The following post comes to us from Kevin S. Haeberle, Post-Doctoral Research Scholar, Program in the Law & Economics of Capital Markets, Columbia Law School & Columbia Business School.
It is well understood that society is better off when public companies’ stock prices are more accurate—that is, when stock prices better reflect firms’ actual values. Enhanced stock-price accuracy, the argument goes, leads to improved corporate governance and capital allocation—thereby increasing social wealth. But it is widely believed that those who make stock prices more accurate are unable to capture the full social benefits of their work—meaning that market forces, without legal intervention, will produce only a sub-optimal level of stock-price accuracy. For these reasons, scholars and policymakers have examined the extent to which securities law can and should be used to spur the production of accurate stock prices. However, their work has overwhelmingly focused on the traditional core of securities law—that is, the corporate disclosure, fraud, and insider-trading rules that regulate stock issuers and their agents—and has overlooked what I refer to as “stock-market law”—that is, the law that governs the market in which stocks are traded.
In my new Article, Stock-Market Law and the Accuracy of Public Companies’ Stock Prices, I theorize that central aspects of stock-market law are resulting in society generating a lower level of stock-price accuracy than it otherwise might. Accordingly, I identify new ways in which the federal securities laws could be changed to enhance both stock-price accuracy and the social benefits that flow from it.
It is well-known that the activity of informed traders—those that buy and sell stocks based on superior information about companies’ actual values, like sophisticated banks, hedge funds, and private equity funds—confers a valuable benefit on society. These traders seek to profit by using their information to buy underpriced stocks and sell overpriced ones. And as a byproduct of this profit-motivated trading, they help generate more accurate stock prices—and the social benefits that arise out of them. Thus, much of modern securities regulation is thought to be aimed at facilitating informed traders’ price-correcting work.
Yet, as I show in Stock-Market Law and the Accuracy of Public Companies’ Stock Prices, central aspects of the securities laws that govern stock trading today discourage informed traders from pursuing their valuable work. More precisely, rules that dictate investor access to trading platforms allow off-exchange platforms (which now account for almost 40% of all transactions) to exclude certain traders, while requiring exchanges to remain open to all traders. The off-exchange platforms use their ability to restrict access in order to target uninformed traders—such as individual retail-level investors and index-driven mutual funds—and exclude informed ones. In practice, then, these rules lead off-exchange platforms to be dominated by uninformed traders—and open exchanges to therefore, by necessity, have a higher ratio of informed traders to uninformed ones than they otherwise might. As a result of this altered environment on exchanges, other traders on exchanges fear that their counterparties will be informed traders—and that those informed traders will use superior information to profit at their expense. Well-established financial-economic literature shows that traders defend themselves against this type of heightened risk by providing inferior prices to all counterparties. Facing these inferior prices, informed traders—who, largely unable to access off-exchange trading platforms, are relegated to open exchanges—have fewer profitable trading opportunities. Accordingly, their motivation to produce information about stocks’ actual values and impound it into market prices—that is, their incentive to improve stock-price accuracy—is less strong, and public firms’ stock prices are therefore less accurate.
This Article thus argues that society can increase the accuracy of public companies’ stock prices by reforming stock-market law. For example, a mandate that all trading take place through exchanges would give traders on exchanges comfort that they will face a lower ratio of informed traders to uninformed ones—and lead them to provide superior prices to all of their counterparties on exchanges. Or, altering stock-market law to impose fees on public firms to subsidize trading in their stocks on exchanges would likely accomplish the same end. Either of these reforms would encourage informed traders to conduct more of their price-correcting work.
Accordingly, I counsel that regulators should recognize and consider this previously unappreciated mechanism for achieving one of the chief aims of securities law: increasing the accuracy of public companies’ stock prices.
The full article is available here.