China stocksSome Chinese companies are listed on U.S. stock exchanges, but their financial audits are not reviewed by U.S. regulators. In general, the U.S. Public Company Accounting Oversight Board supervises U.S. auditors and reviews the work papers of audits of U.S.-listed companies, but it can't do that for Chinese companies, even ones that are listed in the U.S.: "China's accounting firms, including affiliates of giants like Deloitte, Ernst & Young, PwC and KPMG, have long argued that Chinese law bars them from sharing audit work papers with the PCAOB on the grounds that the documents may contain state secrets." One solution to this problem might be for U.S. regulators to say "ah well, I am sure the Chinese regulators are doing a good enough job of reviewing the audits, we'll just trust them." This is a pretty normal approach in a lot of cross-border financial regulation—national regulators will often treat foreign regulatory supervision as equivalent to their own supervision—but it does not seem to be an option here, because (1) the U.S. and Chinese governments generally distrust each other right now and are escalating disputes over all sorts of things and (2) there actually has been quite a bit of accounting fraud at U.S.-listed Chinese companies in recent years. Another solution might be for the U.S. government to prohibit U.S. investors from investing in Chinese stocks, but that seems a little drastic. It's not particularly libertarian, it's complicated to enforce, and of course a lot of Chinese stocks go up a lot and it would be sad for American investors to miss out on that. Yesterday the President's Working Group on Financial Markets (a group of U.S. regulators headed by the Treasury secretary and including the Securities and Exchange Commission, the Federal Reserve and others) released its own proposed solutions. The proposal that has gotten the most attention is that Chinese companies would no longer be allowed to list their stocks on U.S. stock exchanges unless they share their audit work papers with the PCAOB. Companies whose main auditors can't do that could get "a co-audit from an audit firm with comparable resources and experience," and share the co-audit papers with the PCAOB. I am not sure how practical a solution that is; audits are a lot of work and raise a lot of judgment calls, and it would be exhausting to do them twice and have to debate those judgment calls with two different auditors. (Also "this recommendation would require the government of [China] to permit the U.S. Firm to perform the work and retain the relevant work papers outside of [China]," which might be a challenge.) One possible result of this rule—no U.S. listings without U.S.-qualified audits—would be that the U.S.-listed Chinese companies (or the government) would cave and agree to get U.S.-qualified audits (or co-audits). Another possible result would be that the Chinese companies would not cave, they'd be delisted, and U.S. investors would no longer buy their stocks. But there is a third possibility, as the report acknowledges: Enhancing U.S. listing standards would not, of course, prohibit these issuers from listing their securities on exchanges outside the United States, including Hong Kong, Shanghai or London. U.S. investors could purchase such securities on foreign exchanges, and these purchases may be subject to fewer investor protections than in the United States. For example, panelists from the SEC's Roundtable on Emerging Markets in July 2020 expressed concern that China-based issuers would move their listings to foreign exchanges where there would be even fewer transparency and investor protections.
The modern stock markets are pretty global, and if you are an American investor looking to invest in Chinese companies, you can do that in Hong Kong or London if they can't list in the U.S. And if you are an American regulator looking to protect U.S. investors from Chinese companies, not allowing those companies to list in the U.S. doesn't get you all that far. So the working group has some backup plans. It is not going to prohibit U.S. investors from buying Chinese stocks, but it is going to discourage them. The way discouragement often works in securities law is through disclosure: If regulators don't like something, but can't quite bring themselves to ban it, they require a lot of disclosure about it. "This thing is bad, and you can do this thing, but you have to disclose that you are doing the thing and that it is bad" is the basic approach. Here, the working group wants U.S. mutual funds that buy Chinese stocks—listed in New York or London or Shanghai or anywhere else—to say to investors something to the effect of "these companies do not have audits that are supervised by the PCAOB, which is bad." (Just saying "these companies do not have audits that are supervised by the PCAOB" would be meaningless to almost all mutual fund investors, which is why you have to add "which is bad" to make the disclosure effective.) Here's how that reads in the report: The PWG recommends that the SEC issue interpretive guidance to clarify investment companies' disclosure obligations regarding investments in emerging markets, including with respect to PCAOB inspection and enforcement limitations of issuers based in China.
