“Market efficiency” is one of the most widely used, and frequently over-used, concepts in modern financial economics and its cross-disciplinary offspring, law and economics. Every student taking corporate finance or securities regulation knows about the Efficient Market Hypothesis. Every policy proposal must grapple with the issue of how it would impact the relevant market’s “efficiency.” And, of course, innumerable law review articles employ the vocabulary of “market efficiency” to support a variety of doctrinal, empirical, and normative claims. Yet, this theoretically elegant concept often seems to be a rather imperfect representation of what actually happens in real-life financial markets. The latest financial crisis made this problem simply impossible to ignore. Of course, a sensible way to bridge the gap between theory and practice is to refine or revise the theory, so that it provides a better explanation of the relevant reality. That’s easier said than done, however. Not surprisingly, the post-crisis explosion of academic writings on financial markets and regulation has produced disappointingly little by way of true theoretical advancement, at least so far.
Dan Awrey’s new article, The Mechanisms of Derivatives Market Efficiency, is one of the few rare exceptions in that respect. It is cleverly framed as an attempt to update and extend the theoretical framework originally laid out by Ron Gilson and Reinier Kraakman in their canonical 1984 article, The Mechanisms of Market Efficiency. Gilson and Kraakman were the first to identify and map out the key channels through which any particular piece of new information, depending on the cost of acquiring and processing it, gets incorporated into the publicly-traded stock prices. Among other things, they explained how numerous professional traders (broker-dealers, research analysts, investment managers, etc.) obtain, process, and disseminate costly private information, thus collectively enabling stock market prices to move to the new optimal levels. Continue reading "This Is Not Your Parents “Market Efficiency” . . ."