Market Makers and Vampire Squid: Regulating Securities Markets after the Financial Meltdown

Abstract

Investment banks selling securities to their customers that the banks themselves were dumping crystallized the disconnect between Wall Street and Main Street during the recent financial crisis. Goldman Sachs asserted conflict was simply not relevant in the market maker relationship involving swaps and other innovative financial instruments since a dealer, by design, takes the opposite side of a transaction from the customer and does not typically disclose its mark-up or motives in entering into the transaction. Congress, not persuaded by the argument, reached out to move more dealer relationships from the space governed by markets to that governed by legal rules. The immediacy of the crisis has passed but the ongoing regulatory ambiguity over how much of market-making behavior should be regulated suggests continuing gaps in the law’s understanding of the role of intermediaries in securities regulation. This article seeks to fill some of those gaps and shape the learning as to the modern look of securities regulation in the aftermath of the financial crisis and subsequent law-making. First, the position of market-makers, long at the center of the debate over the role for markets and law, illustrates two distinct versions of private ordering that have not been clearly recognized. In one manifestation markets and express contracting will likely work fine, but the other is more like the agency and advisory relationships in which law has inserted fiduciary duties. When the dealer receives additional consideration for its effort on the selling side than the buying side, it destroys the neutral market-making that can be a predicate for leaving those relationships only to markets. Law imposed such obligations on underwriters and broker-dealers after the Depression; it is imposing such obligations on banks selling swaps after the meltdown of 2008. Second, the law’s tool kit in addressing securities markets is broader than disclosure that has occupied so much of our law school courses and thinking in the area. The recent federal response, in fact, has little in the way of disclosure and much more in the way of conflict management and market structuring to combat incentives that have not worked out as anticipated. The derivatives regulation in Dodd-Frank illustrates legal efforts to shape incentives of market participants in a broader way. Third, this spread of legal responses is not new but resembles more the approach of the New Deal legislation enacted during the 1930s that also was motivated by conflicts between investment banks and their customers and melded disclosure with a host of market structures to bring more social control over finance.

Keywords: securities markets, securities regulation, financial crisis

JEL Classification: K2, K22