Why We Should Stop Being Surprised That Lightly – Regulated Markets Fail To Achieve The SEC’s Goals For Market Quality

Robert J. Bloomfield

Cornell University – Samuel Curtis Johnson Graduate School of Management

January 16, 2016

Abstract:

The stated goals of the SEC are to protect investors, maintain orderly markets and facilitate capital formation. These goals can be achieved with very light regulation if, as assumed by traditional economic theory, investors process information costlessly and protect themselves from informational disadvantages, and firms optimally balance the costs and benefits of committing to make their reports reliable. A growing body of research demonstrates that light regulation fails to achieve the SEC’s goals, because investors find information processing costly and fail to protect themselves. After reviewing theory and prior evidence, I discuss new lessons learned from Jiang, Petroni and Wang (2015), who show that PinkSheets reduced the liquidity of firms with low reporting quality and increased the liquidity of firms with high reporting quality, merely by highlighting the quality of their listed firms’ disclosure. While the Pink Sheets innovation might have occurred through many causal channels, all of them entail a violation of costless processing and self-protection, and lead to the conclusion that this lightly regulated market did not initially meet the stated goals of the SEC. I conclude by arguing that markets can achieve the SEC’s goals only if they exhibit a particularly strong version of “dynamic” market efficiency, which requires that each individual trade on the path to even incomplete revelation occur at the then-optimal price. Because dynamic efficiency is unlikely, we should stop being surprised to see yet more evidence that lightly-regulated markets fall short on key dimensions. Instead, we should use our well-developed understanding of market inefficiency to guide regulation.

Why We Should Stop Being Surprised That Lightly – Regulated Markets Fail To Achieve The SEC’s Goals For Market Quality – Introduction

Many accounting scholars have studied the impact of regulatory changes in markets that are already subject to strong regulations.1 Jiang, Petroni and Wang (2016, hereafter ‘JPW’) depart from this familiar path by examining the impact of a change imposed by a private exchange, Pink Sheets®, a market subject to only very weak regulatory oversight.

Specifically, in 2007, Pink Sheets® altered their own presentation of firm’s listings by classifying firms according to the quality of their disclosures (Current Information, Limited Information, and No Information) and making those classifications strikingly salient with colorful graphics (a version of a Pink Sheets® logo, a red yield sign, and a red stop sign, respectively). JPW find that this innovation caused an increase in market liquidity for shares of firms classified as providing Current Information, and a decrease in market liquidity for shares of firms classified as providing No Information. They also find that investors seemed to anticipate this effect, with prices dropping for the former group, over the days in which the upcoming change in presentation was announced.

In Section 2, I place the paper in the context of other archival studies that examine lightly-regulated markets, and argue that such studies provide useful insights into an idealized but never-observed counterfactual that frequently appears in regulatory discussions: the fully libertarian market free of all regulations, in which traders must protect themselves against both misleading reporters and better-informed traders. In Section 3, I argue that JPW’s results provide additional evidence that lightly regulated markets do not achieve the goals of the SEC because information processing is not costless for at least some investors, and investors do not protect themselves as effectively as traditional economic theory would predict. In Section 4, I further argue that the results are consistent with—and in fact totally unsurprising in light of prior evidence of these two investor failures, and that these failures are robust enough to guide regulators.

In Section 5, I discuss the challenges in determining precisely why the innovation had the effects that it did. Because Pink Sheets® intended their innovation in search of profit, not clean scholarly inference, they confounded many possible explanations. Future research could gather new data from laboratory experiments, field experiments, field studies and surveys to clarify the causal explanation. In Section 6, I conclude by emphasizing that ‘lightly regulated markets don’t achieve the goals of the SEC’ is a positive claim about what happens when reporting standards are left to the discretion of managers and exchanges. This claims does not imply that heavily regulated markets (such as those for large public firms in the US) would achieve the SEC’s goals more effectively with yet more regulation, nor does my discussion establish that the SEC’s goals are normatively desirable ones to achieve. Those who disagree with either of these claims can validly argue for less regulation, as long as they do not rely on the claim that investors protect themselves well enough to compensate for the changes they recommend.

2. Theory And Prior Evidence On Lightly Regulated And Unregulated Markets

How would markets behave in the absence of any regulation? Specifically, how well would they achieve the mission of the U.S. Securities and Exchange Commission, which is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”?2 Traditional economic theory allows us to answer this question by imposing a number of assumptions, like individual rationality, rational expectations and risk aversion, but I will focus on three that are particularly important: the costs of processing publicly available information are trivially small (costless processing); traders protect themselves against others with superior information (self-protection); and managers invest optimally in costly technologies, like auditing, that commit themselves to restricting their reporting flexibility, with the restriction increasing with cost (reporting commitment).

Why We Should Stop Being Surprised That Lightly - Regulated Markets Fail

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