Financing Investment Reforming finance markets for the long-term Alfie Stirling and Loren King ippr commission on Economic Justice

28

exchange computers and owned by a third party can respond to information more 

quickly than other market actors. Profits can therefore be made by a third party 

by intervening between a buy and sell order of two other market participants. By 

buying the asset from the original seller, holding it for three thousandths of second, 

and selling to the first would-be buyer, the computer can profit from any difference 

in valuation between the other two actors. The margins are necessarily small, but 

if repeated over thousands of transactions, fortunes can be made over a very short 

time horizon. In turn these fortunes are paid through higher prices to everyone else 

with no productive value added to the economy whatsoever (Davis et al 2016).

The empirical prevalence of this type of activity is striking. Hedge funds, high 

frequency traders and propriety traders make up 72 per cent of equity market 

turnover in the UK (Kay 2012). In the US, 51 per cent of all transactions are 

generated from these types of computer programmes, and 39 per cent in Europe 

(World Federation of Exchanges 2013), and a 2010 study showed that managers 

trade more than they plan or expect to, despite being aware that the effects 

could be damaging for their clients (Guyatt and Lukomnik 2010). The econometric 

evidence also appears to show that the propensity for this type of trading has 

created a systematic bias towards short-term rewards. Research by Haldane and 

Davies at the Bank of England found UK and US stock markets displayed excessive 

discounting of risk that was statistically significant in eight of the last nine years 

of the study’s panel between 1985 and 2004 (see figure 10). Returns were overly 

discounted by around 5 to 10 per cent a year, so that returns on a 30-year time 

horizon were typically negligible, despite returns over this time frame being highly 

valuable to many savers (Haldane and Davies 2011).

FIGURE 9

UK and US stock markets showed systematic, repeated short-termism before the 

financial crisis

Discounting of shares in US and UK stock markets relative to the appropriate time discount, 

1985 to 2004

X > 1

X < 1

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1985

1986

198

7

1988

1989

1990

1991

1992

199

3

1994

1995

1996

199

7

1998

1999

2000

200

1

2002

2003

2004

Note: Values less than 1 indicate an average discounting of future returns on shares beyond 

the appropriate time discount. Coloured years denote those that are statistically significant.

Source: Bank of England 2017

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MISALIGNED INCENTIVES AND AGENCY CAPITALISM

The combination of overly subsidised volume and a culture where relative 

performance wins can also lead to a costly over-diversification by asset managers. 

As Stephen Davis, Jon Lukomnik and David Pitt-Watson (2016) argue, this enables 

fund managers to exploit the rule of averages. As Davis et al observe, a good way 

of guaranteeing a high-performing fund that attracts large numbers of investors 

is to run so many funds that at least some of them will be high performing. If 64 

funds are established then, all else being equal, 32 of them will perform better 

than the market average after one year. After six years, the law of probabilities 

means that simply by chance you might expect to be left with one fund that has 

outperformed the market average in each consecutive year over the period. This 

fund will attract inflows of new investments and assets along the way, while the 

poorer performing funds can be discontinued and restarted with a clean historical 

record. So long as an asset manager has a number of ‘high performing’ funds, they 

will retain and attract clients and the cost of multiple lower performing funds will 

be subsidised by the asset based fee they accrue. Some variation and diversity of 

funds is important, but the current number of funds reported on by Morningstar 

alone is in excess of 53,000 (Davis et al 2016). By contrast, the average defined 

contribution pension schemes tends to have no more than 25 investment options, 

which would suggest the limit to which the ‘investible universe’ can helpfully be 

divided is significantly below 53,000 (Ibid).

This phenomenon is sometimes described as ‘agency capitalism’. Multiple small 

misalignments in incentives are driven by rewarding intermediators based 

on volume and relative – rather than absolute – performance. This in turn is 

exacerbated by derivatives, which can insure the owners of shares against risk. 

This means that not only can the main traders in equity be largely uninterested 

in the underlying value of the shares they own, but beneficial share ownership 

can also be entirely decoupled from the economic interest of a share – leading 

to conflicts of interest (Ibid). As such, misalignments in incentives aggregate to a 

system-wide effect where the owners of shares are ‘rationally reticent’ to actively 

nurture and improve the fundamental value of the companies whose shares they 

trade on behalf of savers (Gilson and Gordon 2013). Intermediaries that are paid 

for the frequency of their activity over short time horizons, and are insured against 

the economic risks they take, are not incentivised to steward UK companies to 

create long-term value. 

