Evaluating Stock-Trading Practices and Their Regulation.

• Author: Fox, Merritt B.
• Position: What Happens in the Dark: An Exploration of Dark Pools and High Frequency Trading

1. INTRODUCTION II. THE USE OF THE ECONOMY'S EXISTING PRODUCTIVE CAPACITY A. The Role of a Well-Functioning Stock Market in Promoting Accurate Share Prices B. How More Accurate Share Prices Deter Non-Share-Value-Maximizing Production Decisions 1. Alerting Corrective Forces to Non-Maximizing Behavior 2. Reducing the Riskiness of the Investment Necessary to Take Corrective Action 3. Providing Guidance to Managers 4. Enhancing the Effectiveness of Share-Price-Based Compensation C. Share Value Maximization and the Use of Existing Productive Capacity to Produce the Output of the Greatest Social Value III. THE ALLOCATION OF CAPITAL A. The Meaning of Efficient Capital Allocation B. How More Accurate Share Prices Promote More Efficient Capital Allocation by Prompting Managers to Maximize Share Value 1. Project Choice in the Presence of Available Internal Funds 2. Share-Value-Maximization Requires Avoiding the Implementation of Negative NPV Projects 3. Avoiding the Implementation of Negative NPV Projects Avoids Social value-decreasing Uses of Society's Scarce Capital 4. The Natural Tendency of Managers to Use Internal Funds to Implement Negative NPV Projects and the Particular Importance of Accurate Prices to Combat This 5. The Danger of Inaccurately Low Share Prices Leading Managers to Avoid Implementing Positive NPV Projects C. How More Accurate Share Prices Promote Efficient Capital Allocation by Their Effects on the Terms of External Finance 1. Classical Finance Theory 2. Institutional Finance Theory a. A firm with a Positive NPV Project and an Inaccurately Low Share Price b. A Firm with a Negative NPV Project and an Inaccurately High Share Price c. The Effect of Inaccurate Share Prices on the Use of Debt IV. THE ALLOCATION OF RESOURCES OVER TIME A. The Meaning of an Efficient Allocation of Resources Over Time B. How a More Liquid Market Can Promote the Efficient Allocation of Resources Over Time V. THE ALLOCATION OF RISK A. The Meaning of Efficient Risk Allocation B. How a More Liquid Market Can Promote the Efficient Allocation of Risk VI. ADDITIONAL CONSIDERATIONS A. Resource Consumption by the Market Itself B. Fairness 1. Actual Fairness a. Situation 1: Ex Ante, the Person Whose Trade Was Affected by the Practice Was as Likely to Have Done Better in Terms of Trading Profits as to Have Done Worse b. Situation 2: Ex Ante, the Person Whose Trade Was Affected by the Practice Was Not as Likely to Have Done Better in Terms of Trading Profits as to Have Done Worse, But the General Existence of the Practice Leads to Some Kind of Fully Compensating Change 2. Perceived Fairness C. Innovation VII. CONCLUSION I. INTRODUCTION

   Pundits, policymakers, and scholars alike have expressed a variety of views over recent years concerning the functioning of the market for the public trading of previously issued equity securities and how this market should be regulated. These commentators, however, have largely failed to consider the overall social criteria by which the answers to these questions should be judged. This Article seeks to set forth a guiding framework that provides these diverse voices with a common language that can facilitate informed analysis.

   How exactly should trading-market practices and their regulation be evaluated? Answering this question requires thinking about why we care about this market in the first place. In other words, we need to consider how a well-functioning secondary trading market for equities creates social value. In this Article, we identify four dimensions along which a well-functioning market can enhance economic efficiency:

   The use of the economy's existing productive capacity. A well-functioning stock-trading market can prompt the more efficient use of the economy's existing productive capacity so as to maximize the value of the goods and services that it yields.

   Capital allocation. A well-functioning market can also assist in the efficient allocation of society's scarce capital, helping to steer it to the most-promising proposed new investment projects in our economy.

