Property Rights in Financial Markets Larry Harris USC Marshall - - PowerPoint PPT Presentation

Property Rights in Financial Markets

Larry Harris USC Marshall School of Business Columbia Program on the Law and Economics of Financial Markets May 20, 2008

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Introduction

• The identification of important issues is a

key object of the Program on the Law and Economics of Capital Markets.

• I will provide a quick survey of property

right issues in the financial markets.

• These issues all have substantial public

policy implications.

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Properties in Financial Markets

• Most properties contested in financial

markets are intellectual properties.

• Network externalities free rider problems

substantially complicate ownership issues for many financial products.

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Common Economic Issues

• Our main focus today

– Network externalities

• Other common economic issues

associated with intellectual property

– Free rider problems – Incentives to innovate and copy – Monopoly costs

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Today’s Topic Agenda

• Big network externality problems

– Ownership of futures contracts – Market data

• Other topics

– Publication of fund portfolio positions – Security research and ratings – Innovative financial products and processes

Futures Contracts

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Contract Monopolies

• Enforced by exchange clearinghouses
• Backed by federal laws preventing off-

board trading

• The order flow externality provides

extraordinary protection to incumbents.

• Contrast to the Options Clearing Corp
• CME-CBOT and CME-NYMEX mergers
• Competition from OTC derivatives

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Intellectual Property Issues

• Contract design can be expensive but

monopoly can be too.

• Contrast to patent law

– 20 years of protection, not forever

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Patents

• Provide incentive to invest.
• Create incentives to share inventions to

promote further inventions.

– Not necessary when keeping trade secrets is difficult

• One-size-fits-all and litigation problems

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A Related Design Issue

• Who should own the right to write

contracts on well-known indices?

– S&P, Dow, Russell, MSCI, … – Presently the index manager

• Should index managers be able to extract

the benefits of the network externality?

• Did you see Titanic?

Market Data

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Exchanges Sell Market Data

• The order flow externality makes the data

from the largest exchanges valuable.

• The data facilitate crossing, internalization,

and preferencing.

• Exchanges and traders both argue that

they should own the data because they produce them.

• Securities and futures market differences

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The Reg NMS Solution

• The order flow externality arises because

an offer to trade is an option.

• Price the externality!

Position Reports

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Mutual Funds

• Mutual funds must publish their full

schedule of portfolio positions within 60 days of the end of each quarter.

– Forms N-Q and N-CSR

• Allows interested investors to monitor

whether a fund is complying with its stated investment objective

• Reveals proprietary fund strategy and

front-running opportunities

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Other Position Reporting Regs

• Institutional investment advisors must

report aggregate positions within 45 days

• f the end of each quarter (Form 13F)
• Actively managed ETFs must report daily

– In effect, giving up all proprietary research in favor of a market-based distribution system – Other actively managed ETF proposals have been stalled at the SEC for at least five years.

Research

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The Research Problem

• Information is easily shared, making it

hard to control its distribution.

• People pay for a first look but not

everyone can get a first look.

• Issuers pay if the consumers will not.

– Research can lower cost of capital. – All sorts of related agency problems

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An Additional Twist

• By writing regulations that depend on

private credit ratings, the SEC

– Uses rating agency properties – Creates markets for the ratings

• Since the SEC does not own the ratings, it

has limited control over them.

Innovative Financial Products

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Patents versus Trade Secrets

• Trade secrets are hard to control with a

mobile labor force and little physical capital.

• Poorly issued patents lead to extortion.
• Without patents, the regulatory approval

process allows slow competitors to catch up to innovators.

– Examples: Index participations, ETFs, …

Conclusion

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Property Rights Are Difficult

• Many disparate governors

– Patent law – Superseding agency jurisdictions – Network externalities and free rider problems

• Many disparate and conflicting interests

– Among private rent-seekers – Among public policy values

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Some Proposed Principles

• Results should not depend on network

externalities and free rider problems.

• Externalities should be priced, if possible.
• Regulators should not undercut incentives

to innovate

• A balance between the benefits of

innovation and the costs of market power should govern market structure

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Free and Competitive

• We seek free and competitive markets.
• Too often people associate the former with

the latter.

• Externalities and free rider problems often

make free markets uncompetitive.

– Free marketers often ignore these problems. – Simple is not necessarily good.

• Benefits and dangers of regulation