Friday, December 19, 2014

Coordination, Efficiency, and the Coase Theorem

A recent post by Matt Levine starts out with the following observation:
A good general principle in thinking about derivatives is that real effects tend to ripple out from economic interests. This is not always true, and not always intuitive: If you and I bet on a football game, that probably won't affect the outcome of the game. But most of the time, in financial markets, it is a mistake to think of derivatives as purely zero-sum, two-party bets with no implications for the underlying thing. Those bets don't want to stay in their boxes; they want to leak out and try to make themselves come true.
Now one could object that you and I can't affect the outcome of a sporting event because neither of us is Pete Rose or Hansie Cronje, and that we can't affect credit events with our bets either. But this would be pedantic, and miss the larger point. Levine is arguing that the existence of credit derivatives creates incentives for negotiated actions that result in efficient outcomes; that the "Coase Theorem works pretty well in finance." 

To make his point, Levine draws on two striking examples in which parties making bets on default using credit derivatives spent substantial sums trying to make their bets pay off, using the anticipated revenues to subsidize their efforts. In one case a protection buyer provided financing on attractive terms for the reference entity (Codere), under the condition that it delay an interest payment, thus triggering a credit event and resulting in a payout on the bet. In the other case, a protection seller offered financing to the reference entity (Radio Shack) in order to help it meet contractual debt obligations until the swaps expire. The significance of these examples, for Levine, is that they are on opposite sides of the market: "the two sides can manipulate against each other, and in expectation the manipulations and counter-manipulations will cancel each other out and you'll get the economically correct result." 

Well, yes, if we lived in a world without transactions costs. Such a world is sometimes called Coasean, but it would be more accurate to describe it as anti-Coasean. The world of zero transactions costs that Coase contemplated in his classic paper was a thought experiment designed to illustrate certain weaknesses in the neoclassical method, especially as it pertains to the analysis of externalities. But the world in which these deals were made is one in which transactions costs are significant and pervasive. Given this, what do the examples really teach us? 

Transactions costs arise from a broad range of activities, including the negotiation and enforcement of contracts, and the coordination of efforts by multiple interested parties. In two party settings (such as the case of Sturges v. Bridgman explored by Coase) these costs can be manageable, since little coordination is required. But once multiple parties are involved transactions costs can quickly become prohibitive, in part because no stable agreement may exist. And as Levine himself usefully informs us, "there are a lot of credit default swaps outstanding on Radio Shack's debt, now about $26 billion gross and $550 million net notional." 

The two sides of this market are populated by multiple firms, each with different stakes in the outcome. For a single party on one side of the market to negotiate a deal with the reference entity requires that its position be large, especially in relation to those on the opposite side of the trade. The resulting outcome will reflect market structure and the distribution of position sizes rather than the overall gains from trade. The examples therefore point not to the relevance of the Coase Theorem, which Coase himself considered largely irrelevant as a descriptive claim, but rather to the fact that coordination trumps efficiency in finance.