Financial Innovation
Contracts and Failures

The current revolution In financial markets has raised many questions for applied economic research. Two important areas for study are the nature of contracts and the extent of market failures in the financial sector. The Centre held a workshop on 7 January to review the literature on this topic and to provide a focus for continuing research, which will include a series of more specialized workshops later in 1987. The workshop was organized by Colin Mayer (City University Business School), Co-Director of CEPR's research programme in Applied Economic Theory and Econometrlcs.

The workshop began by discussing recent innovations in financial markets. In the first paper, 'Will Increased Competition Reduce Financial Instability?', Paul Seabright (Churchill College, Cambridge) considered the effects on financial stability of new financial 'products' and increased competition. The link between innovation and the degree to which markets reflected economic 'fundamentals' was central to Seabright's analysis. He argued that if increased competition forged closer links between trading methods and these underlying economic fundamentals, then stability was likely to increase.

In a paper entitled' Analysing Financial Markets', Ian Cooper (London Business School) reviewed the research methodologies used to characterize innovation. He characterized orthodox finance theory as based on: (i) market efficiency, (ii) portfolio theory, (iii) capital market equilibrium, (iv) term structures and (v) derivative products, such as options. In the world of orthodox theory markets are essentially complete: there exist markets in which transactions can take place in every kind of good for delivery in every time period. But if markets are already complete how can there be innovation -the introduction of new 'products'? Cooper proposed two directions from which to approach this question: through theories of market 'microstructure'; and through information and agency models developed elsewhere in economics.

Discussion of these two papers centred on the role of information and trading practices. One important issue is whether trading is a 'zero-sum' game. If it is, why do the losers not drop out? Some participants suggested that the trading 'game' is only zero-sum across a very wide number of players, and that for market-makers there may be very large positive rewards. Marcus 

Miller (University of Warwick and CEPR) noted that if information and agency models were indeed important, then the basis of contemporary finance theory might be seriously flawed and not, perhaps, the most useful starting point for future analysis.

The second session of the afternoon centred on a paper presented by Paul Grout (Bristol University and CEPR), entitled Regulation and Self-Regulation In Security Markets'. He compared self- regulation to conventional direct regulation and emphasized that many factors influence the value of the output pro duced by the agents that are being regulated. Some of these take the form of rules of conduct that all agents can be requested to follow, such as levels of 'care' exercised in dealings with clients. 'Quality-type' rules, such as membership of a professional body, are also part of the regulatory system, but they can act as a restriction on entry. Self-regulating organizations (SROs) may well tend to place excessive emphasis on quality variables that restrict entry , whereas regulators may favour controlling the degree of 'care' that agents are forced to take. Regulators therefore need to be cautious when evaluating the trade-off of quality against 'care' when judging whether an SRO's rules are sufficiently stringent. Whenever it is possible for agents to build up a personal reputation, they will find it in their interest to offer high 'care'. The level of 'care' is therefore less likely to be a problem in markets where agents can build up individual reputations.

The workshop also discussed the relationship between security prices and volumes. Marco Pagano (Universi ty of Naples and CEPR) presented two papers, based on CEPR Discussion Paper Nos. 142 and 146 (re- ported in this Bulletin). Pagano discussed two models which sought to explain the 'liquidity' of a market, as measured by the volatility of market prices or by the ability of a market to absorb a large purchase or sale. He described one model which displayed a 'vicious circle' of illiquidity. Traders were assumed to enter a market only if they believe others will also do so. Thus if potential traders believe that no one will enter the market, this conjecture will be realized: an equilibrium with a low level of liquidity will result. Distinct equilibria are possible in the model, characterized by different levels of liquidity: public policy may have a role in steering the economy towards a high-liquidity equilibrium. Pagano also presented a second model in which potential traders could choose to trade equities either on the official exchange or elsewhere. Transactions outside the official exchange were often important, Pagano noted: trading volumes on unofficial Italian equity markets were roughly 4 or 5 times those on official exchanges. Pagano's model explained this as a vicious circle, arising from traders' self-fulfilling conjectures concerning trading volumes on the official market.

One of the central questions surrounding deregulation in the City of London has been the effect of intensified competition on the costs of trading securities. In the final paper of the day, Gordon Gemmill (City University Business School) examined the determinants of the 'spreads' between the prices at which market-makers buy and sell securities. He considered two sets of theories. The first treats spreads as compensation to market-makers for the costs involved in holding inventories of securities. The second views the market as comprising two classes of Investors: informed investors who have superior information about future price movements and others who trade for consumption and portfolio reasons. The first, well-informed group of investors transact to the detriment of the market-maker, who must therefore earn a profit on trades with The the second, uninformed group. Using formulae for the valuation of option prices, Gemmill derived predictions of market spreads before and after deregulation. These were remarkably consistent with the observed behaviour of the equity and gilt markets.