Working Paper

Real vs. Imagined Financial Markets The Regulatory Challenge

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We have grown accustomed to regulating financial markets based on imagined, not real markets. Real markets are shaped by and co-evolve with institutional arrangements within two fundamental constraints: Imperfect knowledge and the threat of illiquidity.

Imperfect knowledge implies that the future is unknown and unknowable and that, therefore, investment strategies developed today will need to be revised, if not reversed, when the future arrives. Illiquidity means that it is impossible to convert all claims into cash at any given moment. It follows that when far-reaching downward adjustments to past investment strategies become necessary the illiquidity threat manifests itself and can spiral into a full-blown financial and economic crisis. Institutional arrangements cannot fundamentally alter the binding constraints of imperfect knowledge and illiquidity. However, they determine the relative vulnerability of financial systems to these constraints and the risks they pose to society. In designing regulation for financial markets it is critical to recognize that regulators too are affected by imperfect knowledge, and that central banks, the guardians of domestic financial systems, can face liquidity constraints as well. This calls for a diverse set of regulatory strategies that are flexible and take account of different capabilities for self-preservation.