Legal scholars have long opined on the social benefits of the core securities laws. The chief benefits of issuer-disclosure law and securities-specific fraud law identified to date relate to their positive effects on stock-price accuracy. A price-accuracy theory in support of insider-trading law has also been offered and received considerable support. In each of these areas, the price-accuracy thinking has been the focus of individual broad and deep works of robust legal scholarship (and clearly identifiable sets of the same).

A second, related account of the benefits of each of the core securities laws relates to their positive effects on stock-market liquidity. But, as I argue in a new article, the liquidity rationale has been materially underexamined by legal scholars in both absolute and relative terms. This problem remains despite a number of liquidity-focused aspects of works (including my own) connected to the Columbia Program on the Law and Economics of Capital Markets and published over the past decade or so. My article aims to contribute the type of individual liquidity-rationale-specific work missing from legal scholarship to date – one that also adds to what can now be seen as a clearly identifiable set of recent works with an increasing focus on securities law and liquidity.

The article begins by identifying the existing articulation of the liquidity rationale found in legal scholarship. It discerns two steps in that articulation. Step I involves the argument that the laws at issue improve stock-market liquidity, and Step II the argument that the resulting improved liquidity generates larger social benefits.

On Step I, the most developed liquidity thinking to date is specific to insider-trading law, where it has long been thought that insider trading diminishes liquidity. Liquidity-based arguments also appear – though far less prominently – in support of issuer-disclosure law and securities-specific fraud law.

On Step II, general and larger benefits arise because illiquidity inhibits welfare-enhancing exchange. But well-established economic thinking also connects improved stock-market liquidity to, among other things, the more efficient allocation of (1) resources between current consumption and investment in future production and (2) risk.

This framing and the thinking recounted within it is not meant to present a new theory but a way to organize what has already been said, much of which I then critique. That critique begins by noting the general piecemeal and limited nature of existing articulation of the rationale. It then goes on to focus on further notable problems with what legal scholars have and have not said.

With respect to the former, the articulation is plagued by both conclusory and suspect statements, many of which appear to be tacked on to more substantive price-accuracy-specific thinking without sufficient consideration. With respect to the latter, legal scholars have failed to sufficiently consider (1) the more precise problem at the heart of Step I of the rationale (trading costs and how they are incurred in today’s market) and (2) the extent to which Step I improvements to liquidity trigger meaningful larger Step II benefits. Scholars more generally (including those beyond law schools) have also failed to spot a set of social costs of the Step I reductions. In other words, scholars have failed to note the extent to which securities laws that reduce trading costs operate as a double-edged sword, generating what may be termed Step II larger social costs of improved liquidity in addition to the above-noted Step II larger social benefits.

The path forward, I argue, focuses on trading costs and how they are incurred today. Those costs include items relating to bid-ask spreads, price impacts that arise when trading moves the market against traders before they can complete their desired trading, and the time and effort associated with executing trades at scale. As detailed in the paper, the extent to which investors incur these costs differs based on whether they trade by taking liquidity or making liquidity, which the literature has largely overlooked. A more general conflation of two closely related problems (illiquidity and information asymmetry) appears to have impeded precise analysis along these lines.

In the end, the above critique paves the way toward improved study of securities law by scholars and lawmakers alike. This result is especially important in light of (1) longstanding welfare-focused debates about the core securities laws and (2) required cost-benefit analysis for much Securities and Exchange Commission rulemaking. If the liquidity effects are going to be part of the justification for (or critique of) the core securities laws, they should be stated with precision, supported with robust reasoning, and evaluated for magnitude – rather than invoked as a rhetorical boost to price-accuracy-focused arguments.

Kevin S. Haeberle is a professor at the UC Irvine School of Law. This post is based on his new article, “Securities Regulation’s Liquidity Rationale” available here.