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CHAPTER 4 Securities Regulation

       Douglas Cumming

      DeSantis Distinguished Professor of Finance and Entrepreneurship, Florida Atlantic University

       Sofia Johan

      Assistant Professor of Finance, Florida Atlantic University

INTRODUCTION

      Securities regulation is a diverse topic that covers many areas, including but not limited to the distribution of new securities (United States Securities Act of 1933), trading of securities, brokers, and exchanges (United States Securities Act of 1933), debt securities (United States Trust Indenture Act of 1939), mutual funds (Investment Company Act of 1940), and investment advisors (Investment Advisers Act of 1940). Given that the book's focus is on equity markets and valuation, this chapter focuses on trading securities on public stock exchanges.

      According to Cumming and Johan (2019), some authors have written about the impact of securities regulation without even understanding that the source of regulatory change that they have studied involves exchange-trading rules. Two types of regulatory regimes are available: regulator-led and market-led. Hence, recognizing that trading rule sources are not always the same around the world is important. The source of securities regulations for trading on exchanges varies by country, and the source likewise varies over time. For example, in China, the rules pertaining to the trading of securities are found in the China Securities and Regulatory Commission rules. In the United States, the trading rules are listed on the stock exchange web pages. In Europe before 2004, the rules were likewise made available by the exchange or found on each exchange's web page, but thereafter these rules were harmonized and are now found in a set of pan-European wide directives. Collectively, they are called the Lamfalussy Directives – the Market in Financial Instruments Directive (MiFID), the Prospectus Directive, the Market Abuse Directive (MAD), and the Transparency Directive. The Lamfalussy Directives comprise a four-part system, where MAD is Part 3, and MiFID culminates in Part 4 with computer surveillance and enforcement (Cumming and Johan 2019).

This chapter consists of three main sections. The first part explains the meaning of different types of trading rules and the forms of market manipulation that the rules are intended to curtail. The second part reviews evidence on the impact of trading rules and enforcement on trading outcomes. The third part reviews evidence on the impact of trading rules and enforcement on real corporate outcomes.

TRADING RULES AND RULES PERTAINING TO BROKER-DEALER CONDUCT

      Securities regulation governs the permitted conduct of brokers and other market participants on stock exchanges. At a broad level, most countries have a general rule that prohibits market misconduct in the form of manipulating share prices. However, what constitutes market manipulation is not always perfectly clear, and, as such, different countries have adopted more specific rules at different points in time. Rule specificity is not a trivial issue since more specific rules may signal to market participants that securities laws enumerate surveillance and enforcement of those prohibitive types of trading (Cumming, Johan, and Li 2011). A blanket rule or a general statement against market misconduct may not have the same effect.

      The following explains the different types of trading rules that may be found in different countries around the world. Additionally, some evidence is presented on rule specificity in different countries.

      The three main categories of trading rules are rules designed to: (1) mitigate insider trading, (2) lessen market manipulation, and (3) curtail broker-agent conflicts. Each is described, followed by an explanation of how the rules pertain to broker-dealer conduct.

      Insider Trading Rules

      Insider trading involves market participants who trade on material nonpublic information. The general public is likely more familiar with insider trading cases involving company directors or managers, although insider trading may involve any market participant, such as brokers. Although rules prohibiting insider trading, in general, are commonplace around the world, enforcement is less common.

      The specific regulations as to what exactly constitutes insider trading vary across exchanges. Securities regulations may specify exactly what constitutes material nonpublic information, such as whether the information was from a client order, possibly giving rise to a client precedence violation or a front-running violation.

      Client Precedence Client precedence refers to brokers violating the time priority of client orders. A client precedence rule is violated during insider trading when a broker initiates a trade on his or her own account shortly before executing a client's order, with the client's trade being executed at a worse price. Brokers, acting either independently or in collusion, carry out violations of client preference, which requires trade execution and a change in beneficial ownership. Violations of client precedence, by definition, violate price/time priority but do not by themselves give rise to a manipulated price or volume.

Front Running Front running refers to brokers trading ahead of clients' orders. In the case of front running, upon receipt of a large client order, a broker trades shortly before executing a client's order with the expectation that the client's order is likely to move the price. Front running can also involve brokers that, after receiving a client's order, take the opposite position to the client's order in the market without the client's knowledge and then, immediately thereafter, the same broker crosses with the same client off-market at a profit. Front running is independently initiated by brokers and requires trade execution and a change in beneficial ownership. Front running violates price/time priority. Brokers benefit from front running by trading before executing another trade, but front running itself does not give rise to a misleading price and volume. Lewis (2014) identifies another front run, which shows high-frequency trading (HFT) algorithms using the information of any (nonclient) order and trading in advance of that order by virtue of the speed associated with HFT.

      Other Forms of Insider Trading Other forms of insider trading can involve using material nonpublic information about the company being traded. Trading rules can mitigate the presence of this form of insider trading by prohibiting trading ahead of the public release of research reports created by brokerages, and the separation of research and trading departments at brokerages (commonly referred to as a “Chinese wall”). Trading ahead of research reports is independently carried out by brokers and requires trade execution and a change in beneficial ownership. Trading ahead of research reports possibly violates price/time priority. Brokers benefit by trading before the release of material nonpublic information, but trading ahead of research reports by itself does not give rise to a misleading price and volume.

      Trading rules may limit affiliation between exchange members and member companies, or between

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