulators work to put their stamp of approval only on firms that warrant trading. The market has attracted a lot of investment, and the survival rate of initial public offerings (IPOs) is in line with that of other more regulated markets. This system of private regulation gives more firms access to capital markets and more choices to investors, and it can be viewed as a model for other markets to follow.

1. Introduction

Almost all economists agree that stock markets are a good thing for firms and investors. They help to channel money from savers (however small) to firms that desire capital, enabling savers to share in a firm’s success. Everyone can gain. A matter of debate, however, is what conditions are necessary for stock markets to flourish. Although investors and those entrusted with their money (the invested-in company’s board of directors and its officers) theoretically have the same long-term interest in making investments succeed, their agents might skimp on fiduciary duties to maximize the investor’s desired returns, or they might engage in deliberate fraud. Such problems decrease confidence in markets and lead to fewer mutually beneficial investments taking place (Prentice, 2002). To eliminate such problems, people may look to government “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” (Securities Exchange Commission, 2012). Rajan and Zingales (2004, p.283) write that “markets cannot flourish without the very visible hand of the government, which is needed to set up and maintain the infrastructure that enables participants to trade freely with confidence.”

To some people, the choice is between government oversight and no oversight, and the latter sounds undesirable. What they overlook is third-party oversight from the private sector, which historically was the norm. If rules and regulations are beneficial, private parties can contract to have them.

Until the past hundred years, the world’s major stock exchanges were regulated privately, and in many areas they continue to be. A stock exchange is in business to facilitate exchange (people go to it because trading in the exchange is more attractive than trading elsewhere), and those in control of an exchange can enhance the demand for their market by providing assurances to investors with private rules and regulation. Mahoney (1997) refers to this role of the exchange as the regulator, and other economists describe the rules of stock exchanges as an important part of the microstructure of markets (Neal and Davis, 2006). Romano (1998) argues that a system of private regulation allows potential investors to opt into stock exchanges with rules and regulations that they trust. Stock exchanges without good assurances (or, on the flip side, with onerous regulations) will lose potential investors, creating incentives for stock exchanges to create an environment attractive to investors.

The world’s first formal, rule-enforcing stock exchange was created when eighteenth-century stockbrokers transformed coffeehouses in London into a private club (Stringham, 2002). The club catered to more reputable brokers and created entrance requirements, and it banished those who intentionally or unintentionally defaulted. With these new assurances, the club’s trading venue evolved through Garraway’s Coffeehouse and Jonathan’s Coffeehouse, to New Jonathan’s, to the Stock Subscription Room, and eventually to the London Stock Exchange, whose members adopted as their motto, “My word is my bond.”

Today, even though some stock exchanges are run or controlled by government (Daniel, 2010), almost all have private rules and regulations of varying degrees. One stock exchange that relies on a high degree of private regulation is the London Stock Exchange’s Alternative Investment Market (AIM). The London Stock Exchange sets the rules and regulations for the exchange, while nominated advisers known as “nomads” act as private regulators to ensure that these rules are followed. These nomads are basically paid (directly by the firm but indirectly by the investors) to ensure that a firm is legitimate before giving it a stamp of approval to go public; if a firm is not legitimate, this damages the reputation of the nomad who endorsed the firm.

The system of private regulation at AIM has many benefits. In contrast to a system of bureaucratic rules and regulations that hinders legitimate firms from going public (Stringham, Boettke, and Clark, 2008), the private regulations are much more flexible and enable many smaller firms to access capital markets. Even as American commentators are declaring that the “mounting pile of regulations forced the IPO [initial public offering] market to shrink” (Patricof, 2011), the IPO market for AIM has been flourishing. Beginning in 2001, the number of IPOs in England exceeded the number of IPOs in the United States for the first time in decades, and from 2001 through 2010 the number of IPOs on AIM has equaled or exceeded the number of IPOs on the American Stock Exchange, NASDAQ, and the New York Stock Exchange combined (London Stock Exchange, 2012c). Some people debate why IPOs have gone down in the United States, but Piotroski and Srinivasan (2008) found that small foreign firms were less likely to cross list in the United States because of the high regulation barriers from regulation in the Sarbanes-Oxley Act.

AIM attracts many small firms accessing the stock markets for the first time, and many firms already listed on other exchanges have chosen to switch to AIM. The “firms transferring to the AIM often [cited] lower costs (31.7%), flexibility (20.3%), and minor regulation (16.3%)” (Vismara, Paleari, and Ritter, 2012, p.18). To many advocates of regulation, this should be a recipe for disaster. But even though AIM does not have the same amount of regulation as other markets, the survival rate of IPOs on AIM is in line with the survival rates of IPOs on more government-regulated markets in the United States (Espenlaub, Khurshed, and Mohamed, 2012).

At a time when politicians and lawmakers are imposing more and more regulations (The Economist, 2012a, 2012b), it may be useful to take a step back and analyze a less bureaucratic alternative. Private regulation allows investors to select the set of rules and regulations that they prefer rather than government imposing a set of often questionable and costly regulations on everyone. Even if one assumes that the Securities Exchange Commission provides a beneficial framework for some or even most investors (an assumption that we, like Stigler [1975, p.87] would debate), it does not follow that all investors should be prohibited from opting into alternative regulatory frameworks such as those on AIM. This article provides an overview of AIM, describes how the private regulation works, and summarizes how the market has performed. We conclude that the London Stock Exchange’s AIM can be viewed as a model for others to follow. Provision of rules and regulations by a monopolist regulator is overrated.

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