Academic work on company takeovers gives further evidence on the negative 

impacts of agency capitalism. Standard economic theory might suggest that a 

‘market’ in company takeovers would provide incentives to improve economic 

efficiency (Romano 1992). However, the empirical evidence suggests that there is 

statistically no difference between firms that are bought out or not bought out, 

other than that acquired firms tend to be smaller than non-acquired firms. Firms 

seeking to avoid takeover, then, are incentivised to increase their size, not their 

long-term profitability (Hughes and Singh 1987, Cosh and Hughes 2008). 

Agency capitalism appears to have had a measurable effect on those investors 

who use the services of asset managers. Despite surveys showing that trust is the 

most important factor against which asset managers are judged, just 39 per cent of 

investors in the UK think that the industry as a whole can be trusted to serve their 

interests (CFA Institute and Edelman 2013). 

From the point of view of savers, workers and society as a whole, the danger 

of misaligned incentives in equity markets is that they shape the governance 

decisions of the UK’s major firms, making them more short-term and less inclined 

to invest in long-term value creation. This appears to be happening through two 

important transmission mechanisms: shareholder ballots and CEO remuneration. 

Voting at the annual meeting of companies can have a tremendous effect on 

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absolute value. Ballots elect directors, who in turn appoint the CEO, but they can 

also determine rewards policy for executive staff and decisions over mergers and 

acquisitions (Davis et al 2016). However, there is a measurable lack of engagement 

in asserting ownership rights through voting. Individual investors, who make up 

more than a quarter of beneficial owners, only realise around 29 per cent of their 

voting potential. Institutional investors utilise 90 per cent of their votes, but many 

of these rely on the intermediation chain. This is concerning because despite 

employing hundreds of people, the largest asset managers devote just four people 

on average to conducting analysis in support of voting decisions. This equates to 

one person making the decision to appoint 50 directors every working day of the 

year (ibid). In part this is due to a reliance on proxy voting companies. But this in 

turn raises concerns, given that transparency and accountability for the advice 

these companies give is widely thought to be lacking (Waygood 2014).

CEO remuneration is the second important transmission mechanism for ‘market 

myopia’ to enter corporate priorities in corporate governance decisions. The 

inclusion of share options in CEO and board remuneration packages is intended 

to align company leadership with shareholders. However, there is considerable 

evidence that this approach fails to align incentives properly. Creative 

accountancy, and the backdating of options, help to decouple even short-term 

executive performance from their rewards (Bebchuk and Fried 2006). But more 

fundamentally, even where incentives are aligned with beneficial owners, this 

enables the short-term horizons of equity intermediaries to gain purchase in the 

board room. Share ownership for the median FTSE 100 CEO is worth 200 per cent 

of base salary, and 25 per cent of CEOs own shares worth more than 300 per cent 

of salary (PWC 2012) (see figure 11). Crucially, executives also display excessive 

short termism. Survey evidence shows that more CEOs would opt for £250,000 

paid to them tomorrow than £450,000 in three years’ time. This equates to a 

discount rate of 20 per cent, compared with a ‘rational’ rate of around 8.5 per 

cent (Haldane and Davies 2011).

FIGURE 10

Senior employees of UK publically listed firms have a significant economic interest in 

the stock market

Proportion (per cent of base salary) of share ownership by job type among FTSE 250 and FTSE 

100 firms, 2011

Upper quartile

Median

Lower quartile

0%

50%

100%

150%

200%

250%

300%

350%

ExCo

Main

board

CEO

Source: PWC 2012

These transmission mechanisms appear to be affecting business decisions. 

Econometric analysis of the empirical evidence in the US showed that companies 

that fall just short of their earnings targets would also cut spending on R&D and 

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intangibles, while firms that just miss their targets see a decline in their stock 

market valuation (Terry 2014). Further evidence from the US has shown that more 

than 90 per cent of the largest firms remunerate their highest-paid employees 

for their performance over a time horizon of three years or less, despite the fact 

that any investment in (say) R&D would likely take far longer to bear commercial 

advantages (IRRC Institute and Organizational Capital Partners 2014). A survey 

of more than 400 executives also found that 75 per cent would sacrifice positive 

economic outcomes if it helped smooth short-term earnings: that is, actively 

rejecting highly profitable projects if it affected quarterly expectations. And this 

was reported to be driven explicitly by the desire to satisfy the expectations of the 

intermediary institutions trading their shares (Graham et al 2005). 