But it's not just disclosure; the working group also hints that investing in Chinese stocks might violate a mutual fund's fiduciary duties to its clients: Investment advisers have a fiduciary duty to their clients under the Investment Advisers Act of 1940 ("Advisers Act"), including a duty of loyalty and a duty of care. … For example, an adviser should consider whether investments are recommended only to those clients who understand the risks and provide informed consent, and should conduct a reasonable investigation into the investment sufficient not to base its advice on materially inaccurate or incomplete information. With respect to investments in China and other NCJs, an investment adviser should consider differences in local regulatory, accounting, auditing and financial recordkeeping standards and the effects of those differences on the ability to accurately select investments that meet the client's investment objectives and goals. Accordingly, investment advisers that are recommending investments in these jurisdictions may want to consider, as part of their reasonable investigation, whether there are limitations on the quality or availability of financial information with respect to these investments, as well as possible limitations on investors' legal remedies in such jurisdictions.
These are vague threats, but they are threats; the message is that if you are a mutual fund that invests in Chinese companies, and some of them turn out to be frauds, you might get in trouble, so you'd better be careful. Perhaps this will encourage some mutual funds to dump all their Chinese stocks (and thus encourage Chinese companies to get U.S. audits to get back into the mutual funds); perhaps it will at least encourage them to dump the Chinese stocks whose audits seem fishiest (and thus protect U.S. investors from frauds). But the effect will be limited, because lots of mutual funds don't pick stocks at all: They are index funds, and they buy whatever is in the relevant index. If the index is, for example, a global index, or an index of Chinese stocks, then the index fund will buy Chinese stocks whether or not they have U.S. audits. "What can we do," they will say, "we don't pick the stocks, we just buy what's on the list." So the working group threatens further: You'd better make sure that you have the right list. The PWG recommends that the SEC consider taking steps to encourage or require SEC-registered mutual funds and ETFs that track indexes to perform greater due diligence on an index and its index provider prior to the selection of the index to implement a particular investment strategy or objective. This enhanced due diligence should take into account the index provider's process for index construction, including with respect to index rebalances. In particular, due diligence should address whether the process takes into account any potential errors in index data, index computation and/or index construction if the information from issuers based in NCJs, including China, is unreliable or outdated or if less information about such companies is publicly available due to differences in regulatory, accounting, auditing and financial recordkeeping standards. It should also take into account the potential effects of such differences on the fund's performance. Encouraging funds that intend to utilize indexes to conduct more robust due diligence could result in index providers considering these differences in standards more carefully, and possibly altering how they construct indexes. … Unlike other jurisdictions (e.g., the EU and the UK), the SEC and other federal regulators do not have authority to directly regulate the activities of the index providers that are responsible for, among other things, selecting, updating and rebalancing indexes. In the absence of such regulatory authority, this option may indirectly encourage index providers to consider factors such as transparency and quality of financial information more carefully in index construction.
I am tempted to say that this is the heart of it. The way to do securities regulation of foreign companies is not through securities regulation, because they don't live here and you might not be able to enforce your rules against them. It's not through listing standards, because listings are fungible: Companies can list anywhere, investors anywhere can buy companies listed anywhere, and if you won't list a company then some other jurisdiction will be happy to take their money. The way to do securities regulation is through index construction: The thing that matters a lot to companies, anywhere in the world, is being included in important indexes that drive so much international institutional investment. If a regulator could say "no index shall include a company that does Bad Thing X," that would be an effective rule against Bad Thing X, maybe a more effective rule than just saying "no company shall do Bad Thing X," which could be hard to enforce against foreign companies. But of course U.S. regulators can't directly say that—"unlike other jurisdictions (e.g., the EU and the UK)," they say enviously, they can't directly regulate indexes. But they can lobby and threaten investors to lobby index providers to