The social market

When AP was hacked, unwittingly sending out a Tweet that the White House has been attacked and President Obama injured, markets fell. The combination of social media and high frequency trading proved to be particularly potent, wiping approximately $136bn from US markets within 3 minutes. 

In spite of the influence social media carries, the regulation of the various platforms (Twitter, Facebook, Google, etc.) with respect to stock markets is not well established. The American Securities and Exchange Commission (SEC) now allows company information to be transmitted to investors through social media “so long as investors have been alerted about which social media will be used to disseminate such information.”

The SEC has not given guidance on the timing of disclosures or the outlets allowed. Indeed, the ruling does not even stipulate that information should be available on corporate websites in addition to other mediums. The ruling similarly avoids discussion on the timing of the disclosure or the dissemination of information across a number of channels. It is even less well established in the UK, where social media usage is more pervasive.

The lack of clear regulatory direction places an additional onus on investors, analysts and the media. Information must be sought across more channels. To meet this need, specialized research platforms exist offering investors the chance to gain a competitive advantage. Evidence from these platforms, as well as independent academic research suggests there is an advantage to this trading strategy.

Social media disclosure and trading use should be more stringently regulated in order to limit these market inequalities.  In the short term, the inclusion of social media will result in the value of a company better reflected in the market place. Information will be revealed more quickly, and spread faster. In principle, this will lead to increased volatility, with limited liquidity causing additional concern.

As more companies adopt social media channels as a way to engage investors and consumers, the ability for social media to influence the market becomes greater. As research platforms incorporating social media information continue to develop, the likelihood of social information having an impact becomes larger. This suggests regulation is necessary.

However, there is reason to be concerned that regulating social media usage is a type of censorship. The recent SEC ruling developed from a court case brought against the CEO of Netflix for posting material information on his personal Twitter account. If regulators are able to regulate who is able to say what across different platforms, it approaches the infringement of civil liberties.

That being said, it would be better for regulators provide clearer guidance to material disclosures on social media, before further market problems arise. If not, the chance that misinformation to spread through social media, causing a fall in the market and economic turmoil increases. As it currently stands, investors are unaware where and when to look for company information. This adds to market fragility, and is a cause for concern.

Equity issuance

The Kay Review, which spent several paragraphs discussing the utility of equity markets in raising money for small and medium sized companies, concluded that the equity markets are “no longer a significant source of funding for new investment by UK companies.”

Personally, I find this disconcerting. Equity markets are meant to help companies raise capital, to further their research and development. Through the process of purchases and sales, they ensure money is efficiently allocated. But, it now seems that most companies generate enough money internally to fund R&D, lessening the need for equity markets (especially for large companies). Beyond this, it has become more costly for companies to raise capital through equity issuance. This follows from an increasing number of intermediaries, who must be paid (lawyers, exchange personnel, etc).

What else has prompted this change? For one, modern businesses are less dependent on physical assets, and therefor tend to require less capital. This is, of course, quite ironic given technology companies’ ability to raise capital (see footnote below). Secondly, there has been an increase in private equity and venture capital funds funding small and medium sized companies (this includes angel investors, business incubators and even specialized banks). Tax policies have also had a role, as debt is a more tax efficient method of raising capital.  At the same time, increasing regulation has made raising equity capital “burdensome.”

Does this mean that the fundamental reason for the stock market has changed? That instead of a place to raise capital, it has become a location primarily for easy transfer of ownership? Indeed, that is possible. Exchanges allow for mergers and acquisitions to occur with more ease, through the majority ownership of shares. While this transformation is possible, and seems likely, it is not desired - it turns out that acquisitions do not typically add value to a company.

A third reason exists, and that is the mismatch in expectations between companies raising capital and investors. Again according to Kay, there is a “wide gap between what banks expect to pay for new equity and what savers expect to receive from such an investment.”  This makes investors and companies alike hesitant to raise equity.

So, what should companies do and how should exchanges be used? A focus on developing and maintaining the competitive advantages of British companies is one suggestion by Kay. We must also change our perceptions and see equity markets today “as a means of getting money out of companies rather than a means of putting it in.” While it is hard to fault these recommendations, one must wonder if something more drastic should be done.