SUPPORTING RESPONSIBLE STEWARDSHIP 

The evidence strongly suggests therefore that the chain of intermediation in equity 

markets disrupts and misaligns incentives between savers and company boards 

which, in turn, contributes to lower levels of investment and long-term value 

creation by UK firms. Underlying this misalignment of incentives are two important 

dynamics, in which intermediaries are paid for relative performance, and the 

volume of activity, rather than for nurturing productive long-term investment. 

Critical to this problem are the short time horizons over which intermediaries 

accrue rewards through trading shares. To correct these dynamics, we propose 

a dual strategy, to change the rules by which equity markets operate, using both 

legal and tax reform. 

Our analysis has shown that too much activity is rewarded for relative 

performance over a short time horizon. Our proposal therefore is that regulators 

take a system-wide view in order to demand, support and nurture a realignment of 

incentives between intermediaries and citizen savers. 

As the first step, we propose that government strengthens and extends the legal 

fiduciary duty that applies to actors in finance markets. 

Over recent years many sensible reforms have been recommended by a 

number of institutions, governments and market actors to correct ‘market 

failures’ and to enhance ‘active stewardship’. These range from boosting 

transparency with new disclosure guidelines for derivative ownership or 

new performance metrics for asset managers to shifting away from quarterly 

targets and short-term remuneration packages for CEOs. We agree that the 

approach needs to be multi-pronged and inventive. However, regulation that 

is overly prescriptive and rigid will be ill-equipped to keep pace with fluid 

and complex financial practices and strategies. The new regulatory strategy, 

therefore, should take a systemic view rather than reaching a system-wide 

effect through the sum of multiple individual parts. 

We therefore propose that government inserts a spine of legally enforceable 

responsibility right the way through the intermediation chain. To do this, the 

legal provision for ensuring that trustees act in the interests of savers should be 

strengthened, clarified and – most importantly – extended to intermediaries. This 

legal provision is called fiduciary law, or the ‘fiduciary principle’. Fiduciary law 

requires that agents representing the interests of others take every reasonable 

step to ensure their actions do in fact result in the best value to the ultimate 

client. Unlike contractual law, which governs the issuance of loans, fiduciary law 

allows for agent discretion in interpreting the interests of their clients. This is 

essential for allowing experts to use their skills and experience efficiently on 

behalf of clients. 

At present, the legal fiduciary responsibilities of a trustee, such as a pension fund, 

does not pass automatically to the intermediaries to whom they might contract 

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or delegate tasks. Echoing the recommendation of both the Kay and the Law 

Commission’s separate reviews (2012 and 2014 respectively) for government, we 

propose:

• 

first, that the obligations and powers of fiduciary responsibility must remain 

with a trustee even if intermediaries are contracted to act on their behalf

• 

second, that the legal reach of fiduciary responsibility is extended to asset 

managers and brokers in the intermediary chain.

Such an extension of the fiduciary principle will require independent oversight 

and interpretation. Our proposal is the establishment of a new public body, the 

Responsible Ownership Commission (ROC), which in the first instance would 

examine how the fiduciary principle should be extended and defined for 21st 

century equity markets. Following the model of the Financial Services Council in 

Australia, the ROC should also recommend explicit broader environmental and 

social obligations under fiduciary responsibility. The ROC should also provide an 

ongoing monitoring, supporting and enforcement role. This could include training 

and consultancy for asset managers and financial analysts, a detailed framework 

for obligatory information disclosure (such as of derivative ownership and sell-

side analysis), an independent complaints procedure, and the power to name, 

shame and fine for non-compliance those failing to meet fiduciary and disclosure 

requirements. The ROC should also be seen as the first regulatory response, not 

the last: In due course the ROC would itself make recommendations to government 

for further, individual reforms necessary to meet its systemic objectives. These 

might include proposals such as weighted voting power for longer ownership or a 

maximum number of firms in an investment portfolio.

TAX REFORM – HARDWIRING NEW INCENTIVES

We propose two tax reforms specifically designed to reverse the dynamics which 

underlie the misalignment of incentives in equity markets: excess turnover and 

short-term ownership of shares. The reforms, taken together, would be broadly 

cost neutral. They involve: 

• 

extending stamp duty reserve tax

• 

tapering capital gains tax for long-term share ownership. 

Over recent years there have been growing calls for the introduction of a type 

of financial transaction tax in the UK (Seely 2014). But much of this debate tends 

to overlook that the UK already has a financial transaction tax, known as stamp 

duty reserve tax (SDRT). SDRT is one of the oldest, best established and cheapest 

taxes to administer in the UK. At present, a charge of 0.5 per cent is levied on 

the purchase of shares at the point of certifying a legal transition in ownership. 

