Securities Regulation Outline

Pg. 3-30.
The Goals of Securities Regulation
Federal securities laws regulate some, but not all, of the financial markets.
They focus on markets that allocate capital.
Financial markets are highly diverse in structure and operation. Thus, it does not follow that all markets should be regulated identically or equally intensively.
American securities regulation varies the intensity of its regulation depending on the extent of individual investor participation in the particular market.
The fact that a market is very large does not alone imply that a federal administrative agency should be created to oversee it. Securities regulation is distinct, as it goes beyond simply proscribing fraud and requiring affirmative disclosure.
It also requires continuing periodic disclosure for public companies.
The disclosure system is targeted at the “secondary” market, in which investors trade with each other.
Focuses of Securities Regulation
Consumer Protection
The federal securities laws were passed during the early years of the Great Depression, following the stock market collapse in October 1929.
There were concerns that investors had been systematically misled and vulnerable in a manipulated marketplace, and the stock market crash demonstrated that others (i.e., all of America) suffered when investors disinvested from the market.
During the market boom of the 1920s, aggressive marketing by banks convinced a large number of retail investors to invest in the stock market.
15-20 million people were investing in the stock market in the 1920s. This number did not increase back up to normal levels until the 1960s—which demonstrates that investor confidence is a key, but subjective, variable.
When investor confidence declines, equity markets shrink. Thus, one of the most important goals of securities regulation is to preserve and maintain investor confidence.
The majority of the American middle class has invested its retirement funds, directly or indirectly, in the stock market, and is more exposed today than in 1929 to a severe stock market decline.
Federal securities regulation claims not to be paternalistic—rather, it promotes investor self-determination, and allows risky decisions to be made, so long as full disclosure is made.
Systemic Risk and Financial Stability
Financial institutions are closely interconnected, knitted together by derivatives in a web of risk-sharing transactions.
Thus, as the 2008 financial crisis showed, a crack in the financial foundation underlying all of this—the “big” financial institutions themselves—can cause ranging damage.
Most nations have a single financial regulator for all financial institutions—banks, broker-dealers, insurance companies mutual funds, etc.
Other countries have a “twin peaks” structure—separating consumer protection and financial regulation.
The US is unique in its fragmented system of functional regulation.
This system invites capture by industry in each sector, and permits institutions to engage in regulatory arbitrage and seek the most lenient regulator.
In 2008, the Treasury called for consolidation of financial regulation, but the system is well entrenched.
“Regulatory Arbitrage”—the deliberate relaxing of regulatory standards by one jurisdiction in order to attract listings and trading to its own market.
Standardizing Disclosure to Meet the Informational needs of Investors.
Many markets sell essentially fungible products whose grade and characteristics can be specified without great difficulty. Most markets also have self-help remedies—people can “kick the tires.”
Self-help is not available in securities markets. The typical buyer cannot inspect the “product”—the company—to the same extent that they can an actual product.
Securities laws require that information be presented in a relatively standardized and uniform fashion to facilitate comparisons among securities. Securities information is a “public good,” and public goods tend to be underprovided, so governmental action and mandatory disclosure may be necessary in securities markets.
Inadequate Incentives to Disclose
Even though most stock and listing exchanges require disclosure of information, disclosure of bad news can be devastating for a company.
Disclosure must be balanced against corporate interests in confidentiality, and concerns that high disclosure standards will result in exploitation by a firm’s competitors.
Private costs of disclosure can exceed its social costs, so a socially optimal level of disclosure may only be achievable through mandatory law.
Allocative Efficiencies
Economists claim that informed traders, thanks to SEC-mandated disclosure, will buy underpriced stocks and sell overpriced ones, until prices conform to their optimal values.
Capital markets allocate a scarce resource, capital, among competing users. They encourage the flow of capital to firms with superiors prospects, and penalize less efficient firms by requiring them to pay more for capitals.
Capital markets thus promote efficiency and economic growth, and thereby benefit all citizens, not just investors.
Some argue, however, that given reputational interests and the importance of investor confidence, market forces alone would elicit a near-optimal level of disclosure.
Corporate Governance and “Agency Costs”
Disclosure permits shareholders to gain greater control over their corporate managers.
Mandatory disclosure addresses “agency cost” problems that arise by reducing the shareholders’ cost of monitoring these agents, and requiring that corporate managers disclose inefficient or self-interested uses of corporate assets.
Economic Growth, Innovation, and Access to Capital
Other industrial societies, such as German and Japan, organize their economies around banks, rather than securities markets. However, bank-centered systems produce more centralization, more industrial consolidation, and fewer new entrants to the market. Entrepreneurs with new innovations are encouraged to merge or affiliate with larger corporate groups in order to receive capital and achieve growth.
In contrast, economies that are organized around securities markets tend to favor new entrants, such as start-up and venture capital companies, that are able to convince investors that their technological innovation merits capital.
Maintaining a Competitive Market and the Relative Cost of Capital
In a global economy, issuers and investors have some choice in which markets they participate. They can thus choose to locate in markets where regulatory costs are best balanced by cost of capital.
The cost of capital rises to the extent that investors face greater uncertainty and demand a correspondingly higher rate of return to compensate them for bearing risk.
Markets that overregulate can cause issuers to flee and dissuade foreign investors.
Markets that underregulate increase investor risk and drive up costs of capital.
The Sarbanes Oxley Act of 2002 and Dodd Frank Act of 2010 increased regulation in US markets. As a result, many smaller issuers and foreign companies fled US markets.
A reduced cost of capital benefits all of society, including non-investors, because a reduced cost of capital implies greater economic growth. Thus, securities regulation performs an important public function that goes beyond just protecting investors.
An Overview of Financial Markets
Different financial markets are in direct competitions, as issuers can seek capital in non-securities markets (commercial bank loans), they can issue bonds or notes in US securities markets, or issue equity offerings in a foreign market.
The market that an issuer chooses to locate in depends on:
The relative cost of capital in different markets;
The time necessary to effect a transaction in a particular market
The degree of regulatory supervision and legal liability to which issuers are subjected.
The line between certain securities markets and other capital markets has shifted and blurred. Securities markets sell options on securities, while futures markets offer futures contracts on securities.
Regulatory conflict has arisen over the status of “derivatives”—swaps, options on other financial instruments, and futures.
Non-Equity Markets
Debt offerings dominate equity offerings.
Financial markets serve three basic functions:
Matching lenders and investors with businesses seeking financing; enabling those with surplus funds to earn a return by lending to those unable to finance their operations with internally-generated capital;
Permitting investors to reduce their exposure to risk through portfolio diversification and hedging (such as interest rate or currency derivatives);
Providing “liquidity,” which means that investors can buy or sell shares without appreciably moving the market price.
Money Market: markets that deal in shorter-term debt instruments—typically, a maturity of less than one year.
Short-term credit instruments, including CDs, treasury bills, and commercial paper.
Businesses that have short-term surpluses hold them in low-risk, short-term money market instruments.
Businesses that have seasonal cash shortages or need to finance accounts receivable can turn to the money market for short-term credit.
Short-term co