   Resource allocation over time. A well-functioning market can promote the efficient division of currently available resources between the production of goods and services for current consumption, and the creation of new productive capacity. This new productive capacity in turn will allow for the greater production of goods and services in subsequent periods than would otherwise have been the case, thereby allowing for greater future consumption. In other words, it facilitates the adoption of the most efficient level of savings and investment by individuals and businesses in the economy.

   Risk allocation. A well-functioning market can aid in the reallocation of the risks generated by the inevitably volatile cash flows generated by each of the firms in the economy, so that investors, most of whom are risk averse, hold portfolios of these firms that lead to investors suffering as little pain as possible.

   A critical task evaluating any given market practice or regulation is thus to compare a world with and without the practice or regulation to see whether its presence helps or hurts the market in creating social value in each of these four ways. This task is greatly simplified by the fact that the equities trading market has two key characteristics--price accuracy and liquidity--that are central to the creation of social value along these four dimensions. Price accuracy concerns the accuracy with which the market price of an issuer's shares predicts the future cash flows the issuer will generate. Liquidity relates to the costs of transacting. The latter is a multidimensional concept involving the size of a trade, the price at which it is accomplished, and the time it takes to be completed. Generally, the larger the size of the purchase or sale and the faster one wishes to accomplish it, the less desirable will be the price. The more liquid the market is, however, the less severe are these trade-offs. The more accurate the market's share prices are and the greater these shares' liquidity, the better the market is at generating social value in the four ways introduced above.

   Beyond this analysis concerning the impact of a practice or regulation on the creation of social value in these four ways, a proper evaluation requires three additional considerations:

   Consumption of real resources. Evaluating a practice or regulation requires an understanding of its effects on the amount of resources society devotes to the operation of the equities trading market. All the activities associated with this market, including those involved in compliance with, and enforcement of, its regulations, consume considerable real resources. These include equipment, communications facilities, real estate, and talented personnel. These are resources that, if not used to operate the market, would be available to produce more in the way of other goods and services that people enjoy.

   Innovation. It is important to know effects of a practice or regulation on the capacity of the system to further innovate in favorable ways in the future. Indeed, history has shown the overall system of equities trading to be very dynamic, with changes driven by innovations in both technology and market-participant strategies. Such innovations have often allowed the equity market to generate greater social value or reduce resources it consumes in satisfying a given amount of trading interest.

   Fairness. The actual fairness of a practice is a worthy concern in and of itself. Indeed, promoting such fairness has traditionally been regarded as a core mission of securities regulation. (1) Moreover, mere perceptions of unfairness, whether accurate or not, are important as well. For one thing, perceptions of unfairness associated with a social institution as significant as the stock market create a sense of demoralization that diminishes social utility. For another, these perceptions can substantially affect how well the equities trading market performs in creating social value in all the ways mentioned above, a concept that is often loosely referred to as "confidence in the market."

   The remainder of this Article proceeds along the following lines. Parts II through V detail, in turn, each of the four dimensions along which a well-functioning stock market can enhance economic efficiency and hence create social value. Each dimension thus forms an essential prong of our framework for evaluating market practices and regulations. Part VI then provides an overview of each of the three additional considerations--resource consumption, innovation and fairness--that should be taken into account in the evaluation process.

2. THE USE OF THE ECONOMY'S EXISTING PRODUCTIVE CAPACITY

   One of the critical functions in any economy is to decide how to deploy its existing productive capacity so that it produces the mix of goods and services most valued by society. In a capitalist economy where a significant portion of production is undertaken by publicly traded companies with dispersed shareholdings, a well-functioning secondary market for public-company stocks plays an important role in this process. Specifically, all else equal, the more accurate share prices are in that market, the closer the mix will be to the one most valued by society. The overall story, detailed in this Part, runs as follows.

   Step one involves the accuracy with which a firm's future cash flows to its shareholders is predicted by its share price. The more information relevant to making this prediction is incorporated into this price, the more accurate the price is. A well-functioning market helps in two ways. First, new information allowing a more accurate appraisal of the stock's value than is currently reflected in its market price is constantly becoming publicly available. A liquid trading market fosters buying and selling activity that moves price to rapidly incorporate this information. Second, creating and trading upon new...