The Response Of The London Stock Market To New Issues: Canals, Railways And Empire In The 19th Century

Larry Neal, University of Illinois

Prepared for Allied Social Science Association meetings Washington, DC January 6-9, 1995


Abstract

The London Stock Exchange did not establish a formal organization until 1773, at least a century after trading in shares of joint-stock corporations began there. Its peculiar institutional features, arising originally from the specific character of new trading opportunities in the secondary market for government debt that arose in successive wars, determined the subsequent course of its development over the 19th century. They also determined the role it played in facilitating investment in the new opportunities such as the canals, mines, railways, and empire enterprises. Several peculiar institutional features of the London Stock Exchange (LSE hereafter) drew the attention of the Royal Commission established in 1878 to investigate the practices of the London Stock Exchange.

The Peculiar Institutions
A. Proprietors and Members

First and foremost was the separation of the ownership of the facilities of the LSE by a joint-stock corporation, comprised of Proprietors, from the membership of the traders engaged in using the facilities, comprised of Subscribers. The governance structure of the Proprietors was formal, permanent, and responsive to the relative weight of shares held by the individual Proprietors. By contrast, the governance structure of the Subscribers was confined to a Committee for General Purposes, elected annually by the ever-changing body of Subscribers. It became the pecuniary interest of the Proprietors to increase the rents they could charge for use of the Exchange's physical facilities. This could be achieved either by increasing the number of Members or by increasing the profitability of the business done by the existing members. Both strategies were pursued at various times in response to new opportunities for stock market activity. But the structure was intact throughout the 19th century.

B. Brokers and Jobbers

Another feature of the LSE was the separation of the Subscribers into two distinct bodies of traders - jobbers and brokers. Brokers acted strictly as agents bringing buyers into contact with sellers, taking a commission on the amount of the transaction when it was completed, but never actually buying or selling a stock on their own account. Jobbers, or dealers, would act as principals, always willing to buy or sell particular securities in which they specialized - buying at a stated price, selling at a slightly higher price and making their living on the difference in prices, or the "turn." Brokers relied on the total volume of their transactions to make their living and that meant cultivating long-term relationships with a monied clientele. Jobbers relied on specialized information for a particular set of securities to insure that the "turn" was positive for them more often than not, and on a high volume of turnover in their specialty securities.

The jobbers always acted as principals in their trades and assumed full responsibility, enforceable in courts of law, for fulfillment of their contracts. The brokers always acted as agents only, and by avoiding ultimate responsibility for completion of the trades in which they were involved also avoided risk of default. Despite their different status before the law of the land in terms of contractual obligations, however, both groups had an interest in resolving contractual disputes that arose among them as quickly and definitively as possible. Keeping the Committee on General Purposes small and meeting frequently with the power to adjudicate disputes and enforce its decisions by internal sanctions facilitated the continued smooth flow of business to the advantage of all concerned, including the general public. The only difficulty was that the decisions of the Committee were more binding on the brokers than on the jobbers, because the latter had constraints imposed upon them by a higher, outside authority.

C. Alternative Markets

Another peculiarity of British institutions that differentiated the London Stock Exchange from stock exchanges in other countries or even in the provinces was the maintenance of a large amount of permanent national debt under the custodial care of the Bank of England, a joint-stock corporation itself. As transfer of title of shares in most government stock had to be done in the transfer books maintained by the Bank, the Bank's building on Threadneedle Street was a natural site for trading activity to be conducted as well. When the Rotunda was added to its structure in 1765, in fact, that public space became the major market place in securities. The convenience of the Bank's facilities meant that it maintained the option of providing an open public market as an alternative to the LSE, at least until 1838.1

Origins Of The Institutions

Each of these institutional features just described of the London Stock Exchange, however, derived from an extended period of trial and error, with firm definition coming only under duress. It was the initiative of the traders themselves in response to external shocks from whatever source - government regulation, war finance, investment opportunities created by technological advances or by political developments - that created and perfected these institutional features.

A. Proprietors vs. Traders

For example, in response to the challenge of major new additions to the funded government debt occasioned by the demands of war finance during the Napoleonic Wars, the participating brokers in the activities of Exchange Alley decided to build a new facility at Capel Court. To understand the importance to them of the public debt, it is useful to examine the process by which new issues of the government's debt were placed on the market.