Revenues from this tax are consistently worth between £3 and £4 billion per 

year, with 90 per cent of this collected automatically via the central securities 

depository computer. The tax is exceedingly hard to avoid because it is levied on 

the ‘issuance principle’: no matter where you are in the world, you have to pay the 

tax if you register for legal ownership of a share issued by a UK-based company. 

This is why 50 per cent of revenue is successfully collected from non-UK residents. 

Notwithstanding its impressive effectiveness from HMRC's point of view, SDRT 

has not been updated for three decades, even though the nature of financial 

intermediation has changed and expanded hugely in that time (Persaud 2017).

In principle, anyone seeking to register legal ownership over a share issued 

by a UK-based firm must pay the SDRT. At present, however, exemptions on 

SDRT are made for intermediaries regarded as ‘market makers’: the asset 

managers and hedge funds that seemingly generate liquidity in equity markets 

by deliberately contributing to increased share turnover. Historically, this type 

of activity accounted for around 15 per cent of transactions, but the growth in 

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the intermediation chain now means that 40-50 per cent of share turnover is 

eligible for exemption (ibid). Despite this, increased turnover has been shown 

not to improve liquidity when it is most needed (Huang and Wang 2010). Liquidity 

is provided not by the volume of transactions, but by diversity in buy and sell 

strategies. A review of the evidence shows that because of the homogeneity of 

strategies from high-frequency traders – as they all seek short-term returns from 

large volumes of trades – the recent increases in turnover have mainly served to 

add to liquidity when it is already in excess, but reduce it when it is in short supply 

(Persaud 2017). 

Borrowing from the detailed work by the financial economist, Avinash Persaud, 

we propose that incentives for excess trading should be reduced by replacing 

the 100 per cent relief on SDRT for intermediaries with a new rate of 0.2 per cent. 

IPPR analysis of Persaud’s (2017) own estimates for non-tax transaction costs, 

and the rate of elasticity in demand with respect to an increase in costs, suggests 

that introducing a new 0.2 per cent rate of SDRT for market makers would reduce 

turnover generated by intermediaries by around 60 per cent, and overall turnover 

in equity markets by about a quarter to a third. The reform would therefore have a 

significant effect in reducing short-term equity trading. At a conservative estimate, 

these reforms would also generate new revenue worth around £1.2 billion by the 

2020s (IPPR analysis using OBR 2017 and Persuad 2017). 

This would be in line with recent experiences in France (2013) and Italy (2012). 

From a position of not previously charging stamp duty on shares at all, both 

countries have introduced more far-reaching taxes than the UK’s SDRT, albeit at a 

lower rate. Both countries introduced tax rates of 0.1 per cent on shares, 0.01 per 

cent on equity derivatives and 0.01 per cent on cancelled trades. Together these 

have resulted in a reduction in turnover of around 20 per cent (Persaud 2017). 

Crucially, however, a detailed study of the effects in France found that liquidity in 

the market was not reduced as a result (Capelle-Blancard and O Havrylchyk 2013).

In order to strengthen its effects, the revenue raised from extending SDRT to 

reduce excessive volumes of trade could be used to incentivise the longer-term 

holding of shares. It would be possible to extend reliefs for capital gains tax (CGT) 

and corporation tax for company equities so they become more generous the 

longer a share has been owned. This would provide a marginal incentive to hold 

shares for longer. To the extent that it was successful, rational, longer term owners 

would be expected to adjust their calculations over the implied discounting of 

longer-term gains and therefore become more interested in the underlying value 

of the companies they own. 

A number of countries, such as the US, France and Austria, have reliefs on CGT, 

especially for equity, that apply if an asset has been owned for more than a given 

number of years. Between 1998 and 2008 the UK also had a relief on business 

assets that halved the rate of capital gains tax after one year and two years 

(cumulatively). Although these systems showed some success, they also introduce 

dramatic cliffs in the tax schedule, offering significant discounts at the point a 

share is owned for more than one or two years. This can have perverse effects on 

behaviour, such as market actors selling shares on the day they become eligible 

for a considerably lower rate of CGT. To counteract this problem, we propose a 

formula-based tax rate that gradually tapers away the rate of CGT on corporate 

equity as a function of length of ownership. At the same time, we also propose a 

form of allowance for corporate equity (ACE) in UK corporation tax that becomes 

progressively more generous the longer a share is owned (for an introduction 

to the ACE literature see relevant chapters from Mirrlees et al 2011). Such an 

allowance would have the advantage, not only of incentivising longer ownership of 

shares, but also lowering the cost of equity finance for firms looking to invest.