Mechanisms of Market Efficiency

Kathryn Judge is a professor at Columbia Law School. This post is based on her recent article, forthcoming in the Journal of Corporation Law.

Today’s financial markets are awash with instruments that holders accept at face value with minimal investigation into the quality of the underlying assets. Sometimes this is because everyone trusts the issuer. U.S. Treasuries are a prime example. But the demand for so-called “safe assets” often exceeds the volume of truly safe assets available. When this happens, private actors step in to bridge the gap. Traditionally, it was banks that played this role, and bank deposits continue to be among the most pervasive privately issued safe assets in the financial system. Over the last few decades, however, the capital markets have become increasingly important in the production of safe assets. Mechanisms of market inefficiency—structures that impede or otherwise discourage information generation—have been critical to this rise. These dynamics, and the questions they raise, are the topic of my new essay, The New Mechanisms of Market Inefficiency, forthcoming in the Journal of Corporation Law. Starting from the assumption that safe assets are useful when times are good but can exacerbate shocks when conditions deteriorate, the essay shows the need for an institutional account of how mechanisms of market inefficiency operate across good states and bad and the distinct challenges that they pose during periods of transition.

To understand why such an account is lacking despite the pervasiveness of mechanisms of market inefficiency and the threat that they pose to the resilience of the financial system, a little background is helpful. The literature on so-called safe assets comes largely from economists. Arvind Krishnamurthy, Annette Vissing-Jorgensen, Gary Gorton, and Andrew Metrick are among those who have contributed to the growing body of empirical work documenting the persistent demand for seemingly safe assets. They and others have shown that the demand is most pronounced for short-term safe assets, and that the production and pricing of private safe assets varies in accord with the supply of public ones, like Treasuries. An overlapping group of economists have formalized why holders are willing to treat particular assets as safe, showing how overcollateralization coupled with opacity can discourage private information generation and promote liquidity.

Most legal academics, meanwhile, have been engaged in a very different conversation. Ronald Gilson and Reinier Kraakman have been guiding lights in this domain for nearly forty years now. Their classic 1984 article, The Mechanisms of Market Efficiency, has served as a foundation for generation of literature on the layered interactions among different types of actors in capital markets, the ways these interactions can incent information generation and promote relative informational efficiency, and the frictions impeding information generation that warrant regulatory intervention. The institutions through which theories become manifest—or fail to have predictive power—in the real-world is central to this conversation. The normative assumption was, and often still is, that efficiency is the aim and regulators ought to use whatever tools they have toward that aim.

So long as the production of safe, or information-insensitive, assets was reserved to banks, these conversations remained distinct. The challenge—and the reason these two conversations now must converge—lies in the rise of market-based intermediation, aka 21st century “shadow banking.” As is now widely recognized, in the decades leading up to the crisis, the maturity and liquidity transformation and “money” creation that had once been the bastion of banks increasingly took place through an interconnected web of market-based entities and instruments. “Banking” was now happening not just outside banks, as it had with the trust companies in early 1900s, but outside of individual entities that could be made subject to prudential regulation. It is this system, which evolved but did not go away after the crisis, that has put these two previously separate conversations on a collision course. So far, the interactions between the two have been less than productive. Economists, including Gorton and Holmstrom, have criticized calls by leading legal academics for greater transparency and discipline. They have argued, with some basis, that many of the calls for transparency and market discipline fail to take into account the distinct utility “safe assets” and value of the mechanisms of market inefficiency that enable their production. Legal academics have left themselves vulnerable to such attacks by continuing to assume that efficiency should be the aim, even if acknowledging that the frictions are far greater than anyone recognized when the notion first came into vogue.

The burgeoning literature on safe assets, however, does still have an important lesson to learn from the work of legal academics like Gilson and Kraakman. Contrary to common belief, their core claim in The Mechanisms of Market Efficiency was not about efficiency, but about institutions. They sought to provide an account of the way different types of actors interact to produce a particular outcome, roughly efficient markets, and to illustrate that institutions and information costs always matter. It is this insight, rather than the normative assumption to which it is often married, that can create the needed bridge.

The New Mechanisms of Market Inefficiency reveals the hard work that has yet to be done and lays the foundation for the bridge that must be created for the work to progress. The evidence regarding both the pervasiveness and utility of “safe assets” is too plentiful to ignore or downplay. At the same time, Gilson and Kraakman’s core insight that institutions matter, always and everywhere, remains as pertinent as ever. Those institutions cannot change course on a dime. Whether designed to promote or impede efficiency, market outcomes are achieved through a complex set of interactions. This is why market dysfunction so often follows when information-insensitive assets cease to be accepted as such.

Scholars who embrace the information-insensitivity paradigm acknowledge this. But they have yet to provide a robust institutional account of how to nest the issuance of “safe assets” or “money” in a market-based system when there are necessarily loss-absorbing, and hence information-sensitive, instruments, underneath. In today’s capital markets, the safe are built on top of the risky and the risky enable the safe. This means that there are strong incentives to produce information that will inevitably, some of the time, be relevant to the safe assets that are designed to deter just such diligence.

It has taken decades of trial and error in the banking domain to devise a crude, but workable, set of institutions for bifurcating safe and risky assets when both are backed by the same underlying pool of debt instruments. This entails both standing tools, like supervision, deposit insurance, and capital requirements, and crisis-time ones, like the capacity of the Federal Reserve to provide emergency liquidity when banks need it. We are nowhere near devising a similarly robust set of institutions to deal with the inherent fragility that arises from the issuance of “safe assets” in the capital markets. The failure to address head-on the question of how best to sow mechanisms of market inefficiency in capital markets has had the additional, unintended and adverse, consequence of increasing the government’s role in backstopping the financial system. The New Mechanisms of Market Inefficiency does not provide answers to these difficult questions, but it does show why they are so pressing and the bridges that might enable them to be addressed in the years ahead.

The complete article is available for download here.

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