The visible hands of financial markets

A stream of study reveal that formal institutions and regulations were not and are not the only elements allowing for financial markets to emerge. Late 17th century England  financial revolution provides valuable lessons for todays regulators and all the parties interested in making financial markets more efficient and less risky: formal complex regulation is not the answer. Formal simple regulation might address the need to rebuild confidence in the solvency of financial firms, but Western economies needs to think of mechanisms to address the loss of trust. Financial history perspectives are insightful in that regard. Carlos, Key amd Dupree showed that learning took place before the official establishement of the financial market and how crucial it was for its emergence and proper functionning:

The key is learning. Individual investors learned how to make (and lose) money in ways that did not directly involve productive processes. They learned how to share risk in commercial and financial endeavors; how to buy and sell, and where to buy and sell. They learned about the financial rewards and losses they could incur. Concomitant with this was the learning by specialized brokers who managed the trade during these early years. The goldsmith bankers increased their expertise in the equity section of the market

Murphy shows how shared values help the trading of option, before Black and Scholes. The lack of statistical methods to determine options value could have been hugely problematic to the emergence of a sound and resilient markets for these complex instruments. Yet, historical records seem to suggest that actors  determine the values of options on a mutually agreed set of element. So it shows that a market for highly complex instrument can regulate itself provided actors understand it is not in their interest to cheat the system. 

Quinn’s study of goldsmith-bankers in the late seventeeth century revealed that cooperation emerged endogenously between them through self-interests, but supported by a certain social structure:

In lacking a formal institutional structure governing accpetance and clearing, goldsmith-bankers evince how economic incentives, supported by apprenticeship, proximity, and social ties, shaped an early modern banking network integral to the Financial Revolution

Along the same lines, Stringham showed how securities trading in seventeenth century Amsterdam developed outside the legal structure of the time. Complicated financial transactions took place in Amsterdam then despite the fact that law could not back them, because there were sufficient market incentive to favor that behavior and the other economic actors could understand too the functioning of options trading:

At the Amsterdam Bourse each broker had to work to get business. Capitalists and merchants were able to make the trade themselves so they would only choose to go to the broker and pay his fee if they were getting value out such an arrangement