change the index rules. What a weird and indirect regulatory system! Effectively all the U.S. financial regulators have gotten in a room and identified a practice (not sharing work papers with the PCAOB) that is already more or less illegal (in the U.S.), and they have thought about the best ways to stop it, and what they've come up with is asking investors to ask index providers to ask the companies to knock it off. Fractional sharesIn the last year or so, most of the big retail discount brokerages have begun to offer fractional share trading. You no longer have to buy a share of stock, or a "round lot" of 100 shares; you can buy any amount of stock. The actual benefit of this has very little to do with fractions, and it seems unlikely that you would ever have a particular fraction of a share in mind when you decided to invest. The actual benefit is that instead of buying a nice round number of shares, you can invest a nice round number of dollars, which is way more intuitive.[1] If you have $5,000 and want to build a diversified portfolio, you can put $1,000 each into, say, Amazon.com Inc. and Tesla Inc. and Nikola Corp. and Eastman Kodak Co. and Hertz Global Holdings Inc., and get 0.31 and 0.67 and 27.55 and 62.07 and 645.16 shares, respectively.[2] You never need to think in terms of shares, or even know how many shares you own; you can just think in terms of dollars. It seems to me that this could work out very well for ordinary investors. You get paid every two weeks, you can save $100 from each paycheck, you put $20 into each of your five favorite stocks. It's perhaps not the best approach—perhaps you should use an index fund to get more diversification, perhaps you should not equal-weight your favorite stocks, perhaps your favorite stocks are actually bad, etc.—but it's not the worst either. Moving from a world of arbitrary share prices and large investment amounts to a world of normal, round, possibly small dollar amounts seems like it might encourage more sensible single-stock investing behavior. Let's check in with the actual retail investors buying fractional shares: "I can buy stock in companies I could never afford," said Jacob Gonzalez, 34 years old, who trades fractional shares on Fidelity and Robinhood. "I've got Tesla now. I've got Amazon." … Mr. Gonzalez, a resident of Chino Hills, Calif., said he lost his information-technology job in March and has less than $10,000 in his portfolio. He recently began doing deliveries for food-delivery service DoorDash. A proponent of cannabis legalization, Mr. Gonzalez said he often spends $4.20 on stock purchases. The number 420 is a popular slang code for cannabis consumption among marijuana enthusiasts.
Ah. Well. I suppose $4.20 is as good a number as any other. Numerical roundness is a subjective quality. Plus to be fair Elon Musk once pretended he was going to take Tesla Inc. private at $420 per share, as a weed joke, so Gonzalez is in good company; this is how billionaires operate at the highest levels of finance. He could get exactly 0.01 share, at that price. One adjunct of fractional share trading is the decline of stock splits. Actually the decline of stock splits mostly preceded, and perhaps partially caused, the rise of fractional share trading; when stocks split all the time and rarely got much above $100 a share, there wasn't as much need for fractional shares as there is now, when popular retail stocks like Tesla and Amazon are above $1,000. But the rise of fractional trading might also contribute to the continuing decline of stock splits: When Apple Inc. announced a 4-for-1 stock split last week, a lot of the reaction was "why do you need a stock split when people can buy fractional shares?" If the idea of a stock split is to lower the stock price to appeal to small retail investors, and if all the retail investors can seamlessly buy $4.20 worth of any stock, no matter its stock price, then there's less need for stock splits. I wrote about Apple's stock split last week, and several people emailed to say that I missed the most important benefit of a split. Listed stock options, still, trade in units of 100 shares.[3] If you buy a $455 September call option on Apple, it will cost you about $21.85 per share, or about $2,185 per contract. If you want to exercise it in September, you'll have to come up with $45,500 to pay the strike price.[4] When the stock splits all of those numbers will fall by about 75% and the options will be a bit more affordable. I don't know why Apple would consider that a benefit—does it really want to encourage retail speculation in its options?—but there you go. Meanwhile: Research has shown that trading frequently isn't good for investors, and a simple buy-and-hold strategy works best over the long run. Fractional trading will likely tempt some novice investors to try stock picking, said Terrance Odean, a finance professor at the University of California, Berkeley. Still, he added, that shouldn't be excessively risky, because such investors generally buy small quantities of stock. "Will this encourage some speculation? Probably some," Mr. Odean said. "But it's going to be speculation with a lot less money than if people were forced to buy whole shares."
