The Mechanisms of Derivatives Market Efficiency

In their influential 1984 article The Mechanisms of Market Efficiency[1], Ron Gilson and Reinier Kraakman put forward a causal framework for understanding how new information becomes incorporated into the price of publicly-traded equity securities. This framework was grounded in the observation that the efficiency of public equity markets is a function of the market for information: how costly it is to acquire, process, and verify and, accordingly, its distribution within the marketplace. For any initial distribution of information, this framework then offered an account of how the trading activities of one or more species of market participants serve to ensure that this information finds its way into security prices. This framework thus provided an institutional explanation for the empirical observation underpinning the Efficient Market Hypothesis that prices within U.S. equity markets fully reflected all publicly available information.

Gilson and Kraakman’s framework has gone on to play an influential role in public policy debates surrounding securities fraud litigation, mandatory disclosure requirements, and insider trading restrictions. It has also provided a basis for understanding the economic role of securities underwriters, venture capital firms, auditors, credit rating agencies, and other reputational intermediaries. Yet despite its enduring influence, relatively few scholars have attempted to extend this framework beyond the relatively narrow confines in which it was originally developed: the highly regulated, order-driven, and extremely liquid markets for publicly-traded stocks. This dearth of scholarship is especially puzzling given the Cambrian explosion of new financial markets, institutions, and instruments which has taken place since Gilson and Kraakman published their seminal article. Moreover, many of these new markets, institutions, and instruments bear little resemblance to the conventional stock markets at the heart of Gilson and Kraakman’s original framework.

This paper examines the mechanisms of derivatives market efficiency.   Derivatives differ from publicly-traded equity securities in a number of important ways. These differences stem from the executory nature of derivatives contracts, the dealer-intermediated structure of the markets in which they trade, and the sources of market liquidity. These differences generate information, coordination, agency, and other problems not generally encountered within public equity markets. These problems include the high initial costs of identifying potential traders, along with the subsequent costs of engaging in both ex ante screening and ex post monitoring of their creditworthiness. They also include the costs of determining the prevailing market price in the absence of a centralized coordination mechanism which aggregates and disseminates pricing and other market information. Compounding matters, even if traders were able to observe the market price, idiosyncratic counterparty credit risk and the economic and legal heterogeneity of many derivatives would make it difficult for them to disentangle the constituent elements of price reflecting market, counterparty credit, and other risks. In effect, these features introduce potentially significant price distortions: undermining the ability of traders to distill the informational signal embedded within any changes in the market price of a derivatives contract from the noise generated by idiosyncratic counterparty credit risk and economic and legal heterogeneity.

Predictably, these problems have lead to the emergence of a unique constellation of mechanisms which – in theory at least – serve to enhance derivatives market efficiency. These mechanisms include derivatives dealers, interdealer brokers and electronic communication networks, closeout netting and financial collateral arrangements, and contractual standardization under the aegis of organizations such as the International Swaps and Derivatives Association. Each of these mechanisms holds the potential to make a meaningful contribution to the efficiency of derivatives markets. At the same time, significant questions remain regarding the effectiveness of these mechanisms and whether their benefits outweigh the associated costs. Moreover, the reliance of derivatives markets on these mechanisms raises a host of important and timely policy questions. The most important of these questions revolve around the potential impact of recent regulatory reforms introducing mandatory derivatives trade reporting and disclosure requirements, incentivizing the central clearing of standardized derivatives, and imposing new and more onerous capital, liquidity, and collateral requirements on derivatives dealers. More broadly, this examination raises important questions about the optimal balance between pubic and private ordering within derivatives markets.

This examination of the mechanisms of derivatives market efficiency yields a number of important insights. First, recent regulatory reforms designed to enhance the transparency of derivatives markets by introducing mandatory trade reporting and disclosure requirements may not have a significant impact on market efficiency. Simultaneously, however, the regulatory push toward mandatory central clearing of standardized derivatives may have a previously underappreciated impact on market efficiency by reducing idiosyncratic counterparty credit risk and economic and legal heterogeneity. Second, new prudential requirements introduced in the wake of the financial crisis may serve to undercut the incentives of dealers to perform their important role in the intermediation of derivatives markets, thereby reducing market liquidity and, ultimately, efficiency. Given this prospect, it may be worthwhile rethinking the optimal balance between public and private ordering within derivatives markets with a view to promoting the development of alternative market structures. Finally, and more broadly, this examination suggests that conventional wisdom about what works in securities laws may at best offer an incomplete framework for understanding the regulation of modern derivatives markets.

ENDNOTES

[1] Ron Gilson and Reinier Kraakman, “The Mechanisms of Market Efficiency” (1984), 70:4 Virginia Law Review 549.

The preceding post comes to us from Dan Awrey, Associate Professor of Law and Finance at Oxford University.  The post is based on his article, which is entitled “The Mechanisms of Derivatives Market Efficiency” and available here.