Peter deMarzo (Stanford University) Michael Fishman (Northwestern University) Kathleen M. Hagerty (Northwestern University)
Abstract
The federal government delegates various aspects of financial market regulation to self-regulatory organizations (SROs) such as the New York Stock Exchange and the National Association of Securities Dealers. We model one regulatory task of an SRO, the enforcement of rules designed to prevent the SRO's members from cheating customers. Specifically, we focus on the determination of an SRO's optimal policy for investigating agents who may have defrauded customers and the penalties associated with fraud. We model contracting/enforcement as a two-tier problem. First, an SRO chooses its enforcement policy, consisting of a specification of the likelihood that an agent is investigated for fraud and a penalty schedule. We assume that the SRO's objective is to maximize the welfare of its members, the agents. Taking the SRO's enforcement policy as given, agents compete with one another to handle customer transactions. They compete by offering contracts promising (outcome-contingent) payoffs that maximize customers' expected utility. When choosing an enforcement policy, the SRO anticipates the competition among its members. Indeed, we show that the SRO's optimal enforcement policy is designed to mute this competition. In doing so, an SRO chooses a more lax enforcement policy than would be preferred by customers. Investigations for cheating are less frequent and penalties are lower than what a customer would choose. Moreover, a decrease in investigation cost might lead an SRO to actually investigate less. Enforcement will become more vigorous, however, as a customer's alternatives to dealing with an agent of the SRO improve. A general conclusion of the analysis is that control of the enforcement policy governing contracts confers substantial market power to a group of otherwise competitive agents. In fact, we show that if agents are risk neutral, control of the enforcement policy is equivalent to agents behaving as monopolists. We also investigate the effect of government oversight on the self-regulatory process. We show that in equilibrium the threat of governmental enforcement will lead to more rigorous enforcement by the SRO, to the benefit of customers. Moreover, this benefit is achieved even without actual governmental enforcement taking place.
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Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004.
"Over-the-Counter Markets,"
NBER Working Papers
10816, National Bureau of Economic Research, Inc.
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