Again, I would have thought that fractional share trading might discourage some speculation; it might encourage people to invest round numbers of dollars at regular intervals rather than bet uncomfortable amounts of money on whatever's going up. But "speculation with a lot less money" is good too; if you are going to gamble on Tesla, it's safer to bet $4.20 than $1,489.58. You could tell another encouraging story, which is that the combination of very high dollar stock prices and fractional share trading is good because it discourages retail traders from trading options. You can buy $4.20 worth of Tesla stock if you want, but you cannot buy $4.20 worth of Tesla options; the $1,600 Tesla September call will set you back $9,450 per contract. One thing about stock options is that they offer a lot of leverage, a related thing about them is that they are risky, and another related thing about them is that they cost less, per share, than shares. Historically, if you didn't have enough money to buy a round lot (100 shares) of a stock and still wanted to bet on it, you could buy an option, which cost less. Now that calculation is reversed: If you don't have enough money to buy a whole share of stock, buying 0.01 shares is cheaper than buying an option, and also less risky. I am looking forward to Robinhood introducing fractional trading in options? Two salient stories about Robinhood are (1) it makes it cheap and easy for young people to day-trade on their phones and (2) it does a disproportionate amount of options trades (and makes a disproportionate amount of money from them) compared to other discount brokers. Why not combine the two things and let people trade $4.20 worth of Tesla options? One reason that this might not happen is that it is … bad? Like there may be some limit to how much small-dollar gambling a retail brokerage can encourage, Robinhood is pushing up against that limit already, and "buy any amount of any option" might go too far. Another reason it might not happen is a market-structure one. There is no such thing, really, as a fractional share; if you buy a fractional share on Robinhood, what actually happens is that Robinhood buys a whole share and gives you an economic interest in part of it.[5] If you buy $100 worth of Tesla, Robinhood has to buy a whole share and keep the other $1,389.58 worth. In practice this is a pretty minimal friction because a lot of people are buying fractions of Tesla shares and Robinhood can effectively add them together; if 1,000 investors each own fractional shares of Tesla that sum up to 420.69 shares, then Robinhood buys 421 shares and is only exposed to the residual 0.31 shares. Investors get $626,651.41 of exposure, while Robinhood only has $461.77 left over. But this works less well for fractions of expensive, fragmented, illiquid things. If there were 1,000 different stocks that each cost $10,000, and 1,000 different Robinhood investors each bought $4.20 worth of one of them, then the investors would have a total of $4,200 of exposure, and Robinhood itself would have $9,995,800 of residual exposure. The risk would not be worth it. Options are a little like that: They are fairly expensive (because they trade in 100-share contracts), there are a lot of them for every share of stock (because there are different strike prices and expiration dates), and trading is fragmented and in many cases not that liquid. So they are harder for brokers to fractionalize. Weirdly we have accidentally evolved a pretty good structure? Shares of stock are often expensive, but it doesn't matter because it's easy to buy fractions of them, which might encourage people to make sensible periodic investments or, at least, to make small gambles. Options are expensive to buy and hard to fractionalize, which might push casual day-traders away from them and into safer stock trading. New issuesWe have talked a lot recently, including yesterday, about the mysteries of initial public offerings. Most IPOs are priced "too low": The offering price at which the company first sells shares to public investors is much lower than the price where the stock ends up once it starts trading; there is a big "IPO pop" on the first day of trading, so the initial buyers make a lot of money. Some IPOs, though, are priced "too high"; they "crack," and immediately trade below the IPO price. My view is that this is mostly because it is hard to know how the market will value a brand-new public stock, even if you go out and ask a bunch of big investors for their orders; the stock market is too fragmented and the valuation is too uncertain to get a lot of science in these numbers. There are other views, though; IPO pricing may be a nefarious plot by investment banks to enrich themselves at the expense of companies and venture capitalists. Either way, though, a lot of people don't like this, and have pushed alternative ways to go public, like direct listings and special purpose acquisition companies. Direct listings and SPACs are (very different) ways to solve this pricing problem, to try to get an initial stock price that better reflects the company's value than the underwriter-chosen price of an IPO. Meanwhile bond offerings are sort of the opposite. There is not much mystery. When a big investment-grade company with a lot of bonds outstanding issues a new bond, you pretty much know how that bond will price. If it is sold at 100 and jumps up to 115 on the first day, something has gone horribly wrong. (Whereas 15% would be a modest, nice, normal IPO pop.) Still there are a lot of similarities; in both IPOs and bond offerings, the process consists of the underwriter banks calling up big investors and asking them for their orders. In the bond market that is changing: There's a new runner in the race to automate the outdated new-issue market for corporate bonds. New York-based electronic trading platform Liquidnet will start its own system for ordering new bonds in Europe later this year, according to a statement Thursday seen by Bloomberg News. It joins an array of fintech startups developing products to overhaul the way bonds are sold. The market for new-issue debt still relies on phone calls, instant messaging and emails to handle billions of dollars in orders and is one of the last corners of finance to experience a digital makeover. But with corporate bond issuance hitting records above $2 trillion in the first half of the year, traditional methods are proving increasingly unwieldy, prompting calls for more automation. "The market is growing with many more new issues on any given day and yet the infrastructure hasn't changed really ever," Constantinos Antoniades, Liquidnet's global head of fixed income, said by phone. "There's no question that the direction of travel is towards a more electronic exchange of information and less voice."
