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.

Posted at 1:30 pm IST on Thu, 3 Dec 2009         permanent link

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