Wharton’s David Musto speaks with Wharton Business Daily on SiriusXM about the potential regulatory response to the GameStop trading frenzy.

Could a regulatory overreach in the aftermath of the GameStop trading frenzy hurt stock price discovery for index investors? That is a worry as the Securities and Exchange Commission and the Justice Department investigate alleged market manipulation in GameStop shares in late January. The so-called “short squeeze,” or short sellers being cornered into buying GameStop shares, caused the stock price to soar to levels that many see as unjustified by the company’s fundamentals.

Index investing is a low-cost haven for uninformed investors, and it should be protected as regulators try to prevent market manipulation, according to Wharton finance professor David Musto. “Society benefits from short sellers bringing downward pressure when stocks drift too high,” he said on the Wharton Business Daily radio show on SiriusXM. (Listen to the podcast above.)

In a recent opinion article in Barron’s, Musto and Wharton finance professor Christopher Geczy examine the regulatory path that Treasury Secretary Janet Yellen might follow. They pointed to a seminal paper by Yellen’s husband and Nobel economics laureate George Akerlof on how “asymmetric information” drives price discovery in the market for used cars. In much the same way, “asymmetric information drives bids and asks apart” in the securities markets, they wrote, adding that this concept is likely “to figure in whatever policy response comes next.”

But they urged caution for regulators on that path: “Attempts to prevent squeezes could endanger the price discovery that indexers and others depend on. Traders disagree, and society discovers prices when it lets this disagreement play out.” Musto expanded on those thoughts in his interview with Wharton Business Daily, excerpts of which follow.

Wharton Business Daily: Could you capsulize what you and Chris [Geczy] wrote in the Barron’s article?

David Musto: We look at [the trading frenzy in shares of] GameStop through the lens of one of the most famous papers in economics, which was written by George Akerlof … where he looks at the market for used cars. But people have taken that reasoning and applied it to stocks. What we show is there are several ways in which it helps us think about what happened with GameStop.

The point we’re making there is that if I go trade in the stock market myself, I encounter transaction costs which are driven by the possibility of being an informed trader. When I trade a stock, people [at the other end of the trade] worry that I have inside information. I have to pay a spread because of that, but not if I trade through index funds.

Index funds bring down the cost for retail investors like me to be in the market. [That low cost is] because they don’t charge very much in fees, but also because they also, themselves, trade at very low transaction costs, since they don’t have to pay the spreads that other people pay. [That is why] we invest in index funds. Practically everybody is indexing these days.

But then the problem is when you’re indexing you are just sending your money into stocks at whatever price they happen to be trading for right now, just hoping that other people are doing the hard work of bringing those prices in line with the prospects for those stocks. So, you can free-ride on everyone else doing this hard work. But then once in a while, the price you buy at, as with GameStop, starts to skyrocket out of control. You’re sending your paycheck into a small stock index, and all of a sudden you find yourself paying these crazy prices for stocks.

So then the question is whether this whole [GameStop] episode is an argument for the government to step in and try to suppress the combat that led to these prices going so crazily out of control.

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Wharton Business Daily: You note that short selling benefits the system.

Musto: Yes. If a price starts to drift too high, out of line with the fundamentals of the stock, then people who buy it unwittingly at that price are paying too much. If you’re short selling, you’re trying to make a profit. But if by bringing that downward pressure on the stock, you bring it back in line with its actual prospects, then other people who are just blindly buying the stock at whatever price it’s trading for will benefit. They’re buying the stock at a reasonable price.

The only way to bring it back down to its true value, if it starts drifting too high, is to come in and sell. And if you don’t already own the stock, the only way to do that is to short sell. So, society benefits from the short sellers bringing this downward pressure when stocks drift too high. We benefit from [short sellers] bringing those prices back in line.

“Society benefits from the short sellers bringing downward pressure when stocks drift too high.” –David Musto

Wharton Business Daily: What is the impact of [online trading platform] Robinhood on this entire process?

Musto: Robinhood is the best-known practitioner of gathering retail traders and funneling those traders into the market. It’s been well known for many years that the average retail trade is uninformed — they’re not predictive. Retail purchases do not predict stocks going up. Retail sales do not predict stocks going down.

If I am a trader making a market in stocks, I would love to be on the other side of those trades. I don’t want to be on the other side of people who know what’s happening next. I want to be on the other side of people who don’t know what’s happening next. So, I will pay to be on the other side. Robinhood is focused on this particular sector, ramping up the business of gathering retail trades, selling the right to be on the other side, and taking some of the proceeds from selling it and giving it back to traders in the form of zero commissions.

Wharton Business Daily: What do you think the role of Janet Yellen will be, and that of the government around short selling moving forward?

Musto: This is something to pay attention to when you have the Senate confirmation hearing of Gary Gensler to head the SEC. People look at retail traders who hurt themselves badly in [the GameStop] case. I think this is what people will be talking about at that hearing [and asking], “What do we do about it?” On the other hand, you have the fact that we depend on people’s self-interested buying and selling to bring stock prices in line.

It’s a tough line to walk there. What do you do – if there’s something you can do – that restricts access of traders to put on the trades they want to make, and yet not damage the price discovery that indexers depend on?

You can read Musto’s and Geczy’s article in Barron’s here.