Tuesday, November 5, 2019
Professor Kathryn Judge recently posted an essay, The New Mechanisms of Market Inefficiency (here), forthcoming in the Journal of Corporation Law. It is a fascinating read, in addition to being a beautifully written piece. As a banking law scholar, I’m familiar with the concept of and demand for information insensitive assets/money-like assets/safe assets/money (overlapping terms, as Judge notes). However, this essay challenged me to think more deeply about the delicate interplay in financial markets between such assets and “information sensitive” ones, and about mechanisms fostering market efficiency and those supporting market inefficiency. For example, Judge explains that “in order to produce some assets that are insensitive to information, markets also produce other subordinated assets that are backed by the same pool of assets and that are very sensitive to changes in the value of those assets. As a result, domains of ‘information insensitivity’ are almost always nested on top of information sensitive domains and the border between the two is far from stable.” (p.6)
Ultimately, this essay’s purpose is not to answer a number of “fundamental and as yet unanswered questions about the health and functioning of today’s capital markets” (p.4), but rather to reveal their importance, and lay a foundation for asking them. For legal scholars working in this area, and thinking about important and interesting issues to tackle next, Judge’s essay would be a great place to start. Here’s the abstract:
Mechanisms of market inefficiency are some of the most important and least understood institutions in financial markets today. A growing body of empirical work reveals a strong and persistent demand for “safe assets,” financial instruments that are sufficiently low risk and opaque that holders readily accept them at face value. The production of such assets, and the willingness of holders to treat them as information insensitive, depends on the existence of mechanisms that promote faith in the value of the underlying assets while simultaneously discouraging information production specific to the value of those assets. Such mechanisms include private arrangements, like securitization structures that repackage cash flows from debt instruments to produce new financial instruments that are less risky and more opaque than the underlying debt, and public ones, like the rules allowing many money market mutual funds to use a net asset value of $1.00. This essay argues that recognizing these mechanisms of market inefficiency as such is a critical first step in devising policy interventions that achieve desired aims. This runs counter to the instincts of many market regulators, like the Securities and Exchange Commission, and academics who have often assumed that markets should be structured to promote information generation and efficiency.
The essay further shows, however, that defenders of the information-insensitive paradigm have failed to provide a robust institutional account of how those mechanisms can remain robust across different states of the world or the government support required if they cannot. When an adverse shock or other signal raises questions about the value of the assets underlying an information-insensitive instrument, market participants can refuse, en masse, to treat those instruments as safe. Unless the government or some other actor can provide credible information about the value of the underlying assets or financial support that renders such information irrelevant, widespread market dysfunction can follow. When that happens, the very mechanisms of market inefficiency that had enabled a market to develop can exacerbate dysfunction. Following Ronald Gilson and Reineer Kraakman’s admonishment that institutions always matter, this essay calls for the development of rich institutional accounts of how the mechanisms of market inefficiency work, when and how they can fail, and what these dynamics reveal about the role regulators should play in these domains.