Discussing the Legal Theory of Finance (LTF) on the Marketplace of Ideas has been a great experience. I want to thank my colleague Kathryn Judge for coming up with the idea and for writing an inspiring blog post that raises important questions about the content and boundaries of the theory’s core features. The response to the call for blog posts from practitioners and academics was equally uplifting – and I am extremely grateful to the contributors for their engagement with LTF and the critiques they offered. Thanks also to Jason Parsont who manages the CLS Blue Sky Blog and kept us on track.
Most reassuring but also most humbling to me was that virtually all contributors bought into LTF’s basic framework. Reassuring, because it suggests that there is common ground; that we can find agreement on how to look at the world and in fact see similar things. I did hear the “duh” rumbling between the lines, though – and not only in the pieces written by lawyers, but remarkably also by James Sweeney – an economist who actually practices finance. A kind interpretation is that LTF is an “inductive” theory (Richard Shamos) grounded in and informed by the operation of actual markets. Those who are familiar with real markets should therefore be inclined to buy into the framework; those who are not, never saw and still don’t see a need to rethink.
Yet, the broad buy-in raises the specter that LTF states the obvious: Financial markets are legally constructed; under conditions of uncertainty and liquidity volatility they can self-destruct and are rescued only if law’s binding force is relaxed ex post; jointly, these factors make financial markets essentially hybrid between state and markets, public and private. Even more humbling I find that most contributors emphasized the considerable challenges LTF poses for regulation, legal practice, even to widely-held theories such as incomplete contract theory (Bruno Meyerhof Salama and Osny da Silva Filho). Perhaps LTF is trivial, but its implications seem anything but.
Cathy Kaplan wisely suggests that LTF is only the beginning. If law is indeed endogenous to finance and the nature of financial markets changes as they are regulated and as market participants respond to those regulations with financial innovation – how can we govern them? How should we begin to address the many inadvertent effects that a seemingly benign intervention, such as the extension of government guarantees for securitized mortgages from poor to not so poor households might have on markets for asset backed securities? What safety valves should we build into our regulatory and contractual frameworks to avoid the problem that the system finds itself too frequently on the edge of self-destruction? What institutional forms should these safety valves take? When and why might a common law, reactive judicial approach work – as Jeremiah Pam proposes for sovereign debt restructuring – and when and why would we need more proactive solutions and how should they look? How do we respond to the strong call from the financial sector and their attorneys for consistency of laws and regulations over time and across legal systems, if the financial system is not static but more akin to a boat that is constantly rebuilt at open sea, where rules are constantly altered as the game is being played (Salama and Osny) – and not only by regulators but also by market participants who seek a competitive edge from innovative finance? Which rules should be held constant or made consistent and which should be responsive to the ever-changing market? Who gets to decide? How much emphasis should we place as a normative matter on “free” markets (Richard Shamos) when in legally constructed markets this freedom stands primarily for the ingenuity of financial lawyers to exploit arbitrage opportunities that multiple legal regimes offer to clients who are rationally oblivious to the effects their actions might have on the stability of the system? How are we to regulate “shadow banking” when the entire financial system and not only its shadows has come to rely extensively on “money market funding of capital market lending” – the very essence of shadow banking (Sweeney in his co-authored work on shadow banks)? What position should an organization like the IMF (were it not politically constrained by its largest shareholder) take on sovereign debt contracts, their restructuring or interpretation and enforcement in courts when the contractual choices have manifest implications for the very structure of global sovereign debt markets (Anna Gelpern)? How would a sovereign bankruptcy regime alter this market, and the markets for other securities that explicitly reference sovereign bonds? Last but not least, how should we govern central banks, the lender of last resort and critical lubricator of our shadow banking system? Should they be given explicit legal backing for extending liquidity if and when needed at their own behest? In that case the question pondered by Kathryn Judge, her commentator, Rohan Grey, and Jeremiah Pam, whether such actions are akin to or different from the elasticity of law would not even have to be raised. Clearly, a blank check would alleviate the need for a central bank to ever suspend legal constraints. Giving such a blank check, however, would fundamentally alter one of the constitutive (Salama and Osny) if unwritten rules of capitalism: the existence of a hard, non-negotiable budget constraint for private entities. Neither would it eliminate the critical implication of law’s elasticity: that the power to choose the beneficiaries of liquidity has distributional effects and is therefore inherently political.
These are difficult questions with no easy answers; and they only scratch at the surface of the kinds of issues LTF needs to address. We still have little grasp of the detailed legal structure of financial markets as a descriptive matter, the many interdependencies built into financial contracts made in the past, much less know how financial innovation in the aftermath of the crisis will affect them in the future.
Take the example of OTC derivatives markets and the attempt to make them less opaque and risky by shifting more derivatives to exchanges and interspersing clearing houses between the contractual parties. Will this enhance stability or expose these markets to new liquidity risks – once one looks at the broader picture of legally constructed, interdependent financial markets and includes the critical role of sovereign bonds for these markets and the agencies that trade them – as recently suggested by Colleen Baker in the pages of this Blog? And what are the new frontiers in financial innovation that will take the place of OTC derivatives in providing intermediaries with hefty fee-based income for widely traded instruments? How will they shape our constantly evolving financial system?
Luckily, we have a program in place that will help us deepen our understanding of finance’s legal structure and provide answers to at least some of the questions posed above. Columbia Law School is collaborating with Frankfurt and Oxford Universities in the Global Law in Finance Network (GLawFiN), which sponsors doctoral students in law and finance to explore the ramifications of LTF. See here. The first three students – one each at Columbia, Frankfurt and Oxford – are starting this fall. We hope others in academia and practice will follow the call for deciphering the complex legal structures that comprise our global financial system or offer advice for doing so. Please send any suggestions to my attention at email@example.com.