The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000

The role of Capital Market Intermediaries in the Dot-Com Crash of 2000

1. Financial intermediaries

a. Venture Capitalists (VC)

A large part of VCs' job was to screen good business ideas and entrepreneurial teams from bad ones. Typically, partners in VC firm had a substantial percentage (20%) of their net worth tied up in their funds, which aligned their interests with their investors. In this sense, it is easily for the VC firms to invest in these "high profit" companies. A probably way to avoid this is to set up clear regulation on VC firms so that they could make sure these companies are profitable at least for 3 quarters and operational.

b. Investment Bank Underwriters

Investment banks provided advisory financial services helped the companies price their offerings, underwrite the shares, and introduce them to investors. Investment banks were paid a commission based on the amount of money that the company manages to raise in its offering. Likely, the more money the investment banks help those blue-chips firms raise, the higher commission would the banks got. In this sense, investment banks would introduce these companies whose models were questionable to investors.

c. Sell-side Analysts

Their main functions were to publish research on public companies, provide support during a company's IPO process, providing research to buy-side before the company actually went publicly. Since these sell-side analysts worked at investment banks and brokerage houses. They have the same problems with the investments banks do.

d. Buy-Side Analysts and Portfolio Managers

Buy-side analysts have the same duties as the sell-side analysts and they convince the portfolio managers within their company to follow their recommendations. The compensation of the buy-side analysts was often linked to how well their stock recommendations do and in the case of portfolio managers; compensation was determined by the performance of their funds relative to an appropriate benchmark return. In this sense, even though most of them knew the market was overvalued, considering the compensation, they still will invest on the questionable but "hot" stocks.

e. Conclusion: for financial intermediaries, the best way to avoid their dysfunctions is to separate their compensations from how profitable the investor are. Or there should be clear regulations set up those financial intermediaries could look up to when operating.

2. Information intermediaries

a. The accounting professions

Auditors` opinions are always looked as an additional level of assurance of the quality of the information that investors received from firms. But in Dot-Come