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.
The New Mechanisms of Market Inefficiency,
Journal of Corporation Law, forthcoming; European Corporate Governance Institute (ECGI) Law Working Paper No. 480/2019; Columbia University School of Law, The Center for Law & Economic Studies Working Paper No. 608
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