Changing Law to Address Changing Markets: A Consequence-Based Inquiry

I INTRODUCTION AND NORMATIVE FRAMEWORK This article examines the causal relationship between changes in markets for financial securities (financial markets) and resulting changes in law. It thus engages the first part of a much broader legal inquiry: "The controversy between those who believe that law should essentially follow, not lead, ... and those who believe that law should be a determined agent in the creation of new norms...." (1) This article does not purport to resolve that controversy; it merely examines when the law should "follow" changes in financial markets. To that end, subpart A next describes why it is important to have a normative framework for determining when financial market changes--specifically, material changes in the structure of, or the behavior of participants in, financial markets (2)--should drive legal changes. Subpart B hypothesizes such a normative framework. Subpart C then explains the methodology for testing that hypothesis. Thereafter, parts II and III of the article apply that methodology. A. The Importance Of a Normative Framework Remarkably, no normative framework currently exists for determining when financial market changes should drive legal changes. (3) Such a framework, however, (4) would increase transparency, and hence legitimacy, of legal changes, (5) and possibly also improve law's efficiency. (6) It would also help counter the tendency of politics (7) to distort that causal relationship, which often results in over-reactive, under-reactive, or otherwise inefficient legal responses to market changes. (8) Illustrations of this potential for distortions include enactment of the Volcker Rule in response to the 2008-2009 financial crisis (the "financial crisis") and also, in a broad sense, by the cycle of market deregulation during economic booms and subsequent re-regulation following economic busts. The Volcker Rule had its genesis in a proposal by former Federal Reserve Board chairman Paul Volcker to limit banks from trading in securities for their own account, which had become widespread after the repeal of the Glass-Steagall Act. (9) Enacted into law as one of the more politically motivated provisions of the Dodd-Frank Act, (10) the Volcker Rule bars banking entities and some systemically important non-bank financial firms from "'engaging] in proprietary trading' or 'acquiring] or retaining] any equity, partnership, or other ownership interest in sponsoring] a hedge fund or private equity fund.'" (11) Politicians and other proponents of the Rule "argue[] that [this] proprietary trading had distracted banks from their fiduciary obligations to clients, as well as from their core function of 'safe[ly] and sound[ly providing] long-term credit to families and business enterprises.'" (12) This distraction, they contend, led to excess speculation by the banks and became a primary factor in causing the financial crisis. (13) As even Volcker himself concedes, however, there is little evidence that proprietary trading by banks was a cause of the financial crisis. (14) Furthermore, the merits of the Volcker Rule remain controversial and untested. (15) The market deregulation and re-regulation cycle more broadly illustrates political under-reaction and over-reaction. During economic prosperity, lobbyists for the financial industry, as well as a "delight[ed][constituency]," push politicians for deregulation, (16) which can leave markets under-protected. Once the bubble of prosperity inevitably bursts, "investor confidence in the integrity of the market and its institutions" dissipates, (17) leading to "a public demand for new [over-protective] laws and regulations to punish [alleged] malfeasance in the market." (18) This cycle can lead to "grossly inefficient" (19) under-protective and over-protective laws. A normative framework for determining when financial market changes should drive legal changes would help to counter these inefficiencies. …