The paper, Towards a Legal Theory of Finance, develops the building blocks for a legal theory of finance (LTF). By placing law at the center of the analysis of financial systems LTF sheds light on the construction of financial markets, their interconnectedness and thus vulnerability to crisis, and situates power where law is elastic or suspended in the name of financial stability. LTF has four elements: It holds that modern financial markets are (1) rule-bound systems; (2) essentially hybrid; (3) beset by the law-finance paradox; (4) and in the last instance subject to discretionary rather than rule-bound actions.
Modern capitalist financial markets do not exist outside rules but are constituted by them. It is possible to distinguish different rules and rule makers, such as private and public ones. This may create the impression that finance can be fully supported by private, or self-regulatory, arrangements. There is, however, no financial system of substantial scale that is not backed by a formal legal system with the capacity to authoritatively vindicate the rights and obligations of contractual parties or to lend its coercive powers to the enforcement of such claims. The credibility and value of financial contracts, or IOUs, and the size and viability of markets on which they trade relies on such backing even in case rulemaking has been delegated to private actors.
Anyone can issue IOUs, whether public or private. But not all IOUs find takers at all times; even those that do initially may not be sellable at a future date when liquidity shortages privilege cash or cash substitutes. Cash, of course, is the legal tender that states, not private parties, alone can issue. This official money is the default currency and the benchmark for valuing other assets traded in the economy. Final settlement between financial institutions and between them and the central bank is done in the official legal tender or close substitutes (government bonds). Money is also the currency used by the government to make its (domestic) payments and collect on its claims, including its tax claims. Last but not least, when financial systems face collapse only a backstop with unlimited access to high-powered money can stabilize the system. Only sovereigns with coordination capacity and tax authority meet these requirements as private entities by definition operate under hard budget constraints. In short, financial systems are not state or market, private or public, but always and necessarily both.
The Law-Finance Paradox
Law lends credibility to financial instruments by casting the shadow of coercive enforceability over them. But the actual enforcement of all legal commitments made in the past irrespective of changes in circumstances would inevitably bring down the financial system. If, however, the full force of law is relaxed or suspended to take account of such change, the credibility law lends to finance in the first place is undermined. Individual market participants will seek to protect themselves against the vagaries of fragile finance. They will enter into hedging transactions or buy insurance that places the burden of future loss on their counterparties. When too many rely on insurance of this kind and the event that triggers payout actually materializes (irrespective of the low probability assigned to it), these legal mechanisms set the system on autopilot to self-destruction. At this point the system can be saved only by relaxing or suspending the full force of law: By making funding available where no funding is owed and by bailing out intermediaries that should be liquidated in accordance with the law.
The Elasticity of Law and the Location of Power
Law is not equally binding throughout the system. It can be designed to be more or less elastic. Yet, the relative elasticity of law is not random. It is inversely related to the hierarchy of finance, which is determined by the differential access different actors have to liquidity. The law-finance paradox tends to be resolved by suspending the full force of law where the survival of the system is at stake, that is, at its core. Here, power becomes salient. Still, power is exercised throughout the financial system. It is exercised by those who have the resources to extend support to others without being legally obliged to do so, whether public or private. Those who have access to central bank liquidity are better placed to backstop other private actors than those that don’t. Those who have access to unlimited resources have the most power: Sovereigns with control over their own currency and debt. The absence of any of these conditions can undermine the credibility of a sovereign as effective lender of last resort and places them closer to the periphery of the global financial system.
LTF demands a reorientation of regulatory strategies. Rather than focusing exclusively on legal commitments and ex ante rule making, it calls for a shift of attention to the sources of financial instability and its management. The former requires closer monitoring of the creation of liquidity by private and public actors; the latter for more safety valves for enhancing the elasticity of law not only at the core, but also at the periphery of the financial system.
The full paper is available for download here.