A given amount of debt would be advertised for placement. By the time of the Napoleonic Wars, the typical package would be a mix of 3% Consols, another irredeemable security and an annuity for a fixed term of years. Fixed terms would be announced for the annuity and one of the irredeemable stocks. Bidding would then be invited on the remaining stock. Applications would be received either from the public or, increasingly after the middle of the 18th century, from various groups of contractors. When allotments were made to the highest bidders, an initial payment of 10-15% had to be made by each subscriber, with the remainder paid in installments over the next eight-nine months. Only when the full amount subscribed had been paid in was the stock registered in the books maintained by the Bank of England. Until then trade could be done in subscription receipts, a cheap form of speculation in the first few months when only a few installment payments had been made. Moreover, dealing could be done in advance of allotment, if one wished to speculate upon the price at which the loan would finally be settled in the market. Given the large sums involved, only a limited number of groups could cover the subscriptions and each had to involve a large ring of subsidiary subscribers. By the end of the Napoleonic Wars, the government was receiving identical bids from each group and the allotments were divided up proportionally among them.2 This confirmed the division of traders into brokers and jobbers, a division maintained to the present day.

As self-interested, profit-maximizing, rent-seeking stock brokers and jobbers, the Members of the London Stock Exchange responded eagerly over the course of the 19th century to new clients made available by the improved communications with the provinces or with foreign countries. And just as naturally, they defended their new source of income from competition by new brokers and jobbers. For example, each enlargement of potential demand for their services inspired a new format for the Stock Price List issued to serve as the official gauge of the accuracy and fairness of prices quoted to the brokers' customers. But each increase in the number of potential competitors also provoked a new set of regulations or, in extremis, a new institutional form.

From the animosities between the two (or more) groups came the odd institutional structure of the London Stock Exchange. The Exchange itself was owned by a joint-stock corporation with closely held shares by the Proprietors, who set the terms for use of the building by subscribing Members. These, in turn, were the active traders, divided by then into the distinct categories of Jobbers and Brokers.

B. Brokers vs. Jobbers

The more problematic institutional arrangement was the division of the Members into Brokers and Jobbers. The reliance of the British government upon contractors for placement of each new issue of debt doubtless led to the emergence of jobbers as specialized dealers after the Napoleonic Wars, and the distinction between brokers and jobbers seemed to hold up primarily in government stocks. The government's procedures also validated the practice of trading in subscription receipts for private joint-stock companies that were applying for a charter from Parliament. Promoters could induce major price swings in subscription receipts only partly paid up on the anticipation that the charter would finally be granted under the terms of the Bubble Act of 1720.

During the stock market mania of 1825 when hundreds of new firms were being promoted, the delay between advertisement of a new venture and news of its charter being granted lengthened and the uncertainty over the value of subscription receipts increased as a result. The abolition of the Bubble Act in late 1825 was likely an attempt to reduce the uncertainty in the market by speeding up the disposition of applications pending. In the Joint Stock Companies Act of 1844, dealing before allotment was formally outlawed.3 This legislation was repealed, however, by the Joint Stock Companies Act of 1856. The difficulty was that such contracts would continue to be enforced by the Committee on General Purposes, provided they were accepted as common practice by the membership. And they were good business for the traders of the LSE. So the division between brokers and jobbers worked to encourage risk-taking on Initial Public Offerings. Jobbers could "make a market" or test a market for a new issue, while brokers could avoid these risky ventures entirely.

The difficulty with this division of labor arose when handling trades for the great majority of stocks, which, once listed, were seldom traded. Dealers were not willing to take positions in these stocks without knowing in advance from the broker how many shares were involved in the commission and whether it was for a buyer or a seller. Given the risks involved for the dealer in seldom traded stocks, this seemed reasonable, but dealers frequently insisted on knowing the price the broker's client was willing to pay or take. They would then take as their "turn" the full difference in price from the counterparty they managed to find.

