In a paper just posted on SSRN, Cornell PhD student Young-Jun Cho and I assess the performance of a stock market called SLCapex.  From the abstract:

SLCapex is a stock exchange owned and operated by “residents” of the online virtual world Second Life. Despite its almost complete lack of regulation and legal protections against fraud or insider trading, issuers were able to raise approximately US$145,000 from investors, which grew to US$900,000 in market value before plummeting, resulting in overall investor returns of -71%. Investors in large issuances lost more than investors in small issuances, and small investors experienced more severe losses relative to large investors when more money was at stake, suggesting that the market did a poor job of protecting investors from issuers and of providing a level playing field for investors. Theories from financial economics can explain the markets’ poor performance in the absence of regulatory and legal institutions, but cannot easily explain why issuers were able to raise capital in such a setting.

Traditional economic theory tells us that firms that can’t provide credible financial reporting and other investor protections won’t be able to raise capital, because investors protect themselves from the obvious risks of fraud.  This reasoning is the bedrock of libertarian-style claims that market regulation is unnecessary.  But laboratory research shows repeatedly that people fail to protect themselves from risks of exploitation.  Sometimes people trade too much (violating the Milgrom-Stokey no-trade theorem by exposing themselves to others with better information).  My favorite example is a paper by Forsythe, Lundholm and Reitz (JF 1999) that was once called the “half-a-sucker” paper.  Why?  It showed that in the absence of credible standards against overreporting asset values, sellers would indeed overreport and buyers would believe them, to their detriment.  But since the buyers and the sellers were the same people–they alternated between acting as buyers and acting as sellers–the authors modified a famous quote, noting that half-a-sucker is born every minute.

The paper on SLCapex suggests that another famous quote could be modified.  Why would issuers try to raise capital in a market with no investor protections?  Because you can fool all of the people some of the time, and and some of the people all of the time–and that is more than enough to make it worth trying to do so.

And that, in turn, is enough to make it worth imposing regulations that wouldn’t be necessarily if the traditional assumptions of economic theory were valid.