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Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation Lynn A Cornell Law Library Scholarship@Cornell Law: A Digital Repository Cornell Law Faculty Publications Faculty Scholarship 4-1995 Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation Lynn A. Stout Cornell Law School, [email protected] Follow this and additional works at: http://scholarship.law.cornell.edu/facpub Part of the Corporation and Enterprise Law Commons, and the Securities Law Commons Recommended Citation Stout, Lynn A., "Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation" (1995). Cornell Law Faculty Publications. Paper 751. http://scholarship.law.cornell.edu/facpub/751 This Article is brought to you for free and open access by the Faculty Scholarship at Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in Cornell Law Faculty Publications by an authorized administrator of Scholarship@Cornell Law: A Digital Repository. For more information, please contact [email protected]. VIRGINIA LAW REVIEW VOLUME 81 APRIL 1995 NUMBER 3 ARTICLES ARE STOCK MARKETS COSTLY CASINOS? DISAGREEMENT, MARKET FAILURE, AND SECURITIES REGULATION Lynn A. Stout* INTRODUCTION ............................................... 613 I. A HETEROGENEOUS EXPECTATIONS MODEL OF STOCK TRADING ................................................. 620 A. The Puzzle of Speculative Stock Trading ............ 622 B. A Simple Model of Heterogeneous Expectations and HE Trading in a World of Imperfect Information ... 625 C. Potential Deterrents to HE Trading: The Roles of Self-Selection and Successive Generations in Fostering Speculative Markets ........................ 635 1. Optimistic Self-Selection and the Lake Wobegon M arket ........................................... 636 * Professor of Law, Georgetown University Law Center, Guest Scholar, The Brookings Institution. A.B. 1979, M.P.A., 1982, Princeton University; J.D., 1982, Yale University. Earlier versions of this Article were presented at the Annual Meeting at the American Law and Economics Association, and at workshops at the Duke University School of Law, Georgetown University Law Center, George Mason University School of Law, and the New York University School of Law. The author would like to thank the participants in those sessions for their helpful comments and insights. The author also would like to thank Jean-Pierre Benoit, Mark Geistfeld, Marcel Kahan, Michael Klausner, Avery Katz, Don Langevoort, Mark Ramseyer, Steve Salop, Warren Schwartz, Joel Seligman, Jack Slain, and Pete Wales for their readings and suggestions, and Alan Cabral, Neal Kochman, Tonya Lindsey, Alex Sliheet, and Frank Supik for their invaluable assistance researching and preparing this manuscript. 612 Virginia Law Review [Vol. 81:611 2. A Longitudinal Model of HE Trading. Darwin Meets Barnum ................................... 637 D. The Role of FinancialIntermediaries in EncouragingHE Trading............................ 641 1. The Role of Brokers ............................. 641 2. The Role of Institutional Investment Funds ...... 643 E. HE Theory and the Relationship Between Stock Prices and Fundamental Values in an Efficient Market ............................................... 646 1. The Rise (and Fall?) of Conventional Efficient Markets Theory .................................. 646 2. Modifying Conventional Efficient Markets Theory To Account for Heterogeneous Expectations...................................... 651 II. ARE U.S. STOCK MARKETS HETEROGENEOUS EXPECTATIONS MARKETS? . 656 A. Nonmistaken Reasons for Trading and the Value- Adding Model of Stock Markets ..................... 657 B. The Value-Adding Model Versus the HE Model: Some Evidence on Why Investors Trade ............. 659 1. The Predominanceof Active Institutional Management ..................................... 661 2. Trading Volume and Patterns .................... 665 m. THE POLICY IMPLICATIONS OF THE HETEROGENEOUS EXPECTATIONS MODEL FOR FEDERAL SECURITIES REGULATION ............................................ 667 A. The Social Costs of HE Trading ..................... 669 1. Welfare Losses Resulting From HE Traders' Mistaken Investment in Active Portfolio Management ..................................... 670 2. Welfare Losses From HE Trading's Distortive Effects on Stock Prices ........................... 677 B. The Social Benefits of HE Trading .................. 682 1. HE Trading and Market Liquidity ............... 683 2. HE Trading and The Fundamental Value Efficiency of the Market ......................... 688 C. Reducing Welfare Losses from HE Trading: Some Policy Implications................................... 691 1995] Are Stock Markets Costly Casinos? 1. Reducing Welfare Losses From HE Trading Through Rules That Reduce the Dispersion of Investor Expectations ............................ 