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Anthony Hilton: Over-zealous watchdogs have put the bite on liquidity

Yui Mok/PA

At a conference for small private companies the other day, one of our leading investment banks sent a clutch of people to see if they could interest the audience in taking out a loan for their businesses which the bank would arrange.

But at the same event there was absolutely no one from the bank to see if these same people would be interested in equity or an Aim flotation.

Does this matter? Yes it does.

Katie Potts, who runs the small-cap Herald Investment Trust, says you cannot build a serious company if you have a five-year time horizon.

Debt is usually short term, five years or so, whereas equity is long term and to establish a company you often need 10 years or more. She worries that we may not be helping those small companies which have the potential to be future giants.

Last year was interesting, says Potts. In Aim, the largest of the small-caps did reasonably; the middling small-caps did half as well in performance; but the smallest, the £100 million sized, showed no share price appreciation at all.

Aim is getting smaller, as is the main share market, and indeed Nasdaq in the United States. The way things are going the equity market might cease to exist in 20 years. We ought at least to think about this and its consequences, rather than just letting it happen.

Arguably the regulators have caused much of the problem.

The Financial Conduct Authority and others have decided to protect the investor and put the security of a share above performance. They have imposed legal restrictions on securities houses, Mifid II, to protect investors, but there was little political input which might have warned them not to go too far. The unintended consequences are now occurring.

Elsewhere, institutional investors have deserted the small-cap sector as insurance companies have been pushed by Solvency II to buy bonds so they will meet their policyholders’ guarantees. Pension funds have been told to buy bonds rather than equities on the same principle to guarantee their members’ pensions. Even wealth managers who invest for middling-to-large private clients have been pushed by the FCA to make sure they focus on shares which are not going to go pop.

Over the past few years this has led wealth managers to construct portfolios which are basically large capitalisation issues because the regulator thinks smaller stocks are too risky for private investors. Large-caps also go pop but wealth managers and the FCA don’t get the blame because “no one could have seen this coming”.

The result is small new issues are extremely difficult to get away. Institutions were the backstop of the stock market — they would buy the new stocks if the company had potential. But if they are no longer active, private investors cannot take up the slack. They have less money and they invest much less. This means the issuing bank has to spend a fortune to stir up interest, and are reluctant to do so.

Companies are also much less likely to come on Aim, preferring to stay private.

Partly this is the cost, partly it is the reporting requirements. But there is also a dearth of research — most banks have given up at the smaller end — which has again been the result of regulation. Good research would normally help the share price, and improve marketability.

But Mifid II, the regulatory document in question, said rather than give clients a flat figure for all costs, the houses should unbundle the various income streams, so investors could choose what they would pay for, and ignore the rest.

Having to unbundle meant a lot of houses simply stopped doing small-cap research because they could no longer make it pay. That meant investors could not tell anymore how the company was doing and what its prospects were.

In turn, that led to the further fall in liquidity, which is the ability to buy or sell in normal market size without affecting the share price.

There were other issues caused by Mifid and similar regulations caused by the financial crisis, but the result is that liquidity in most stocks has collapsed. That is why every day sees some share plunge by 25% or more because of a poor trading update. In the old days a share might fall 5%. But now the market is thin.

What is the major short-term problem facing the City? Recession? Trade wars? The Middle East? Donald Trump?

Perhaps it is none of these. Perhaps it is liquidity.