Complexity, Innovation and the Regulation of Modern Financial Markets

Abstract

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the selfcorrecting nature of markets and their consequent optimality as mechanisms fr the allocation of society's resources. This ideology, in turn, exerted a projound influence on how we regulate financial markets and institutions.The GFC has exposed the folly of this market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives-securitization, synthetic exchange-traded fnds and collateral swaps-the objective of this paper is thus to start us down the path toward a more robust understanding ofcomplexity, financial innovation, and the regulatory challenges flowing from the interaction of these powerful market dynamics. This paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.

Complexity in Structured Finance and Difficulties Faced by Market Participants-A Critical Assessment of the Role of the Complexity in Financial Crisis

“…Apart from the complex design of these structured securities, Awrey (2012) has identified six drivers of complexity in the structured finance market. These drivers of complexity can be classified into: technology, interconnectedness, fragmentation, opacity, regulation and reflexivity.…”

“…All Rights Reserved. many financial institutions and markets (Awrey, 2012). Finally, the term 'reflexivity' is used to explain the intrinsic dynamism of modern financial market which is usually derived by previous discussed actors of complexity.…”

“…The emergence and steep growth of structured finance market was nothing but a complex market that had been driven by a complex bundle of supply-side and demand-side incentives as pointed out by Awrey (2012). To explain the motives for developing more complex structure securities, perhaps the most striking one was the strong investors' demand for AAA rated structured financial securities.…”

Relationships Between Relevant Contextual Influences and Information Security Threats and Controls in Global Financial Services Industry

“…Innovative infrastructure capable of improving existing needs, including those specific to the financial sector, are relevant to societal progress [30], [36]. Indeed, capacity for innovation -in almost all aspects of human endeavor -is positively associated with societal advancement and progress [25].…”

Hedge Funds and Risk-Decoupling – The Empty Voting Problem in the European Union

“…The financial industry is notoriously well known for inventing new products within ever narrowing horizons. 271 In this way, new structures allow for the creation of economically similar results. Alternatively, opportunities for circumventing regulations arise where derivatives can be configured that do not reference the full value of the underlying securities, but rather only refer to several economic aspects of them, as is the case for some credit derivatives.…”