A Legal Theory of Finance

By Katharina Pistor (2013)

LTF holds that financial markets are legally constructed and as such occupy an essentially hybrid place between state and market, public and private. Financial markets exhibit dynamics that frequently put them in direct tension with commitments enshrined in law or contracts. This is the case especially in financial crisis time when the full enforcement of legal commitments would result in the self-destruction of the financial system.  This law-finance paradox tends to be resolved by suspending the full force of law where the survival of the system is at stake. 

LTF asserts that finance is legally constructed. Financial assets are contracts the value of which depends in large part on their legal vindication (Bradley 1902). Which financial assets will or will not be vindicated is a function of legal rules and their interpretation by courts and regulators. This may vary from legal system to legal system. In a world of free capital flows, legal enforceable financial commitments that link market participants from different countries and legal systems to one another determine the scope of the financial system. The ability to design instruments are not obviously in conflict with existing rules in different jurisdictions even as they seek to mitigate their costs on the issuers or holders renders a comparative advantage. Law and finance are locked into a dynamic process in which the rules that establish the game are continuously challenged by new contractual devices, which in turn seek legal vindication.

LFT if based on two premises outside of yet reinforced by law: Fundamental uncertainty and liquidity volatility. The two go together. If the future were known we could take precaution to deal with future liquidity scarcity; if liquidity were always available on demand, i.e. a free good, we could refinance commitments as needed when the future arrives. Based on these premises, LTF can illuminate core features of the contemporary global financial system, including its inherent instability, the differential application of law in its different parts and last but not least the locus of discretionary power. As such LTF can serve as the foundation for a political economy of finance. Within this framework there is room for analyzing the behavior or actors using rational choice models, but also a more socially embedded approach in socioeconomics. LTF's critical contribution is to emphasize that the legal structure of finance is of first order importance for explaining and predicting the behavior of market participants as well as market-wide outcomes.

Keynes emphasized that the process of accumulating wealth is necessarily a long-term project that is beset by our inability to know the future. We cannot fully predict the future and that, therefore, any investment strategy devised today will have to be adjusted should the future deviate from assumptions made today. This does not have to but frequently goes hand in hand with a financial crisis. Evidences show that financial crises occur much more frequently than people are willing to believe. Entities that engage in maturity transformation, i.e. banks, are widely held to be vulnerable to crisis. They finance long-term commitments with short-term funds that can be withdrawn on demand. Whenever too many depositors seek to withdraw their money these entities face extinction with potential repercussions for other entities and the system. The vulnerability of financial markets to such bank runs has found a regulatory response in the form of deposit insurance. Private intermediaries that engage in similar bank-like activities, such as hedge funds, have instead unilaterally imposed at times redemption restrictions to ensure their survival in times of liquidity shortage.

The disagreement is on whether instability extends beyond intermediaries to financial markets, or whether financial markets can instead solve the instability problem by diversifying risk. Financial innovation has made possible the splitting of credit, default and interest rate risk, which prior to the global crisis it was widely believed that this kind of risk diversification had ushered in a period of great moderation. However, there are good reasons to believe that the root causes of instability are the same form banks and markets. Both offer mechanisms for investing capital today in the hope and expectation of positive future returns, and both have to confront the conundrum that knowledge about the future is imperfect and liquidity is not a free good. Under these conditions, splitting risk cannot offer full protection against future events or a reversal of liquidity abundance.

The concept of liquidity is the ability to sell any asset for other assets or cash at will. It is intertwined with balancing one's assets and liabilities and as such necessarily links funding liquidity and market liquidity. Market liquidity is defined as the difference between the transaction price and the fundamental value. Funding illiquidity is defined as speculation scarcity (or shadow costs) of capital. This assumes that it is possible to determine an asset's  fundamental value as compared to its value or volatility relative to other assets and to conceptually differentiate speculation from other investors. 

In a market-based credit system that is largely reliant on "Ponzi-finance", the distinction between speculators and other market participants becomes less tenable. In the worst case scenario, a fire sale of assets may occur which can trigger an economy-wide downward price readjustment and potentially mass insolvencies. The likelihood of such an extreme scenario depends on how many investors will have to seek refinancing at the same time; the number will be higher the more investors have built their strategies on the ability to refinance on demand. In short, for a crisis to occur uncertainty must meet liquidity shortage.

