Klein, Dalko, and Wang, Regulating Competition in Stock Markets

In recent years many individual investors have lost faith in the financial markets and their credentialed professionals. From the financial crisis to the flash crash, from Madoff to Wasendorf, and now of course the Libor scandal, there is a relentless flow of damaging headline news.

Regulating Competition in Stock Markets: Antitrust Measures to Promote Fairness and Transparency through Investor Protection and Crisis Prevention, edited by Lawrence R. Klein, Viktoria Dalko, and Michael H. Wang (Wiley, 2012) tackles one aspect of the problem, using data from both U.S. and international markets.

Before the authors propose remedies, however, they look at the human toll of the 2008 global financial crisis. They surveyed 335 young professionals who were former graduate students of the authors and found that the crisis “had a measurable and detrimental impact on health and happiness.” Their sample was far from random, and therefore it is a bit disingenuous to compare the emotional health impact of the 9/11 attack on people not living in the vicinity of the attack (within half a year) to the impact of the financial crisis on the survey participants in the fall of 2008. But about twice as many people in the second group were worried and had problems with sleeping. And 35% reported worse physical health in the spring of 2009 than in the previous fall.

Since stock market crises are so devastating, it is critical to understand how they can be prevented. The authors find an answer in regulation: regulating shareholding concentration, trade-based price-lifting, earnings manipulation, trading by corporate insiders, information manipulation by sell-side analysts, information-based manipulation, and news reporting that cultivates long-run manias and triggers short-run panics.

Let’s look very briefly at one of the areas that need regulation: trade-based price lifting. It includes, but is not limited to, pump and dump schemes. Trade-based manipulation tactics include self-dealing (wash sale) and cross-dealing (matched orders), advancing the bid, marking the close, and fake trading (a characteristic of much high-frequency trading). The first pair of tactics, which the authors dub fictitious trading, is frequently seen in China, Hong Kong, India, and Japan, rarely in the U.S. (or at least rarely investigated by the SEC). The U.S. markets, on the other hand, specialize in fake trading.

Few of the authors’ proposals for dealing with trade-based price lifting are likely to be incorporated into U.S. financial regulations any time soon. For instance, they propose a daily volume limit and time constraints—that “the time interval between two consecutive orders by any investor cannot be less than 10 minutes at any given time during a trading day” or that the minimum interval between any two consecutive voluntarily canceled orders be set at one hour. (pp. 106-107) Yes, minutes and hours, not nanoseconds. Of course, the authors leave it up to the discretion of the regulators of individual markets to adjust and implement their suggestions.

Each of the seven chapters dealing with financial regulation was presented as a paper at a 2011 conference. Two of the conferences were held in China, two in Taiwan, one in Brazil, one in Greece, and one in the U.S. International venues, with recommendations for stock markets worldwide. Even though the financial crisis was largely made in the U.S.A., I suspect that the authors’ recommendations will resonate more with regulators of markets who don’t have such a long history of price manipulation, and regulatory response, as do the U.S. markets.