Stock Wall street NYSE
Wall Street is facing the inevitable outcome of decades of lax regulation, cheap money and misguided notions about the efficiency of financial markets. Image Credit: AP

Twenty years ago, Michael Lewis, the Boswell of Wall Street, profiled a 15-year-old from New Jersey, Jonathan Lebed, who had been sanctioned by the Securities and Exchange Commission for using what was then new technology - Internet bulletin boards and online trading platforms - to manipulate the market in penny stocks.

The pump-and-dump schemes had earned at least $800,000 for Lebed, his friends and some very grateful teachers at his high school.

It was a hilarious tale with a serious point: that in publicly touting stocks owned by his friends and clients,Lebed was doing nothing different from what legions of Wall Street analysts did every day.

Orchestrated short squeeze

I was immediately reminded of the piece this week as a similar drama played out on Wall Street, with a group of amateur day traders banding together on social media to execute a short squeeze on some of Wall Street's most successful hedge fund managers.

The reactions have been as comical as they are predictable: Wall Street grandees bemoaning the sophomoric heathens who've turned finance into a video game. Dire warnings from analysts and brokers of painful losses for retail investors. Finance professors bemoaning how the extreme volatility is interfering with the market's "price discovery" process. Angry politicians threatening to hold hearings and clueless regulators promising to investigate.

All week, threats and denunciations lit up social media while readers of mainstream media cannot get enough of the David and Goliath, Silicon Valley vs. Wall Street, and angry-insurrectionists-storming-the-ramparts-of-capitalism narratives. I'd be surprised if Michael Lewis hasn't already inked a seven-digit deal for the book and movie rights.

Outdated regulation

What you need to know about this unfolding morality play is that it is the inevitable outcome of decades of lax regulation, cheap money and misguided notions about the efficiency of financial markets. The result is an oversize and overcompensated financial market that has long since abandoned itsrole to channel savings to the highest and best use, becoming nothing more than a high-tech casino.

Those unschooled in the nuances of modern finance might be forgiven for thinking that a bunch of investors openly conspiring to drive up the price of stocks with the aim to profit from it is a case of market manipulation that ought to be illegal.

But of course, what the Reddit cabal did to inflate the stock of bygone-era companies like GameStop, AMC Entertainment and Bed Bath & Beyond simply mirrored what the hedge fund sharpies had done in conspiring to "short" those same stocks and drive down the prices.

Hedge funds ran for cover

When the day traders won and prices rose rather than fell, the hedge funds had to scramble to buy the shares they did not own but had promised to sell, at a cost of not only billions of dollars but their reputation as the smartest guys in the room.

But in terms of manipulating the market, either both groups engaged in market manipulation or neither did. And the ridiculous thing is that, in the eyes of market regulators - the SEC and its cousin, the Commodity Futures Trading Commission - it's all perfectly legal.

The amateurs are like the pros in two other respects.

In conspiring to drive up the price of stocks, the insurgents made aggressive use of call options - contracts that give them the right to buy the stock over a certain period of time at a higher price from a broker who may not actually own the stock. The advantage of buying the call option rather than the stock itself is that it allows investors to place the same bets at a fraction of the upfront cost, substantially increasing winnings if the price rises. Call options do for investors who think the price of a stock will rise what short sales do for those who think the price will fall.

Note what is happening here. By offering puts and calls and all manner of other fancy derivative contracts, Wall Street makes it possible for investors to wager much more money on each company than the company is actually worth. In effect, multiple bets can be placed on every share. And that, in turn, makes it easier for people to manipulate a stock price and prices to swing wildly when they do. Does anyone other than Wall Street and its regulators think that's an economically or socially useful activity?

Leveraged bets 

The other thing the amateurs and pros have in common is that they placed many of their bets with borrowed money. Margin debt is at record levels for both small and large investors. That is due, in part, to a lax regulatory environment. But even more significantly, it is due to the loose money policy of the Federal Reserve, which over the past decade has injected $8 trillion into the financial system.

The ostensible reason for all this money printing has been to keep the economy out of recession. But much of that cheap money has been used to fuel an orgy of speculation in stocks, bonds, real estate and crypto currency, driving prices to levels that bear less and less relationship to underlying economic value.

Indeed, as the Reddit crowd roiled the market this week, the Fed doubled down on its loose-money policy, reaffirming its intention to continue pumping $120 billion a month into the financial system even after the economy has returned to full employment. Market bubbles? What market bubbles?

While the Fed has provided much of the fuel for the speculation and manipulation running rampant in Wall Street, it is the SEC and CFTC that have enabled it. The SEC's statement Friday that it is looking "to identify potential wrongdoing" offered a wonderful little window into the regulators' pathetic performance in recent decades.

Under both Republican and Democratic leadership, the SEC and CFTC have viewed themselves primarily as a law enforcement agency whose job is to punish those who break rules meant to protect investors. The problem with this cramped, prosecutorial vision of their role is that the rules wind up being so narrowly drawn and literally enforced that they invite the kind of clever workarounds that Wall Street lawyers and traders come up with so they can conform to the letter of the law but not its spirit.

Regulatory failure?

What Congress envisioned when it set up the SEC in the 1930s, and what is so badly needed now, is an agency that takes a broader and more muscular approach to market regulation, one that goes beyond protecting investors and prosecuting wrongdoing to creating healthy and open financial markets that serve the economic needs of the country.

It is a role that is as much about setting the right rules and guardrails and culture for the financial markets than it is about enforcing them.

Such a regulator would be constantly rethinking the role of a public company and public markets and their obligation not just to investors but to other constituencies.

When Wall Street comes up with new products or trading strategies or market-making technologies, competent regulators would ask who loses and who benefits, what risks and economic distortions they might create - and allow only those that serve the broad public interest.

These regulators would have long ago made clear that neither God nor the Constitution gives investors an inalienable right to short any stock, hedge any bet, repackage any bond or engage in any form of computerized trading, no matter its affect on financial or economic stability.

And such regulators would give a higher priority to reducing the frequency and severity of economically harmful booms and buststhan they do to marginally reducing the cost of capital or narrowing the bid-ask spread.

Once one of the most respected agencies in Washington, the SEC and its younger cousin, the CFTC, have abdicated their role as economic policymakers by buying into the free-market fantasy that markets are rational and self-correcting. But as we were reminded again this week by hordes of iPhone-wielding investors, financial markets are prone to herd behavior, manipulation, inside information and undue risk-taking, requiring constant surveillance and aggressive regulation that adapts quickly to changing market conditions and technologies.

If the flat-footed regulators at the SEC and CFTC want to "identify" those responsible for this week's market failures, all they have to do is look in the mirror.