Yeah I mean, right, obviously? It's a pretty straightforward product, putting in orders is pretty mechanical, lots of new issues don't particularly need a lot of hand-selling, why not do the whole thing over computers rather than the phone? Fine, right. The pitch here seems to be mostly operational efficiency—do deals with fewer phone calls, etc.—but I suppose you could make a pricing efficiency argument too. If you do a deal by phone, then only the people who get calls from the bankers can put in orders. If the bankers favor a few big clients, then they might price the deal less efficiently (from the issuer's perspective, i.e. a higher interest rate) than if they canvass everyone. If you build a neutral mechanical computer system that blasts out the deal to everyone and lets everyone put in orders, you might end up with better pricing (for the issuer) than if you use the traditional system. Or not; again, new-issue bond pricing mostly isn't that mysterious. You might apply some of these (obvious) insights to stock offerings! Including IPOs! If you don't like the current mechanism of an IPO, in which banks call up big investors, take orders at different prices, and then apply judgment to decide on what price will "work," you don't have to abandon the IPO entirely for some complicated expensive process like a SPAC. You could imagine a process in which banks blast out the deal to lots of investors, big and small, and let them put in orders in an automated system. The issuer could look at the system and pick whatever price clears the market, without a lot of banker judgment and bias. It might get a higher price, or not (maybe IPO pricing is genuinely hard and investors' orders will be more conservative in a true auction), but it will certainly reduce the risk of nefarious banker bias. This is a very easy process to imagine. It is kind of what Liquidnet is doing with bonds, and it is kind of what Google did in its 2004 auction IPO. I proposed it, last October, as a simpler way for companies and venture capitalists to get what they want from IPOs. If your objection to the IPO mechanism is that it produces low and biased prices, you don't need to throw away the entire concept of the IPO for some weird thing like SPACs; you can instead use a bit of technology to try to improve how IPOs work, to get higher and less biased prices. Things happenInside The Frenetic Days That Changed Argentina's Debt Talks. Trouble at Calpers: Abrupt Exit Hits $400 Billion State Fund. NYSE Owner Agrees to Buy Mortgage-Software Firm Ellie Mae. Fortunes Won and Lost Trading in Kodak Stock: Inside a Wild Week. Wall Street's Top Ranks Look Nothing Like the Nation They Serve. Banking Regulator Fines Capital One $80 Million Over 2019 Hack. ESG Shareholder Engagement and Downside Risk. Sinclair's Sports Empire Was Able to Profit From Canceled Games. Tourist Posing With 200-Year-Old Sculpture Breaks Her Toes. Scientists rename human genes to stop Microsoft Excel from misreading them as dates. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] In fact, "in about 80% of fractional trades, Fidelity says, the customer specifies a dollar amount"; in the rest I guess they specify the fraction. [2] It feels like this sentence in particular cries out for a "not investing advice!" disclaimer. Hertz is bankrupt! Etc. [3] Here's a fun Reddit thread in r/Robinhood, "Do you have to buy all 100 shares in a call?" [4] Obviously you could just sell the option and get back at least the in-the-money amount, this is not a serious problem, but still. [5] This seems to actually be done on Robinhood's balance sheet, though some other retail brokers will instead use an external dealer (a "wholesaler") to do this. | 
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