Genesis of capital markets, one pitfall investors to watch out and what is the approach Ethiopian Capital Market Authority is following?

In my previous article, I have shared the optimism and excitement albeit with caution. The Ethiopian Capital market to thrive or at least to have a strong start needs all aspects of the ecosystem to function optimally (emphasizes collaboration among different stakeholders, including governments, regulators, financial institutions, investors, and businesses. By working together, they can address challenges and create synergies).

Before dissecting the one of potential pitfalls, it may be worth to look at the genesis of capital market and have a historical grasp.

The concept of capital markets has a rich history that dates to the 14th century in Europe, where the first examples of financial markets were banks and lenders. However, the modern form of capital markets, specifically the stock market, began to take shape much later. The history of the stock market dates back to the 1500s when it began taking shape in Antwerp and London. The modern stock trading began when the Amsterdam Stock Exchange was established in 1668. This exchange introduced certain concepts associated with modern stock markets such as initial public offerings or IPOs. By 1792, the stock market was also found in the newly formed United States on Wall Street in New York City. The initial trading activity mostly included government bonds and bank stocks until the official launch of the New York Stock Exchange in 1817, nineteen years before the New York Stock Exchange the London Stock Exchange was officially formed in

1773, However, the London Stock Exchange restricted shares, and the New York Stock Exchange immediately traded stocks.

Over time, more private stock exchanges joined hands, leading to the formation of more closely regulated and monitored stock exchanges. The efficiency of the stock market increased with the creation of the Dow Jones Industrial Average Index to measure industrial stocks that were being traded at the New York Stock Exchange.

The establishment of the Securities and Exchange Commission or the SEC in 1934 was a vital step toward making the stock market more well-regulated. Since then, stock markets around the world have witnessed significant growth due to global expansion, better regulations, increased public participation, and rapid technological advancements like electronic trading platform.

Notwithstanding, the crucial role the capital markets play they also face several challenges and pitfalls. If we look back over the last 100 years, we have seen five major financial crises since:

1929 Stock Market Crash (Great Depression), 1987 Black Monday Crash, Dotcom Bubble Crash (2001), 2008 Financial Crisis, and 2020 COVID-19 Crash. Each of this financial crisis has specific causes and similarities, however it suffices to say capital markets harbour a level of risk some that could be mitigated by ‘the ecosystem approach’ and some cannot be mitigated such as the financial crisis as the result of COVID 19.

Though Ethiopia’s Capital Market is its formulation stage, it would worth pointing out some of the pitfalls that investors/ market participants need to understand. Among many factors for this article, I focus on with what is known as market concentration and explain what it is and how it impacts market activities and return in another article to address other factors which negatively affects capital markets and possible mitigating strategies.

The term market concentration is used in economics to describe the degree to which small number of firms dominate a particular market. It is the function of the number of firms and their respective shares of the total production, capacity or reserve  in a market. Further market concentration indicates few firms dominate the  market, and  oligopoly or monopolistic competition is likely to exist. This could lead to reduced competition and higher prices. While there is a call for some of the private banks in Ethiopia to merge and to consolidate the banking sector and enable liquidity (potential buffer from expected severe competition- if and when foreign financial institution come into the Ethiopian Market.

Banking sector consolidation refers to the process where banks merge with or acquire other banks, resulting in fewer but larger institutions in the banking sector. This move is often made to achieve scalability, expand client base, enhance competitive positioning, or improve financial strength and efficiencies. Larger banks can often operate more efficiently, reducing costs in technology, compliance, and administration.

it is important to bear in mind this call to consolidate might lead to market concentration as it may reduce the number of banks and potentially reducing competition, conversely from the financial sector perspective as alluded earlier it may give the banks a strong position to withstand foreign banks capital and market strength.

Another type of market concentration is, if we have excessive representation of the financial industry listed on the stock exchange than other sectors such as telecommunication, technology which restricts diversification- this would mean it would make  the stock  exchange less competitive (compared with others in the  continent and  elsewhere) and  the  retail and institutional investors less choice. Particularly as there is limited sectors to be listed and buy share in the Ethiopian Stock Exchange (ESX)- this is for at least two reasons: one, it is an emerging economy with no significant industry leader with the exception of Ethiopian Airlines and may be well run State owned Ethio Telecom. This will create lack of diversity dominated by the banking sector (Sector concentration risk). The very nature of financial market concentration influences asset prices and liquidity affecting capital allocation and decision making. Additionally, it gives the listed institutions excessive market power to dictate market terms and small and new companies often struggle to access capital markets. The primary market overseen by regulatory bodies (e.g. Capital Market Authority) can be challenging for them to enter. This is often the rigorous process, and go through complicated process and compliance, as a result established institution to benefit more particularly at the early stage of Ethiopian Capital Market formation.

There is instances market concentration by a firm happens because of business decision in innovation at the firm level, where a firm finds a way to deliver better value than their competitors in the marketplace and this could reflect change in their market size and power and dominate competition.

As a result of these, that is, increases due to efficiency gains or productivity differences it can lead to market concentration. Conversely, it can result from barriers to entry or predatory behaviour which could distort the market. This is not an easy challenge to deal with for policy makers and regulators. However, through time as the regional markets open up and the rest of the world start to invest in Africa competition might lead to better playing field.

In short context matters, and the impact of concentration varies across industries and regions. Analysing both sides helps policymakers and investors make informed decisions.

Some of the ways to deal market concentration at a macro level is ensuring level playing field, rigorous governance framework, market intelligence and the like. It would be insightful to hear from the Ethiopian Capital  Market Authority, if they are anticipating market  concentration (banking institution) and if so, how they intend to deal with it. Leaving the market to do its magic may not be a good start particularly if we have a long-term strategy to attract retail investors (mum and dad).

I want to finish from the excerpt that the Ethiopian Capital Market Authority CEO said in a public forum prepared by Meri Podcast in conjunction with Mastercard foundation: I am paraphrasing: He was questioned if there is a particular approach/ philosophy (US, European or Chinese) the Authority is adopting as they are formulating policies etc. The response has given me great confidence that that there is no template to copy from. Dr. Brook said our approach and philosophy is ‘pragmatism’ whether it is economic or social policies what works for Ethiopia will be implemented. He has given an example of the recent Telecom liberalisation where the government successfully sold Mobile Money Financial Services licence for 850 million USD which no other African government was able to do. Further, responding to other questions such as Collective Investment Scheme (CIS) he has assured participants his agency is working on directives as such to contact his team to ensure that future rules and regulations will not impact those who are working on CSI currently negatively – This in my view is pragmatism and a commitment to make the Capital Market work into the future.

In my next article I will return to address capital market pitfalls in general terms and will explain the importance of: Strengthening regulatory bodies to monitor and enforce rules. educating investors about risks, diversification, and long-term strategies. Research has shown time and again informed investors make better decisions. And lastly, implement robust surveillance systems to detect irregularities, insider trading, and market manipulation.

Mengistu Weldemariam is a senior consultant in business and finance. He was a lecturer in corporate finance and accounting. He currently works in consumer and investor protection. -Senior Program Manager

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