John Flood’s recommendation of Julia Black’s recent paper “Empirical Legal Studies in Financial Markets: What Have We Learned?” has proven to be a gem! While we are hunting for our research questions in various areas of financial market regulation, this paper is a must-read! In short, it provides a useful insight into the current state of empirical studies concerning the interaction of law, regulation, and financial markets in four major areas or research questions:
- what is the impact of law and regulation on financial markets?
- what is the impact of financial markets on law and regulation?
- what are the impacts of different understandings of behaviour of actors within the markets for using law and regulation as an instrument to affect the operation of markets?
- what are the dynamics of the regulatory regimes for financial markets?
One of the under-researched areas cited in the paper is the unintended impact of law and regulation on the markets. A good example of such an impact is an emergence of money market funds in the U.S. in early 70s. As we all know from my talk on Feb. 12th, money market funds came about as a by-product of the legal restrictions, or Regulation Q, on how much interest banks could pay to their depositors. Law has been a significant source of inspiration and innovation for the development of many more new financial instruments.
One of the most exciting areas to look at is the markets as a source of law. The paper cites a number of high quality studies on the subject suggesting “that lawyers have been absent in the development of some financial markets.” Markets can function in the absence of law. There are studies of non-contractual relations in business even if the parties have a formal legal contract in place. One example that comes to my mind is the fact that sponsors, or investment advisors, in the U.S. language, have an established tradition of purchasing impaired securities out of money market fund portfolios. They do so to maintain a constant share price and avoid passing losses on the fund’s shareholders even though the legal contract, which is the fund’s prospectus, explicitly states that “the fund is not insured or guaranteed and it is possible to lose money investing in a money market fund.” Yet, while there is no shortage of such examples, the paper concludes that “the dynamics of the production of contemporary financial ‘merchant’ law are under-researched.”
Impacts of behavioral aspects on the markets, law and regulation is a relatively new and a quite significant area of research, which adds enormous complexity to the regulator-market dance: “regulated firms adapt to legal and regulatory requirements in unpredictable ways, giving rise to unintended consequences, to which regulators in turn react and respond, to which firms in turn adapt and respond in a dynamic, never-ending, iterative process.” The paper cites a number of studies in this area produced mainly by finance and economics scholars. There are also works mentioned providing insights into the studies of the dynamics of regulation: competition and practices. The paper concludes drawing our attention to existing “academic silos” in different aspects of research of the same phenomenon and “methodological biases and cognitive assumptions of the researches themselves.”
We are looking at a complex, dynamic and unpredictable relationship between law and markets as an area of study. Julia Black’s paper is a great help in making sense of it!