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University of Toronto Law Journal 56.3 (2006) 223-280
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The Impact of Hot Issue Markets and Noise Traders on Stock Exchange Listing Standards‡
A. Douglas Harris*
Stock exchanges choose the firms and securities that will be traded using the facilities of the exchange. As the functions historically performed by stock exchanges become subject to competition or divestiture, the listing decision is the last traditional function that remains unique to stock exchanges. In whose interest is this decision made: investors' interests, issuers' interests, exchange members' or shareholders' interest, or some version of the 'public interest' that balances all of the foregoing? Many describe stock exchanges as capital markets 'gatekeepers,' suggesting that exchanges fulfil a broader public interest mandate. But exchanges, whether organized as mutuals or as corporations, also have a mandate to act in the interests of their members or shareholders.1
This article analyses the quantitative standards that stock exchanges apply to select the firms and securities that will be traded on the exchange. In particular, the article focuses on how two market phenomena - hot issue markets and noise traders - create a conflict between exchange shareholders' private interests and the public interest in connection with this critical exchange function when exchanges compete [End Page 223] with one another for listings. Exchanges may act in their shareholders' interests - and not in the public interest - by setting listing standards in order to allow their shareholders to profit from hot issue markets by increasing the amount of noise trading on the exchange. Far from ameliorating the 'irrational exuberance' of such markets, exchanges have strong incentives to consume a portion of their reputational capital in order to secure listings that will allow them to promote and exploit noise traders' irrationality.2 The unique contribution of this article is its analysis of the impact of hot issue markets on exchanges as self-regulatory organizations, as opposed to the traditional analytical focus on issuers, investors, and intermediaries.
This article proceeds as follows: Part II describes the role that stock exchanges play in capital markets, focusing on the gatekeeping function. Part III reviews prior literature on stock exchange listing standards, highlighting the relative lack of academic study of this critical function. Part III also reviews the more developed literature relating to hot issue markets and noise trading. Parts IV and V develop the following hypothesis about the relationship between stock exchange listing standards, hot issue markets, and noise traders: faced with competition for listings and a hot issue market propelled by noise traders, exchanges will act in their shareholders' interests - and contrary to the interests of existing listed companies and investors - by lowering their listing standards in order to increase the number of IPO listings. Exchange shareholders generally benefit from an exchange's listing of hot issue IPOs through increased levels of listing fees and trading fees, while specialists or market makers benefit through increased levels of uninformed trading associated with hot issue markets. Part VI provides case studies of stock exchange amendments to listing standards during hot issue markets. The principal case study is of the Toronto Stock Exchange (the TSX3 ), the senior equities trading market in Canada, which announced in June 2000 that it had developed new original listing standards for technology companies. This paper also presents evidence of similar changes to listing standards by the New York Stock Exchange (NYSE), the London Stock Exchange (LSE), and the American Stock Exchange (Amex) during the same or similar hot issue markets. [End Page 224]
Part VII considers briefly two alternatives that are open to exchanges faced with hot issue markets for firms that do not meet the exchanges' existing listing standards. Part VIII concludes.
II The role of stock exchanges in capital markets
A The Gatekeeping Function and Stock Exchange Listing Standards
1 Stock exchange competition
The important role that stock exchanges have played in capital markets has historically included the following functions:
- Gatekeeping: through their quantitative and qualitative listing standards, stock exchanges perform a screening function, admitting only some securities for trading through...