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Facebook Fiasco Damages U.S. Markets

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The Facebook initial public offering fiasco is just the latest in a string of events that have seriously damaged the credibility of U.S. equity markets.

The exodus of retail customers from our stock markets is the most obvious and dangerous indication of this loss of credibility. Too many things have happened in recent years that cast doubt on the integrity of our markets. That's bad news for long-term investors. It's bad news for growing businesses that need access to financial markets to raise capital. And it is especially bad news for a country that owes much of it economic power to its reputation for honest and transparent markets.

The Facebook IPO was a mess in many ways; we may know more when the inevitable investigations are completed. But there is no question that, just before the stock offering, the analysts for the firms responsible for the sale revised their earnings estimates for Facebook downward, and shared that information with favored customers. If you bought the stock based on earlier analyst forecasts, tough luck. What's more, according to lawyers I talk to, the analysts did nothing that is now considered illegal.

Has Wall Street become, in the words of some traders at Goldman Sachs, a "rip your face off" culture, in which customers are there to be fleeced? As much as we hope that isn't true, the signs aren't good. There have been some high-profile convictions in insider trading cases in the past few months, but the message they send is that it takes really flagrant examples to be prosecuted. If you define insider trading as "using non-public knowledge to buy or sell securities," most people I know on Wall Street concede it happens every day.

Yes, there has always been insider trading, and abuses caused by greed are nothing new. But things have gotten much worse in the past few years. Back in the early 2000s, the Securities and Exchange Commission pretty much decided there was no need for major financial regulation. It eliminated the "uptick rule," which had been instrumental in helping to control market attacks by predatory bears since its inception in 1938. It put in place some new rules that made the investigation and prosecution of stock swindlers very difficult. Bernie Madoff did more than ruin his own clients; he put another nail in the coffin of individual trust in our markets.

Congress didn't help when it passed the Commodity Futures Modernization Act of 2000, which deregulated all over-the-counter derivative trading. This led the way to the widespread use of what Warren Buffet has called "financial weapons of mass destruction." Trading in derivatives was complicit in the 2008 failures of Lehman Brothers, Bear Stearns, AIG, the Royal Bank of Scotland, and the nation of Iceland. In fact, it came close to bringing down the entire world financial system.

While all of this deregulation was going on, our equity markets were expanding. With no real oversight by the SEC, we moved from trading at essentially two highly regulated exchanges, the New York Stock Exchange and the NASDAQ, to 15 exchanges and over 50 "dark pools"or other trading platforms. Dark pools are where big institutional customers often go to trade huge blocks of stock, out of the public eye. Individual investors no longer know how many shares are traded of different stocks, or even at what price they last traded.

At the same time, again with no regulatory investigation or oversight, High Frequency Trading grew rapidly so that it is responsible for a majority of stock trades. HFT uses mathematical algorithms to run computer programs that execute thousands of trades in less than a second. On May 6, 2010 the computers malfunctioned and the markets had a flash crash where the Dow Jones Industrial average fell by 1,000 points in minutes. Long term individual investors, already concerned that HFT might give large institutional investors an edge, took note.

There is a very strong ongoing Wall Street lobbying effort that labels any attempt to regulate anything they do as "anti-capitalist." That's self-destructive nonsense. I am a fervent believer in capitalism and free markets. I also believe that if investors think the system is rigged against them, those Wall Street types will have effectively killed the goose that lays their golden eggs.

The only way we can ensure that our markets are honest, transparent, and credible is to hire tough policemen and give them the tools needed for effective regulation. We have had warning after warning. If we are going to preserve the kind of markets that helped build this country, we must act soon.

Ted Kaufman is a former U.S. Senator from Delaware. Please visit www.tedkaufman.com for more information. This piece first appeared in the Wilmington News Journal.