This conflict between brokers and jobbers foreshadowed a growing problem at the end of the 19th century: brokers found that their expanding clientele from the provincial and foreign exchanges overlapped with the expanding number of securities from the provinces and abroad in which jobbers could profitably specialize. As a result, brokers and jobbers found themselves in competitive positions when attempting to exploit these new trading opportunities. With the advent of telegraph connections, jobbers could make direct contact with off-site brokers and continue to make substantial profits from the differences in prices for the same security in different places. Their increased business, however, came at the expense of the on-site brokers who were also members of the LSE, and much more numerous when it came to voting on regulations and on electing the Committee for General Purposes.4

The efforts of the brokers to discourage off-site trading by the jobbers culminated in 1909 with a ban on any trader acting in the dual capacity of broker and jobber and in 1912 with a set of minimum commission rates. This was potentially very disruptive to the nationally integrated securities market.

C. Price Lists

More subtle institutional changes in response to competitive challenges were usually more difficult to detect. These usually took the form of changes in rules governing settlement of contracts among brokers but on occasion were manifested in changes in the stock price lists themselves. One example that occurs in the second quarter of the 19th century, first in Amsterdam and then in London, is a change from the reporting of prices at close of day to merely reporting the average, or official, bid price and the average, or official, asked price. This method of reported prices led to confusion and resentment among the buying public who felt, understandably enough, that they were either getting too little for the stock they sold or paying too much for the stock they bought. Worse yet, in the London case not all classes of the same security, usually bonds or debentures issued in a series of different denominations, were listed, so that small variations in price could occur from the general price that was published.

Role Of The Stock Exchange In New Issues

It is clear that the London Stock Exchange evolved along a path that was dependent upon the initial allocation of property rights. It was owned by a subset of the traders who increased the value of their property by variously increasing members, and raising their fees. Membership was enlarged sporadically whenever new trading opportunities arose. Examples are the mines and new governments which arose in the remains of Spanish America in the 1820s, the provincial railways occurring in the 1830s and 1840s, and overseas railways or public utilities which spread around the globe starting in the 1850s and continuing to World War. Incomes of members, and consequently their fee base, were increased by providing them with a monopoly position in the process of "making a market" for new ventures before allotments were made. Reciprocally, they were limited from participating in complementary or substitute forms of intermediation. Eventually the distinction between brokers and jobbers and the conflicting responses of each to the new opportunities for trading activity that arose over time led to an internal political conflict resolved in favor of the more numerous brokers by 1909.

The rise of canal companies was quite independent of the activities or initiative of the London Stock Exchange. The canals were financed by local landowners anticipating capital gains on their properties and were closely held corporations from start to finish. It appears that the role of the London market was important for some of the canals at times when the stock market was expanding in general. At those moments, a canal company could turn to the broader market for additional funds, always needed to maintain or extend the route and to add facilities for increasing the flow of traffic. Typically, however, canal companies had to make calls on the existing stockholders, or to issue mortgage bonds, mortgaged against either the right of way or tolls.5 Despite the existence of a well-organized, central market in London with access to huge amounts of investor capital, then, it appears to have had little influence on the rise of canals. Rather, the exchange added the shares of long-standing companies held mainly by stockholders in their respective service areas when it wished to increase the volume of its business or to widen the range of its clientele.

The rise of railways, by contrast, was very much enhanced by the initiatives undertaken by the stock traders in London as they tried to interest investors in iron railways before the age of steam and promoted a number of steam railways prematurely. On the investing side, the new railways were less interesting to landholders than to the mercantile and manufacturing class. As railways spread from the original success stories in Lancashire and Yorkshire, those local investors also invested disproportionately in the railways elsewhere, necessarily directing their orders through the London market. Despite the long lag between listing iron railways on the London Stock Exchange and the actual start of a serious round of railway construction in England, it seems clear that the stock exchange was important for the finance of railways in a way it was not for canals. The reason stems from: 1) the long process required under British law for registration of a joint-stock company formed to construct a railway; 2) the long period of construction required for most railways; and 3) the peculiarity that in the long run, local landowners tended not to be the major shareholders in their area's railways, unlike the U. S. experience with railway investment in this period and unlike the earlier U. K. experience with canals.

The rise of the Empire and the attendant investment flows from the 1850s on to the outbreak of World War I built steadily on portfolio investments in precisely railroad and public utility corporations that mimicked the organizational forms found so attractive by the original class of investors and traders in London.

Endnotes

1 Morgan and Thomas, pp. 52-54.

2 Morgan and Thomas, pp. 45-50.

3 LSEC, p. 19.

4 Morgan and Thomas, ch. 9.

5 Ward, ch. IV, "The organization of canal finance".