Last week, the US Treasury Department issued its second of four reports related to President Trump’s Executive Order 13772 (on regulation in alignment with the Core Principles). The first report was on Banking, this report is on the Capital Markets, and other reports will follow over the coming months (including on asset management, insurance, products, vehicles, non-bank financial institutions, financial technology, financial innovation, and others).
As BofA notes, the main recommendation in this report was to foster growth in-line with the Core Principles. Specifically, the biggest focus was to enhance access to capital and investment opportunities, i.e. increase the number of IPOs. Indeed, the US Treasury recommended changes to encourage companies towards public ownership (particularly given that the number of public companies in the U.S. is down 50% over the past 20 year ), which would create more investment opportunities. In addition, other recommendations including helping entrepreneurs, reviewing proxy advisory firms, and revisiting the accredited investor definition to open private market investment opportunities to more investors.
According to BofA, this reco is one of the most critical for the long term growth of the capital markets and the economy. In addition to the recommendations encouraging companies towards public ownership, institutional investors that allocate capital need to refocus on longer term fundamentals versus short term momentum and the market structure needs to be revamped to benefit corporates and long term investing.
Indeed, it would be delightful if "capital markets" once again become discounting mechanisms, that rewarded careful analysis and fundamental stock selection, instead of just rampant capital inflows via passive instruments. Alas, for now that remains a pipe dream.
Meanwhile, the Treasury report recommendations are trying to make it easier for smaller companies to become public, including a review of rules and regulations (including a review of the global research settlement rules given that a common complaint from small companies is the lack of research coverage). Ironically, MiFID II out of Europe, could take research in the opposite direction, and significantly reduce the level of research coverage, particularly for smaller firms. Depending on whether MiFID II is limited to Europe or is implemented globally, as well as how pricing pans outcosts to asset managers would be 0-1% to 2-3%, and for investment banks equity revenues as 1-3% to mid-single digits, though less on total revenues given the broader revenue streams.
Yet while the collapse in IPOs in recent years, alongside shrinking investor participation in equity capital markets, has been extensively discussed, a more compelling observation by the Treasury was its view on market fragmentation, an artifact of broken markets from HFT domination; as a result the Treasury recommends changes (including the tick size) to improve equity market liquidity for small companies given the current market fragmentations (12 exchanges & ~40 alternative trading systems, ATS – Exhibit 3), reduce complexity, and harness competition in some areas (market data, order types, ATS, etc).
As BofA adds, the equity market structure has changed dramatically over the past 20 years, including regulation NMS, ATS, decimalization not to mention microwave and laser-based signal carriers and various HFT intermediaries spend hundreds of millions on the latest and greatest equipment allowing them to frontrun their competitors.
As a result, improving secondary market liquidity for small companies would be a positive for the capital markets, although the offsetting question whether there are any other material traders aside from central banks who would stand to benefit, remains open. Some of the other recommendations around simplifying order types and increasing competition for market data could benefit some areas of the capital market, yet place some pressure on others.
Some other recommendations from the Treasury include:
- Safeguarding the treasury market
- Encouraging lending through quality securitization
- Recalibrating derivatives regulation
- Ensuring proper oversight of CCPs and FMUs
- Modernizing and rationalizing regulatory structure and process
- Promoting U.S. interests and ensuring a level global playing field
And to think the Treasury hopes to get all this done before the next market crash...