Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Pirate stock exchanges and the origin of stock exchanges

Reuters has an interesting report
on the stock exchange set up by Somali pirates to fund their
activities. It is a fascinating story of how a stock exchange is
operating in a near-barter economy. One of the shareholders got her
“dividend” for contributing a grenade launcher which she
received as alimony from her ex-husband.

The interesting thing is that this is exactly how finance
began. Meir Kohn provides the following interesting description
of the capital market before 1600 (page 13-14):

While landowners and governments could finance themselves with
long-term debt, this option was generally not available to business:
it lacked the security and the reliable cash flow required for a debt
issue. On the other hand, business could promise substantial gains if
things went well to compensate for the possibility of loss if things
went badly. This potential for extraordinary returns did provide a
basis for equity finance.

The fundamental problem of equity finance is to ensure
equity-holders a fair return on their investment. Today, there
exists a complex of institutional mechanisms to address this
problem – accounting procedures and an accounting profession, legal
protections, extensive reporting and analysis of financial
information. Since none of these existed before 1600, equity finance
had to rely on a simpler mechanism: wind up the business periodically,
and divide up the proceeds among the shareholders. This procedure was
possible, because business was largely commercial and did not require
any substantial investment in fixed capital.

A few months ago, I wrote a post
on ultra-simplified finance which revolved around equity markets. To
see how powerful equity markets can be even when there is almost
nothing else by way of a financial system, one has three choices:

  1. read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of
    risk-bearing”);
  2. go back in time to the pre-industrial era;
  3. take a trip to Somalia.

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