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[1] Google, raised $1.67bn US at their IPO, and gave them a market capitalization of $23bn US. Google’s share price increased 18% on its first trading day. Other technology companies that have IPOd since Google have done even better – Linkedin, for example, gained 108% on its first trading day (closing at $94.25 US, up from its initial offering of $45 US). Let us not forget the Instagram purchase by Facebook for $1bn US. Given these prices, it also seems prudent to mention worries about a tech bubble. 

Trusting the financial markets

Former Bank of Canada governor, David Doge, said trust “is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone.” 

Unfortunately, this shared understanding of rules and behaviour is seemingly missing in financial services. According to the Edelman trust barometer (2012), a yearly survey monitoring public trust in institutions, only 40% of people trust banks. Trust in the more general “financial institutions” sits only slightly higher at 45%.

Trust is not a unitary concept, however.  There are many forms of trust, and the various forms are malleable. All follow the basic premis that an agent will act in a consumers best interest. But, problems of performance based executive compensation, commission fees and a focus on short-terminism means this is rarely the case. 

A loss of trust in financial services is problematic for several reasons. Trust helps the functioning of the financial system, which positively impacts the real economy. With trust, less effort is expended on “keeping tabs, so systems can run more efficiently,” and transaction costs are reduced.  There is less of a chance of bank runs and capital is allocated more efficiently.

While all three forms of trust can and have been broken in recent history, the most common breach of trust occurs in an agency relationship. An agency relationship is a contract where “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.”  Unfortunately, “there is a good reason to believe the agent will not always act in the best interest of the principle,” if both parties are utility maximizers.1

Agents in financial firms are particularly well placed to maximize their own utility because of asymmetric information, moral hazard and complexity inherent in the financial system. In fact, financial firms exist, in part, because of asymmetric information. Financial agents, be it investment advisors, fund managers or bankers, are employed to utilize this superior information on behalf of the consumer. Agency relationships are fraught with moral hazard, as the agent is not typically responsible for the costs associated with risk taking. The complexity of the financial system is, in part, is what makes agents able to maximize in this way. Together, these three issues create a severe principal-agent problem.

How can regulators help bring trust back into financial services? You can’t, really. Trust develops slowly but surely over time. But, here are some recommendations to develop and maintain trust into the future.

1. Increase transparency
2. Principles over rules based regulation
3. Increase competition in the financial sector while reducing switching costs (consider portability of account numbers)
4. Only allow certain products that meet risk requirements
5. Criminalise breeches of trust
6. Increase financial literacy

Some of these are already occuring, or at least there are movements in this direction. After LIBOR, for instance, criminal charges are being levied against perpetrators. Think tanks and educational instituitions are attempting to encourage literacy. But, its not enough. 

Social media and the stock market

The most significant trend affecting the financial services industry currently is increasing regulation. One of the main purpose of these new regulations (and new regulatory bodies) is to restore confidence in the market place. Social Media is the best way to reach investors, especially a new generation of investors, who are accustomed to receiving information faster, in different media platforms, and who are currently cynical of the financial industry. How can, will and should regulatory bodies and exchanges capitalize on this movement in 2012? The TSX already has a twitter page, for instance. What about an FSA Blog on upcoming regulations?

Consider, for instance, how online sentiment is already being used to predict market trends and stock prices. Social media can show attitudes “towards certain things and disdain for others, all the while displaying the overall appeal of a company.” As it turns out, this information can be incredibly influential in determining share prices. For example, the number of “followers” a company has is predictive of its valuation. More generally, the number and type of emotional words on Twitter can predict daily moves in the DJIA with almost 90% accuracy. (Personally, I’m curious how an analysis of facebook or blogs -- professional and laypersons -- would hold up). “Tweet” analysis is already being used by several companies. But, if companies begin mining for information online in order to conduct sentiment analyses, the likelihood of impulsive (or fraudulent) posts to have a meaningful (and potentially wrongful) impact is high. With social media increasingly prevalent in the world today, this risk is growing.

While one of the advantages of social media is the immediacy of information, the opportunity for mistaken stories to have a significant impact on a company’s stock is highly probable. What if major funds instantly relate to readers the trades they make?  Share prices have the potential to change drastically in a short period of time. This begs the question if social media, as it relates to the financial industry, should be regulated.  Won’t regulations of this nature have a negative impact on transparency and investor confidence… the reason for increased regulation in the first place? Clearly we’ve come full circle. Regardless, there are certainly ways for institutions and investors to further capitalize on this trend going forward.