For financial instruments that are issued by private entities, they may be tailored to specific clients or standardized with or without clauses that allow some adaptation. Shares in publicly traded company must be transferable, and laws or stock market rules impose voting arrangements, such as one-share-one-vote. Further, the proliferation of preferred stock or convertible shares illustrates how legal innovation can alter firms' capital structure with important governance implications. Complex capital structures devised by banks in response to regulation or diffuse takeover threats have undermined shareholder 'voice' in these entities.

Credit contracts entail obligations to repay the principal plus interest at a future date, but the form and structure of payments and interests are varies. In addition to credits and bonds, there is a wide range of tradable IOUs, from commercial paper to asset-backed securities, from options to futures and swaps, from simple derivatives to synthetic ones. 

The critical role law plays in the construction of financial markets is illustrated by the emergence of global derivatives market. OTC derivatives had been known before a global market in these instruments arose. Contractual practices had to be standardized to ensure scalability and investors needed reasonable assurance that these instruments would withstand legal scrutiny by regulators and courts in countries where they were issued, held and traded. ISDA created standard contracts, adapted them to different legal systems around the world, enlisted major law firms in these jurisdictions to opine on their enforceability and lobbied legislatures to adapt their bankruptcy laws to the netting agreements contained therein. Without having extended the legal infrastructure to these new instruments it is hardly conceivable that global derivatives markets would have grown into multi-trillion dollar markets.

The IOUs -- credits, bonds, derivatives, common stocks, convertible shares, etc -- that link parties to one another constitutes financial markets. Many IOUs explicitly reference other assets or IOUs. Securitized mortgages are tied to underlying mortgages and their interest schedule. Credit default swaps (CDSs) are insurance contracts designed to protect buyers of bonds and other instruments against changes in the value of the underlying asset and require their issuers to put up additional collateral should that price change. Other instruments are contractually linked to changes in anchor interest rates, such as LIBOR, or in the price of assets that were deemed safe at the time of issuance, such as certain sovereign debt. These contractual cross-references can trigger a predetermined chain reaction with potentially system-destabilizing effects.

Every depositor who places his money in  a bank account has the right to withdraw her funds on demand. This right is contractually created an protected by law. If they enforce their rights at the same time, a system built must collapse. Deposit insurance is one way to mitigate against this risk, but because of moral hazard concerns is limited to regulated banks. Market-based solution protect individual parties against future events through insurance; they ten to operate in a pro-cyclical fashion and can therefore exacerbate rather than mitigate the system's instability.

Financial innovation plays an important role in managing the elasticity of contractual commitments as well as legal constraints. An important purpose of financial innovation is to alleviate the costs of regulation by, freeing capital from reserve requirements and making them available for lending purposes. Regulatory reforms in the aftermath of financial crisis have triggered another round of financial innovation to mitigate the costs of these regulation for individual firms. In the case of central bank swap lines, when financial markets froze, trade suffered because parties no longer had access to liquid FX markets. The solution was for Central Banks to act as each other's go between in supplying the relevant FX to domestic parties. However, not every central bank received a swap line from the Fed or the guardians of the other major currencies, only those deemed critical for stability did.

Law matters for the position of different actors. Whether housing loans are structured as recourse or non-recourse loans determines the distribution of losses between borrowers and lenders from a steep decline in real estate value; whether the parties to a derivatives contract can net out their claims outside the pool of assets available for distribution to all other creditors; whether sovereigns can issue debt under their own law or that of a foreign jurisdiction affects the borrower's room to maneuver ex post. 

The elasticity of law can be defined as the probability that ex ante legal commitments will be relaxed or suspended in the future, the higher that probability the more elastic the law. In the context of a highly instable financial system, the elasticity of law has proved time and again critical for avoiding a complete financial meltdown. The degree of elasticity and discretion that is required to stabilize a financial system depends on how much instability it tolerates i.e. on its legal construction. The greater the tolerance for financial instability ex ante, the more likely that law and contracts will have to be suspended ex post -- even though this undermines the credibility of financial contracting on which the system rests.