Complexity, Innovation and the Regulation of Modern Financial Markets

The working paper, Complexity, Innovation and the Regulation of Modern Financial Markets, which was recently made publicly available on SSRN, was motivated by two observations.

First, the perfect market assumptions underpinning the canonical theories of financial economics – modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model, and the efficient market hypothesis – are increasingly unreflective of how many modern financial markets work in practice.  More specifically, these theories share a common and highly stylized view of financial markets, one characterized by perfect information, the absence of transaction costs and rational market participants.  Yet in reality, of course, financial markets rarely (if ever) strictly conform to these assumptions.  Information is costly and unevenly distributed; transaction costs are pervasive, and market participants frequently exhibit cognitive biases and bounded rationality.  Despite these seemingly uncontroversial facts, however, the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.

Second, and somewhat paradoxically given the first observation, the ideology of modern finance has exerted a profound influence on how we regulate financial markets and institutions.  Perhaps most significantly, the pervasive belief in the social desirability of unfettered markets represented the driving force behind the sweeping agenda of financial deregulation witnessed in many jurisdictions in the decades leading up to the GFC.  This market fundamentalism was grounded in the conviction that rational and fully informed market participants – utilizing sophisticated quantitative methods and the innovative financial instruments these methods made possible – had effectively mastered risk.  Public regulation, by implication, was largely relegated to a supporting role: namely, the provision of private property rights and efficient contract enforcement necessary to support private risk-taking.  Ultimately, it was this market fundamentalism which justified turning a blind eye to the potential adverse effects of vast global current account imbalances; acquiescing to the build-up of huge amounts of risk within the so-called ‘shadow banking’ system, and devolving significant responsibility for the design and implementation of capital adequacy standards to the very financial institutions which were ultimately subject to this micro-prudential regulation.

The GFC has revealed the folly of this market fundamentalism as a driver of public policy.  It has also exposed conventional financial theory as fundamentally incomplete.  Perhaps most glaringly, conventional financial theory failed to adequately account for both the complexity of modern financial markets and the nature and pace of financial innovation.   This paper aspires to help rectify these theoretical blind spots: to start us down the path toward a more robust understanding of complexity, financial innovation and the regulatory challenges flowing from the interaction of these powerful market dynamics.  The paper makes two principal contributions toward this end.  First, it articulates a theoretical framework for understanding complexity which conceptualizes it as a function of two variables: information costs and bounded rationality.  It then examines six key drivers of high information costs (and information failure) within modern financial markets and their points of intersection with the cognitive and temporal constraints on our ability to process information.  Second, it advances for the first time a supply-side theory of financial innovation, re-conceptualizing it as a process of change (but not necessarily improvement) influenced by, inter alia, the incentives of the principal innovators: financial intermediaries.

This theoretical exploration is grounded in three case studies drawn from the world of OTC derivatives: securitization, synthetic exchange-traded funds and collateral swaps.  OTC derivatives markets epitomize both the complexity of modern financial markets and the nature and pace of innovation within them.  For this reason, they offer us an illuminating window into the regulatory challenges generated by the interaction of these powerful (and yet poorly understood) market dynamics.  Perhaps not surprisingly, these challenges ultimately stem from the availability and allocation of a single and immensely precious commodity: information.  How costly is it to acquire?  Who has it?  And, importantly, who doesn’t?  The answers to these questions are highly instructive in terms of how we should approach the regulation of OTC derivatives markets – and the broader financial system – going forward.  Ultimately, this paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.

The full paper is available for download here.