Friday, October 4, 2013

What happens when stock markets die?

What effect does a stock market listing have on the value of equity? Companies can always choose to issue shares privately rather than list them on public centralized exchanges. That the world's biggest corporations are all publicly-listed implies some sort of advantage to being listed.

To answer this question, it helps to see what happens to listed share prices upon the sudden dissolution of a stock market. The cryptocoin universe has just provided us with a great natural experiment (which, unluckily for me, resulted in a loss). Due to what it called "recent changes in the virtual currency regulatory environment," LTC-Global, a litecoin-denominated stock market, and sister exchange BTC-TC, a bitcoin-denominated exchange, announced that they would be shutting their doors. Both exchanges listed twenty to thirty securities each, including shares, bonds, and ETFs. BTC-TC did ~2,000 BTC in daily volume or ~$350,000, while LTC-Global was doing 5,000 LTC a day in business, or around $10,000.

The fateful announcement was made on the morning of September 23. Trading was immediately halted and order books cleared, presumably to allow investors to digest the information. When trading was re-opened, the immediate reaction of almost all share prices was to plunge in value. Shares continue to trade almost exclusively below their pre-September 23 price. All trading will be halted on October 7. After that point, de-listed companies will have to reconfigure the way by which their shares are traded. They may either relist on another crypto share market (there are a few), they might provide their own venue for trading on their personal website, or they might simply leave it to the shareholders to locate each other and trade over-the- counter, say on forums or message boards.

Here are a few charts showing the reaction of some of the more liquid stocks to the closure. I get them from Coinflow:

Labcoin (BTC-TC):  Labcoin is in the business of manufacturing and marketing cryptocoin mining equipment. It immediately fell from 0.0023 BTC to 0.00025 BTC, or around 90%, soon recovering to 0.001 BTC, about 50% below pre-announcement prices.

Basic Mining (BTC-TC):  Basic Mining units offer a share of revenues earned from a bitcoin mining operation. They stabilized the day after the announcement at around 40% below their previous price.

LTC-Miner (LTC-Global):  The share price of LTC-Miner, a cryptocoin mining farm's value, was halved on September 23.

This event clearly illustrates how an unanticipated de-listing affects a firm's stock price. Despite no change in underlying fundamentals—the earnings of most of the listed cryptofirms would have been unaffected by the stock market's closure—the market value of most firms' shares declined. Alternatively, we might say that the listing of a stock on a stock market would cause a rise in the market's valuation of a firm, despite no improvement in underlying fundamentals.

There are two non-mutually exclusive reasons that might explain the collapse in crypto shares upon the closure of LTC-Global and BTC-TC, a real and a monetary one:

1. Stock markets vet firms to ensure they are legitimate. They also set standards for communication and governance, and this forces firms to be more accountable to shareholders. The graduation of a firm's shares to an exchange like LTC-Global or BTC-TC may be taken by investors as an indicator that the shares are less risky than before, and therefore they can be discounted by a smaller factor. When LTC-Global and BTC-TC were suddenly closed, shareholders had no guaranty that the issuer, no longer under the glare of the public eye, would treat them as fairly as before, and therefore the large selloff. Or put differently, investors chose to suddenly put a larger risk premium on cryptoshares.

2. By bringing together many stocks and investors in one space, stock markets promote the liquidity of shares. Liquidity is its own return. By that I mean that investors "consume" liquidity in the same way that they consume other durable goods that provide protection, say house alarms, guns, or fire extinguishers. Though these goods are unlikely to ever be used, the services they provide are steadily consumed through time in the form of comfort and security. By ensuring liquidity, stock markets increase the non-pecuniary flows of comfort and security provided by listed stock. A liquid share, after all, can be easily sold should some unforeseen arise—an illiquid share can't. All other things staying the same, this improvement in a stock's non-pecuniary yield should result in a rise in its price (see this post for more).

So upon the announced shutdown of LTC-Global and BTC-TC, expectations about future liquidity were reduced, the non-pecuniary return on shares declined, and thus prices fell. The fallback option—that shares trade over-the-counter—results in inferior liquidity since there are significant search and monitoring costs entailed when exchanging stock via forums or email.

One wonders when some bright programmer creates a decentralized ledger to store a stock market's order book. Just like it is impossible to shutdown bitcoin since it doesn't exist in one particular location, it would be impossible for authorities to shutdown a decentralized cryptocoin stock market. Companies operating in the bitcoin universe would flock to list on this market since it would provide them with the most legitimate guarantee of future liquidity, and a higher stock price. All for a juicy fee, of course.


  1. It would be interesting to compare the impact on prices of shares that were already listed on other exchanges, those that were listed in response to the BTC-TC announcement, and those that are no longer listed anywhere. This may indicate how much of the premium is due to the legitimacy provided by being listed versus the extra liquidity.

    By the way, a smart programmer has already created a decentralised stock market. Check out BitShares.

    1. Interesting. Hadn't heard of BitShares -- checking it out now. Is is just this whitepaper?

      ...or do they have something functioning?

    2. I think the implementation is complete, and that they are close to being ready to go live.

      Some info here, but getting a little out of date:

    3. I must confess that after reading your link and the white paper, I still have no idea how BitShares works. I'm not sure why a distributed order book needs to be so complicated. But perhaps they're dealing with problems I simply can't grasp and those are their solutions. Thanks for the links.

  2. You're roughly in the position of the Pacific islanders during WW2, coming up with theories as to what and wherefore is going on in the world and why the raft of strange white men they could see in the distance suddenly caught fire and sunk. There's an ocean around, it is deep and there's such a thing as submarines.

    The difference, of course, is that the islanders didn't have readily available access to information, nor the ability to notice that after the shoe dropped the end of BTCT was a given, nor indeed the record to show that the exact same happened already once before. Exactly the same way.

    Lurk more, and in better chosen places.

    1. If you're interested in Pacific Islanders, please read my Yap stone money posts.