November 23, 2009
Black Swan? Brown Cow? The Financial Markets Commons
Posted by Kristin Johnson
Many thanks to Gordon Smith and company for inviting me to guest blog on The Conglomerate.  I am delighted to discover in academia a place like The Conglomerate – a home for legal scholars engaged in the development of corporate law.  During my years as a transactional lawyer at a large firm in New York, friends directed me to this blog, and its participants inspired to believe that I would one day achieve my dream job – a law teaching position (hang in there, for those on the market).

My current research focuses on U.S. securities regulation and more specifically, credit default swap agreements. In the rush to judge these instruments, I believe that we may miss an important teaching moment.

Sage commentators have challenged the notion that the financial crisis is a black swan. I am not sure if it is a black swan, but I think that that we may be able to describe credit default swap agreements as brown cows. I have closely followed Erik and David’s posts discussing regulation of credit derivatives. I am working on a paper arguing that the regulatory response to these credut default swap agreements (self regulation, joint governance or a strict prohibition) should consider the instructive and illustrative “commons” literature.

Brown cows? Let me explain. In 1968, Garrett Hardin wrote the Tragedy of the Commons, an essay in which he described the “commons” as a large pasture open to cattle herders for public grazing. Each individual herder receives the full benefit of adding an additional cow to graze on the pasture but experiences only a small fraction of cost of adding the cow. Herders are, therefore, incentivized to add additional cows. The herders will not cease to add additional cows until the total number of cows exceeds the grazing capacity of the pasture, essentially exploiting the resource of the pasture to the point of exhaustion. Hardin described this illustration as the “tragedy of the commons” and noted that the “[f]reedom of the commons brings all to ruin.”

Later theorists adapted the tragedy of the commons and applied the theory to a variety of natural resource markets that faced the risk of over-exploiteation such as fishing and logging and industrial activities that threatened water and air pollution. We have now applied the lessons from the tragedy of the commons in a diversity of contexts. There is an interesting analogy between the incentives of market participants in financial markets engaged in the origination and trading of investment products and other market strategies that create grave potential for over-exploitation. While consistent with the solutions proposed by Hardin in his original essay, solutions such as government intervention or licensing of rights to prevent exploitation fail to achieve the desired results. The SEC and CFTC’s turf wars facilitated the creation of the shadow behind which these instruments developed. During the two decades prior to the current financial crisis, notwithstanding the Shad-Johnson accords, self-interest and aggrandizement by the agencies may have prevented a successful effort to identify a sustainable regulatory approach to innovative investment instruments like credit default swap agreements. The current proposals crafted to fill the regulatory gap and limit or ban credit default swap agreements treat the symptoms but fall short of a cure.

Analysis of the regulation question may be better informed by a more careful description of the conditions that motivated the innovation of credit default swaps, the benefits and costs the instruments engender, and imagination enough to apply by analogy a thesis proffered by Elinor Ostrom, the first woman Nobel laureate, and Carol Rose in their analysis of the commons. In future posts, I will discuss Ostrom and Rose’s suggestions and explain the valuable contributions they make in solving some of the challenges posed by the financial markets commons generally and credit default swap agreements in particular.

Corporate Law, Financial Crisis, Securities | Bookmark

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