693 2. Reducing Welfare Losses From HE Trading Through Rules That Decrease the Costs of Speculative Trading .............................. 697 3. Reducing Welfare Losses From HE Trading by Taxing or Prohibiting Trading ................... 699 D. Some Thoughts on the HE Theory's Applicability to Other Speculative Markets, Especially Derivatives M arkets .............................................. 703 IV. CONCLUSION ............................................. 710 INTRODUCrlON HE U.S. stock market is one of the largest markets in the world. In 1992, over three trillion dollars in shares changed hands on the exchanges and in the over-the-counter ("OTC") mar- ket,' almost twice as much as consumer spending on durable and nondurable goods combined.2 Trading on such a gargantuan scale costs investors $100 billion or more annually.3 Despite these costs, trading volume on the exchanges and in the OTC market has qua- drupled over the past decade.4 Moreover, investors no longer are content to trade just stocks; they now trade stock "derivatives," complex financial instruments whose values depend on the prices of publicly traded equities.5 1 National Ass'n of Securities Dealers, 1993 Nasdaq Fact Book & Company Directory 7 (1993) (stating that in 1992 $1.75 trillion traded on New York Stock Exchange and $1.31 trillion traded on regional exchanges and in OTC market). 2 See Bureau of the Census, U.S. Dep't of Commerce, Statistical Abstract of the United States 1993, at 442 tbl. 690 (113th ed. 1993) [hereinafter 1993 Statistical Abstract] (charting the $480.4 billion and $1290.7 billion spent on durables and nondurables, respectively, in 1992). 3 See infra notes 191-207 and accompanying text (noting that mutual funds' expense ratios suggest investors spend at least $100 billion annually researching, managing, and trading stock portfolios). 4 See National Ass'n of Securities Dealers, supra note 1, at 6 (noting that NASDAQ annual dollar volume rose from $84 billion in 1982 to $891 billion in 1992); 1993 Statistical Abstract, supra note 2, at 522 tbl. 829 (noting that dollar volume on all exchanges rose from $476 billion in 1980 to $1612 billion in 1990). S See infra notes 313-25 and accompanying text (describing aspects of derivatives trading). 614 Virginia Law Review [Vol. 81:611 Why do traders trade? A common assumption is that equities trading serves both buyers' and sellers' self-interest, as well as the interest of the larger society.6 In the tradition of classical econom- ics, exchange between rational actors is equated with mutual bene- fit and a corresponding increase in social welfare.7 Thus, scholars and regulators believe that more stock trading is better than less, that increasing opportunities to trade stocks is desirable, and that lowering trading costs, including regulatory costs, is an important policy goal.8 Congress and the Securities and Exchange Commis- 6 The securities literature often assumes that stock trades are mutually beneficial. See, e.g., Thomas Lee Hazen, Rational Investments, Speculation, or Gambling?-Derivative Securities and Financial Futures and Their Effect on the Underlying Capital Markets, 86 Nw. U. L. Rev. 987 (1992) (suggesting that securities regulation is premised on the view that government should not interfere with investment decisions); Donald W. Kiefer, The Security Transactions Tax: An Overview of the Issues, 48 Tax Notes 885, 896 (1990) (arguing against tax that discourages trading as cutting against economic assumption that activity is valuable if participants are willing to pay for it); Donald C. Langevoort, Information Technology and the Structure of Securities Regulation, 98 Harv. L. Rev. 747, 803 (1985) (noting that information technology that lowers trading costs benefits investors); Robert W. Vishny, Three Comments on Economic Implications of Alternative Portfolio Policies of Institutional Investors, in Institutional Investing: Challenges and Responsibilities of the 21st Century 159, 165-66 (Arnold W. Sametz ed., 1991) (defending stock trading as activity of "consenting adults"); see also Division of Mkt. Regulation, SEC, Market 2000: An Examination of Current Equity Market Developments 1 (1994) [hereinafter Market 2000 Report] (praising U.S. stock markets for "[r]ecord amounts of trading activity"). In addition to its presumed benefits to trading parties, stock trading also is believed to provide significant social benefits by contributing to the "liquidity" and "efficiency" of the market. See infra notes 234-239, 257-258 and accompanying text. Only a handful of scholars have suggested that stock trading is not socially valuable. See infra note 10. 7 See Richard A. Posner, Economic Analysis of Law 10-11 (4th ed. 1992) (stating
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