Making Markets: Network Effects and the Role of Law in the Creation of Strong Securities Markets

Abstract

As Russia and other formerly socialist states construct market economies, the appearance of strong securities markets remains an unfulfilled expectation. Notwithstanding broad privatization of state-owned enterprises and the elimination of industrial subsidies - essential precursors to demand for capital-raising securities markets - stock markets in Central and Eastern Europe remain illiquid, inefficient, and unreliable.

Strong securities markets do not, it seems, neatly follow from the welfare-maximizing behavior of individuals and institutions. Nor can the appearance of securities markets be effectively dictated by government decree. Post-communist securities market transition therefore presents a puzzle: Do markets emerge, or must they be created?

Joining the debate over whether "law matters" in the creation of securities markets, this Article draws on recent finance and microeconomic analysis of network effects to propose an alternative theory of why law might matter in the creation of securities markets, and to challenge traditionally limited views of how it matters. After articulating the proposed network model of securities markets, this Article outlines the model's implications for securities market transition. Specifically, it highlights two categories of network inefficiencies that may help explain the persistent weaknesses of securities markets in Russia and other transitional states. The model suggests such inefficiencies may also arise in the modernization of established securities markets, however, implying lessons for the United States and other developed economies as well.

Where network effects undermine the spontaneous emergence of strong markets, this Article proposes a limited coordination of market expectations - as distinct from law's demarcation of property rights and enforcement of contracts, as conventionally acknowledged, and its protection of minority investors, as recently emphasized by "law matters" corporate and securities law scholars - as a central role for law in the very creation and design of strong securities markets.

Keywords: networks, network effects, network externalities, externalities, securities markets, stock markets, equities markets, transition, law matters, preconditions

JEL Classification: D52, D62, G18, K22, P34