The challenge of designing Asia-proof markets

Conventional economics is dominated by the idea of free markets and the ideology of minimal government. Roth argues that markets are everywhere, and notes that free markets can only exist if there are effective rules, effectively enforced. He quotes the free-market economist and philosopher Friedrich Hayek: “There is … all the difference between deliberately creating a system within which competition will work as beneficially as possible, and passively accepting institutions as they are.” 

It is too simplistic to suggest that free markets would work well if there were no effective state to enforce the standards and rules. The global financial crisis demonstrated that under certain conditions, free markets can fail. Roth’s insight is that markets are as old as humans – they evolve and adapt, but we can always design markets to function better. In other words, the state has a key role in markets – though this doesn’t mean it should replace markets as the mechanism to allocate resources and facilitate price discovery.

There are two broad types of market – public and private, the latter also known as “matching” markets. Public markets include international trade and commodity exchanges as well as financial markets in foreign exchange, stock and bonds. These markets succeed because they are efficient (in the sense of low transaction costs), transparent (with prices and volume data available to all) and generally have high turnover and public confidence. However, every now and again they fail, with large public consequences. Roth points out that matching markets exist everywhere – from dating services and kidney exchanges to jobs and college selection – but they are illiquid, opaque and often do not work well. They match demand and supply, but not always successfully, because of information asymmetry and mistrust between buyers and sellers.

Roth uses a new vocabulary to describe markets. A market that is “thick” is one that has a lot of participants, but thick markets also face congestion, like a traffic jam or market panic when everyone wants to get out, but can’t. A good market place is one that makes participation safe and simple, with rules that are enforced and obeyed effectively. In Roth’s view, a free market is not a “free-for-all”, but one that has well-designed rules that make it work well. 

Markets fail more often in developing economies because  they were introduced without a full understanding of local culture and behavioural characteristics. In the 1980s, it was assumed that copying the New York Stock Exchange would work well for a developing country. But the recent experience shows that it took a long time for Chinese investors, financial institutions and regulators to experience and understand how the complex rules work – or do not work. The A-share debacle showed that the issues of market manipulation, margin losses, illiquidity, inadequate regulation and bad corporate governance were a consequence of the market’s design. These are flaws that need to be fixed. 

Good market design means that we cannot assume that all Chinese investors have the same degree of sophistication and experience as traders on the New York Stock Exchange. “Best practice” does not necessarily mean “best fit”. A Lamborghini drives superbly on superhighways, but will not perform as well as a Jeep on bad roads. 

Markets are of course networks, and a public network, such as a stock exchange, also operates symbiotically with many private networks, such as the venture capital/private equity business that seeks good start-ups for eventual listing on the stock exchange. Furthermore, illegal markets – such as syndicates that operate to manipulate shares, engage in insider dealing and short-selling – take advantage of lack of supervision or policing. Proper supervision of sophisticated public markets also needs good understanding of how these “private” markets, sometimes called shadow banking, operate. 

Professor Roth built his theory of market design not on ideology but by common sense. Private markets operate mostly through strategic decision-making or game theory, because the number of participants is limited, with limited information. Public markets have mass participation, making them subject to mass behaviour, where common sense may not lead to good common outcomes, such as everyone running for a crowded exit in panic that leads to market crash.

What looks simple can be actually very complex, but what is very complex works on simple algorithms. Building sophisticated Asian stock markets thus requires making the markets more simple for retail investors, which means that there must be strong institutional investors with long-term perspectives and professional management to give the stock markets “thickness”. It also requires very sophisticated regulators and policymakers who understand that, as markets become more complex, it is important to redesign the market algorithms regularly to prevent behaviour that can become predatory and manipulative. 

Herein lie the contradictions between state and market. The market thrives on mistakes, because it is fundamentally zero-sum – your loss is my gain. The state bureaucracy works on asymmetric rewards – success may not be rewarded whereas failure is seldom tolerated. But long-run stability, as Minsky pointed out, leads to instability. 

Achieving the simple balance between state and market requires careful market design. This is more complex than we imagined before Professor Roth’s intervention.