Dan Awrey

Toward a Supply-Side Theory of Financial Innovation

Innovation. The word is evocative of ideas, products and processes which have somehow made the world a better place. Prior to the global financial crisis, many viewed financial innovation as unequivocally falling into this category. Underpinning this view was a pervasive belief in the self-correcting nature of markets and their consequent optimality as mechanisms for allocating society’s resources. This belief exerted a profound influence on how we regulated financial markets and institutions.

Complexity, Innovation and the Regulation of Modern Financial Markets

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of 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, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions 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. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions. The GFC has exposed 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 the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives – securitization, synthetic exchange-traded funds and collateral swaps – the objective of this paper is thus 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. 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 Dynamics of OTC Derivatives Regulation: Bridging the Public-Private Divide

Over-the-counter (OTC) derivatives have emerged as a global behemoth — the ‘800 pound gorilla’ of modern financial markets. In the wake of both their precipitous growth and prominence in the thick of the current global financial crisis, financial market regulators have found themselves under pressure to enhance their regulation of OTC derivatives markets. This paper explores both the private and social costs and benefits of OTC derivatives and the respective strengths and weaknesses of public and private systems of ordering in pursuit of the optimal mode of regulating OTC derivatives markets. On the basis of this exploration, this paper advocates employing modes of regulation which abandon the largely artificial distinction between public and private ordering, align the incentives of public and private actors and facilitate the long-term transfer of information and expertise between these actors in order to generate more nuanced and responsive regulation and thereby enhance social welfare.

Between Law and Markets: Is There a Role for Culture and Ethics in Financial Regulation?

The limits of markets as mechanisms for constraining socially suboptimal behavior are well documented. Simultaneously, conventional approaches toward the law and regulation are often crude and ineffective mechanisms for containing the social costs of market failure. So where do we turn when both law and markets fail to live up to their social promise? Two possible answers are culture and ethics. In theory, both can help constrain socially undesirable behavior in the vacuum between law and markets. In practice, however, both exhibit manifest shortcomings. To many, this analysis may portend the end of the story. From our perspective, however, it represents a useful point of departure. While neither law nor markets may be particularly well suited to serving as “the conscience of the Square Mile”, it may nevertheless be possible to harness the power of these institutions to carve out a space within which culture and ethics – or, combining the two, a more ethical culture – can play a meaningful role in constraining socially undesirable behavior within the financial services industry. The objective of this article is to explore some of the ways which, in our view, this might be achieved. This exploration takes place across two dimensions. In the first dimension, we hold constant the core internal governance arrangements – corporate objectives, directors’ duties, board composition, committee structures and remuneration policies – within financial institutions. We then examine how the law and markets might be leveraged to engender a more ethical culture in two important areas: bilateral counterparty arrangements and socially excessive risktaking. More specifically, we examine how ‘process-oriented’ regulation – backed by a credible threat of both public enforcement and reputational sanctions – might be employed with a view to reframing personal ethical choices and fostering a more ethical organizational culture within financial services firms. Intuitively, we would expect the success of this strategy to be a function of the incentives generated by existing internal governance arrangements. Lamentably, however, many of these arrangements give primacy to the financial interests of shareholders and managers over those of other stakeholders including, perhaps most importantly, society. In the second dimension, therefore, we examine how we might cultivate a more ethical culture through reforms of the core governance arrangements of financial institutions.

The limits of EU hedge fund regulation

This article examines the mechanics of the recently adopted EU Alternative Investment Fund Managers Directive. On balance, the results of this examination are not encouraging. The EU has failed to mount a persuasive case for why the Directive represents an improvement over existing national regulatory regimes or prevailing market practices in several key areas. Furthermore, by attempting to shoehorn an economically, strategically and operationally diverse population of financial institutions into a single, artificial class of regulated actors, the EU has established what is in many respects a conceptually muddled regulatory regime. Most importantly, however, the Directives approach toward the amelioration of the potential systemic risks associated with alternative investment funds manifests an inherent and ultimately fatal structural flaw. This flaw punctuates the necessity of a globally co-ordinated response toward macro-prudential risks arising within a globally integrated financial system.

The Shadow Payment System

Banking, derivatives, and structured finance may attract the lion’s share of accolades and approbation in global finance – but payment systems are where the money is. Historically, payment systems in most jurisdictions have been legally and operationally intertwined with the conventional banking system. The stability of these payment systems has thus benefited from the unique prudential regulatory strategies governing deposit-taking banks. These strategies include emergency liquidity assistance, deposit guarantee schemes, and special resolution regimes. Importantly, these strategies have the practical effect of relaxing the strict application of corporate insolvency law, thereby enabling banks – and the payment systems embedded within them – to continue to perform payment and other functions even under severe institutional stress.Recent years have witnessed the emergence of a vibrant shadow payment system. This system includes peer-to-peer payment systems such as PayPal, mobile money platforms such as M-Pesa, and crypto-currency exchanges such as Mt. Gox. The defining feature of these shadow payment systems is that they perform many of the same payment functions as conventional banks, but without benefiting from the prudential regulatory strategies that ensure that bank-based payment systems can continue to function during periods of institutional stress. This paper examines the potential risks to shadow payment system customers generated by this functional gap, along with the likely effectiveness of various strategies that these systems currently – or might in future – employ to address these risks.