Goldman Sachs and the problem of regulatory flight

January 13, 2011: 2:34 PM ET

With its Facebook deal, Goldman found favorable reception in an unregulated corner of the securities market, further widening the divide between the haves and the will-never-haves.

By Moshe Silver, Hedgeye

Applying standard measures, professional economists assure us the economy emerged from the Great Recession in June of 2009. You couldn't prove that by looking at real levels of current unemployment in excess of 10%, at millions of Americans who have lost their homes, or at the fact that real incomes have fallen to a degree not experienced since the Depression.

The financial revolution that got us here, much like the industrial revolution, rested on an explosion of brilliant creativity. Rather than the steam engine, the financial revolution gave us mortgage-backed securities, CDOs and high-frequency trading. But its transformational effects on the world have been no less powerful, nor has it done anything to bridge the gaps of social inequality.

This became apparent yet again when Goldman Sachs (GS) recently found itself so overwhelmed by orders for Facebook shares that it closed its order book prematurely. Goldman availed itself of a standard parallel market structure, in which a special purpose investment vehicle purchases the Facebook shares, and private investors buy shares in the vehicle. Predictably, Goldman partners get a better deal than others – though we would hardly call any of the prospective buyers "the general public."

One of the greatest frustrations of regulating the securities markets has been regulatory flight. In the debate over global financial regulation, the argument is often raised that, if regulation is not uniform, investment will flee to more restrictive jurisdictions and move to more laissez faire countries. This is a red herring.

What we call regulatory flight doesn't mean moving your business to a jurisdiction where the regulation is more favorable -- it means finding a form of business that is not regulated at all. For instance, the proliferation of hedge funds is the direct result of a lack of regulation of private investment partnerships. While the entities with whom they do business are highly regulated – banks, brokerage firms, investment banks and stock exchanges, to name a few – the unregulated tail powerfully wags the dog, as revealed when Long Term Capital created a black hole in the world's financial system.

Leaving out the little guy

The Facebook-Goldman alliance is perfect in this regard: it allows two of the most powerful organizations on the planet to micromanage the value of their asset. And it allows them to reward the select of the select – that one-tenth of one percent, the Mega-Haves – while enforcing cooperation. Without the price discipline of the marketplace or the ability to freely trade one's shares, Goldman and its client retain effective control of the value of the enterprise.

At the same time that Goldman began running this private offering, the SEC blessed the nation's first private stock exchange. There have long been firms making a secondary market in private placement interests. Now Xpert Financial of San Mateo, CA, a registered broker dealer, will offer an electronic trading platform for unlisted equities. It will also offer equity direct to private investors in a form of venture capital. A two-tiered marketplace has now officially emerged for a two-tiered economy. The SEC has blessed this arrangement that formally divides the investment marketplace into the haves, and the will-never-haves.

It can fairly be argued that these developments represent a necessary change in a securities market that has failed to keep up with the times. They also create a yawning chasm between the wealthiest investors and everyone else. Indeed, as transactions such as Facebook are offered privately by Goldman and then trade privately on Xpert, an ever-increasing percentage of the investing population recedes into the Everyone Else category.

Innovations are driven by the elite – in brains, in ambition, and in money – but in order for society to remain robust, the benefit of those innovations must accrue to all. In a dynamic society, this would mean small businesses would also be able to offer equity on Xpert, and small investors would be able to band together to make venture capital available to enterprises they understand, such as the local butcher, baker, or candlestick maker.

Instead, the retailization of markets such as Xpert will likely only come when the wealthiest investors need distribution for their illiquid purchases. Watch for the day when your aunt calls to tell you her broker recommends she buy a fractional share of Facebook as part of a group of investors.

Also on Fortune.com:

Yes, there is still Facebook stock for sale

Timeline: Where Facebook got its funding

Will Goldman deliver on glasnost?

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Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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