In a new article, I examine the regulatory goals of creating “fair, orderly, and efficient” securities markets in light of the recent issues involving trading in the shares of GameStop Corp. (GME) through the broker-dealer firm Robinhood Financial LLC. The article contributes to the literature on the regulation of securities markets by explaining what the terms “fair,” “orderly,” and “efficient” markets really mean. A fair market is a market in which average, “Main Street” investors get what they pay for. Under this definition, U.S. capital markets are generally fair because they are generally efficient. Efficient markets reflect all relevant information about a company, and therefore efficient markets are markets in which prices reflect the present value of the future income associated with those investments.
On the other hand, it appears that the SEC embraces a different definition of market fairness. According to the SEC’s rival definition, a market is fair if and only if all investors have an equal chance of earning abnormal returns, where abnormal returns are defined as returns above the risk-adjusted returns that one would receive on a diversified portfolio of securities. My article argues that fairness simply is unattainable under this second definition of the term.
Thus, in order to make markets fairer, we have to make them more efficient. Rivalrous competition for trading profits among traders, particularly market professionals, are what make markets more efficient. Securities regulation, however, inevitably restricts competition among market participants by restricting and otherwise imposing costs on the process of identifying and trading in mispriced financial assets.
Regulation FD, which impedes the flow of information from corporate insiders to analysts, is an example of regulation that makes markets less efficient, and therefore less fair, in a quixotic quest for an unattainable ideal of fairness. More generally, the SEC’s regulation of insider trading, which ostensibly is done in the interest of making markets fairer, also makes markets less efficient and less fair by restricting trading on information not already reflected in a company’s share prices.
The stated goal of creating “orderly” markets also is worthy of focused attention. The notion of an orderly market implies a market that is neatly and methodically arranged. Markets, however are by their very nature not orderly; they are chaotic and unpredictable. In fact, the available evidence overwhelmingly shows that stock prices follow a very disorderly “random walk.” The random walk means that future price movements are random and impossible to predict on the basis of historical patterns. The reason that securities prices follow a random pattern is that they react quickly to reflect new information. As such, it is not possible to make markets orderly without making them less efficient, and, therefore, less fair.
The GameStop/Robinhood saga casts significant doubt on the notion that the SEC is helping markets achieve its long standing “tripartite mission to protect investors, maintain fair, orderly, and efficient markets, and facilitating capital formation.” Moreover, the saga provides further support for the view that market forces tend to make markets fairer, where fairness is properly defined as investors getting what they pay for. The GameStop saga also shows that the notion that fairness can be defined as having an equal opportunity to “beat the market” is incoherent. Only insiders can outperform the market by earning abnormal returns. Thus, market processes tend to make markets more efficient, while regulation tends to make markets less efficient. Finally, it appears that regulation tends to further the interests of Wall Street elites over the interests of ordinary investors.
Turning from the fairness of the securities markets to the fairness of the regulatory framework that governs those markets yields a similar, and similarly depressing, conclusion. Regulation is not only unfair, it also appears to be perceived to be unfair by ordinary investors. Ordinary investors flocked to Reddit’s WallStreetBets forum and coalesced into a powerful coalition, referred to as a “stock market flash mob,” to drive up the price of GameStop shares by collectively buying the stock. These buyers were motivated not only by the potential to make profits, but also by a desire to take down the hedge funds that had been shorting GameStop.
Instead of attempting to drum up crowd sentiment on a social media platform such as Reddit, however, the hedge funds shorting Reddit employed a different strategy to accomplish the same goal of creating a flash mob. Specifically, hedge funds shorting GameStop, particularly Citron, pursued a strategy publicizing its “research” and its strategies in research reports, known as “short reports.” Under the name Citron Research, Citron publishes reports claiming that firms are overvalued or are engaged in fraud, and the head of Citron, Andrew Left, frequently made appearances on news outlets such as CNBC and Bloomberg to disparage companies that Citron had sold short.
Despite the functional equivalence of what the hedge fund short sellers were doing on CNBC and on their own websites, and what the Main Street long buyers were doing on Reddit, regulators have responded very differently to these groups. Specifically, regulators appear to be taking a hands-off approach to the hedge funds while the SEC, state regulators, and even the Department of Justice are investigating whether the Main Street investors who posted on Reddit and traded GameStop shares engaged in illegal share-price manipulation. This difference in treatment seems monumentally unfair.
In sum, the GameStop episode provides a valuable opportunity to reflect on the notion that securities regulation can promote the goals of achieving fair, orderly and efficient capital markets. Markets are not, by nature, particularly fair and orderly. To a large extent, “fairness” in the context of investor protection in capital markets means that investors receive fair market value for the financial assets they buy and sell. As such, it is efficient markets, not regulation, that make markets fair for investors.
Unfortunately, efficient markets are a threat to regulators, because in efficient markets, regulators are simply unnecessary.
This post comes to us from Jonathan R. Macey, the Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School and a professor at the Yale School of Management. It is based on his recent article, “Securities Regulation and Class Warfare,” forthcoming in the Columbia Business Law Review and available here.