Everybody’s talking about Goldman Sachs’ deal to invest $450 million of its own capital in Facebook and to raise another $1.5 billion from its wealthy clients to do the same. The deal raises fascinating questions. Does it violate the Volcker rule (a provision in the 2010 Dodd-Frank financial reform bill named after its proponent, former Federal Reserve Chairman Paul Volcker), which is meant to limit the amount of money banks may risk in proprietary investments? Probably not. Is the deal’s structure, which presents that $1.5 billion as coming from a single investor, a way to game the Securities and Exchange Commission rules requiring companies with more than 499 investors (as Facebook would be if each investor were counted individually) to file financial statements as a public company would? Of course!
But the true fascination in this deal is that somebody is getting something most of us can’t have. You need multiple millions to invest your money at Goldman Sachs. (The firm doesn’t disclose precisely how much, which brings to mind the old adage, “If you have to ask, you can’t afford it.”) These very wealthy clients are stampeding to make a (relatively) early-stage investment in a smoking-hot company. Who wouldn’t do the same, given the chance? While Goldman does have mutual funds for non-millionaires, these average Joes won’t get any Facebook shares. (Did you even have to ask?)
Goldman’s Facebook deal is just one more piece of evidence that the claim Wall Street’s made repeatedly over the last two decades—average individual investors can compete on a level playing field with the big boys!—is total bunk. The regulators have sometimes, sort of, tried to make it true, but these efforts have either failed or made things worse.
The last time there was an investor frenzy surrounding start-up Internet companies was during the late-1990s dot-com bubble. After it burst and many individual investors lost most of their money, it turned out that the “research analysts” working for Wall Street investment banks, who had been telling investors that stocks could double, triple, fly to the moon, were doing so not because they believed it was true, but because saying so could help their firms win lucrative investment-banking business. Meanwhile, big investors were often getting advance notice of important information from companies.
To solve this problem, the Securities and Exchange Commission in 2000 implemented “Regulation Fair Disclosure” (otherwise known as Reg FD). This rule required companies to disclose material information to all investors at the same time. Elaborate mechanisms were put in place to prevent research analysts from being influenced by the bankers. In addition, the SEC made Wall Street firms pay a $1.4 billion settlement. Goldman’s share was $110 million.
Did the world became a better, safer place? Um, no. Rather than improve their research departments, brokerage firms made them a backwater, so the quality of information available to average investors went down, not up. At the same time, so-called “expert networks” sprouted. These are firms that specialize in putting big investors, particularly hedge funds, in touch with “experts”—maybe in the medical community, or inside technology firms—to help those big investors get an informational edge on everyone else. The SEC and the Justice Department are currently trying to figure out how much of that information qualifies as insider trading. Even if most of it doesn’t, it’s perfectly clear that big investors found a new way to keep—actually, to increase—their edge.
You don’t have to be a cynic to wonder whether the Goldman-Facebook deal is just Wall Street’s latest trick to inflate stocks in the post-2008 financial market. Using research analysts to whip individual investors into a frenzy is no longer kosher, so maybe the new method is to create such an aura of exclusivity that by the time Facebook does go public, investors will be absolutely crazed, allowing Goldman and the others to sell their stakes at a high price.
During the past four decades regulators made various changes to introduce greater competition into the stock market, with the idea that a more competitive market would be more hospitable to individual investors. Before 1975, the commissions that big Wall Street firms charged to trade shares were fixed, and they were fixed at a high level. That made trading a relatively easy, lucrative business. Then the commissions were deregulated, opening the door to upstarts, like discount brokerage firms. In 1998, the Securities and Exchange Commission allowed the use of “alternative trading systems,” which competed directly with established exchanges like the New York Stock Exchange and Nasdaq. In 2005 the SEC basically endorsed automated trading. Anyone with a computer would be able to start a trading platform. All these changes were supposed to level the playing field between the big guys and the little guys.
But it turns out that all orders to buy and sell stock aren’t created equal. In recent years, the SEC’s rule changes have enabled “dark pools,” or private markets where big investors can trade their shares without tipping off outsiders, to become a big chunk of the market. (Like most brokerage firms, Goldman owns a dark pool.) According to the Wall Street Journal, such markets accounted for fully one in three U.S. stock trades in December. The arrangement makes a certain amount of sense for big investors because in a market where other traders constantly try to capitalize on big investors’ positions, anonymity can let the big guys execute their trades more efficiently. But critics worry that the rise of these walled-off trading systems makes prices less transparent and accurate for everybody else. In November 2009, the SEC proposed rules on dark pool trading, but the agency has yet to make any final decisions.
Wall Street firms also have the advantage of faster computer systems able to keep track of a market accelerating ever faster. These systems are better than anything any individual could hope to access. Traders now engage in something called high-frequency trading, which uses automated computer programs to process all sorts of information faster than any mere human ever could. High-frequency traders argue that they increase liquidity, but critics say that they create a two-tiered system in which those with access to this technology can steal returns from those without—usually individual investors. A variation on high-frequency trading is “flash trading,” which allows privileged traders to see buy and sell orders before they are transmitted to the broader market, which is patently unfair. Many people believe the “flash crash” last spring, in which the market basically seized up, confirmed some of the dangers of this newly automated world. (In 2009, the SEC moved to ban flash trading, and in early 2010 it asked for comments on market-structure rules, but the agency has yet to take action on either proposal.)
Do you even need to ask whether Goldman is a major player in high-frequency trading?
I could continue, but let’s end on a happy note. There actually is a silver lining in some of this, which is that distinctions between big investors and little investors aren’t always real. You can’t compete because you’re a little guy. But your pension fund or your mutual fund is a big guy—a big guy made up of lots of little guys—and therefore might benefit from a venture-capital investment you can’t access on your own, or from dark pools.
Conceivably we will one day look back at the Goldman-Facebook deal and smirk with schadenfreude. Goldman’s big investors aren’t getting Facebook on the cheap. According to the New York Times, the deal values Facebook at $50 billion, nearly twice the $27 billion that Google was worth after its first day as a public company. Goldman’s clients are also paying up for the privilege—Goldman will collect a 4 percent up-front fee and 5 percent of any profits, according to the Times. In other words, even Goldman’s wealthiest clients aren’t guaranteed a killing. Only Goldman is. Which is yet another reason that it’s good to be Goldman Sachs.