A new and influential economic literature places much of the blame for the global financial crisis on so-called ‘safe assets,’ debt contracts that investors treat as if they had very low risk. According to this literature, global demand for safe assets surged at the turn of the century, driven by governments and investors in Asia and the Gulf States. Treasury bills could not meet all demand, the theory goes, and thus investment banks began manufacturing new safe assets, including repos and investment grade asset-backed securities. The safety of these privately-created debt contracts, however, disintegrated once the global crisis set in. The freezing of markets in asset-backed securities spread to other safe assets, including repos, money-market mutual funds, and even sovereign debt, once markets lost confidence in the ability of some sovereigns to backstop financial sector losses. The collective illusion that these debt contracts were low-risk evaporated. Some economists now believe that continuing imbalances in the supply and demand of safe assets jeopardize global financial stability. Even though parts of this narrative are disputed, stark facts remain: trillions of dollars of debt contracts trade on financial markets, investors treat these assets as if they involved almost zero risk, and risk can suddenly and catastrophically rematerialize in these markets.
Strangely, in the economic debate on safe assets, law is largely missing. For many economists, safe assets seem to be an almost organic phenomenon. In a trio of works recently posted on ssrn, Anna Gelpern (Georgetown) and I argue that law plays a fundamental role in constructing safe assets. In an article in the Yale Journal of Regulation, we set out a three-part framework for the role of the law in constructing safe assets. In a symposium piece in the Brooklyn Journal of Corporate, Financial, and Commercial Law, we compare and contrast how private and public ordering create safe assets according to this three-part framework. In our chapter in the 2016 book, Reconceptualising Global Finance and Its Regulation (Ross Buckley, Emilios Avgouleas, and Douglas Arner eds. Cambridge), we provide case studies of how the law constructs four different types of safe assets: sovereign debt, bank debt, repos, and asset-backed securities.
One theme runs through all three works: precisely because there are no risk-free contracts, state intervention supplies the essential infrastructure to let people act as if some contracts were risk-free. The law constructs and maintains safe asset fictions and places them at the foundation of institutions and markets. If safe assets are under- or overproduced, or misused, or if safety is misperceived, then the law is at least partly to blame. Understanding how legal and regulatory tools help construct safe assets is an essential first step to managing the risks safe assets entail.
In our framework, whether through private or public ordering, three types of legal tools operate to construct safe assets:
1. Making Assets Safe: one set of tools contributes to the production of safe assets by regulating the cash flows into and out of an issuer of safe assets to increase the likelihood of full and prompt payment to investors. These tools might take the form of:
- engineering the asset side of an issuer’s balance sheet to reduce the risk of inputs in safe assets;
- engineering the liability side of an issuer’s balance sheet to give holders of safe assets priority over other claimants of the issuer; or
- creating and regulating the secondary market for safe assets.
A range of prudential bank regulation fall into this first category of safe asset-creating tools, including capital requirements that mandate issuers maintain a buffer to protect liabilities on the right side of their balance sheet. However, rules that construct safe assets extend beyond bank regulations and include bankruptcy laws that give preferences to certain debt contracts.
2. Labeling Assets Safe: another set of legal tools focuses on the demand for safe assets by granting special status to these contracts when held on the books of investors. These tools create liquid markets for certain assets by either:
- signaling the low risk of default by issuers of those assets; or
- coordinating the collective treatment of those assets as having low risk and high liquidity.
Credit rating agencies’ ratings, often required by law for financial institutions to invest in certain debt contracts, represent the clearest example of a safety ‘label.’ However, other regulations, such as money-market mutual fund regulations that allow funds to price their shares at a fixed net asset value, also ‘label’ those investments as safe. Regulatory labels can reduce or eliminate the incentives of market participants to research the risk attributes of debt contracts.
3. Guaranteeing Asset Safety: financial intermediaries and governments can also guarantee the performance of safe assets, putting their own credit on the line. Guarantees may be ex ante or ex post, explicit or implicit. The law authorizes and frames the design of such guarantees.
If all goes well, the three categories of tools feed a virtuous cycle for safe assets: eg, when low-risk assets are labeled safe, it increases demand, broadens the investor base, boosts liquidity, and reduces the cost of funding for their issuers. When the tools are misaligned, they can contribute to instability. Investors might herd into risky assets mislabeled as safe, then flee in panic when the perception of safety vanishes, with spillover effects on the broader economy. The government may have no choice but to step in with guarantees ex post, creating distortions and moral hazard. In safe asset crises, poor coordination among long-established legal and regulatory tools stood out as a severe problem.
The construction and rescue of safe asset markets are not pure technical acts. They involve deep but often masked political commitments and distributive consequences. We underscore a kind of first law of thermodynamics for safe assets: neither private nor public ordering can banish risk altogether from safe asset markets or financial markets in general. They merely move risk around or, worse, obscure risk until it rematerializes. When law moves the risk, it creates winners and losers in financial markets and the real economy. Professor Gelpern and my framework lays bare the tradeoffs in safe asset construction.
We also offer preliminary prescriptions to address some of the failings we identify. Assets should not be labelled as safe unless governments deploy adequate regulations to make them safe and are prepared to provide guarantees should those regulations fail. We argue for stress testing of safe asset markets. We also outline how the three types of safe asset interventions could be dynamically aligned. This could enlarge the macroprudential regulatory toolkit without creating brand new regulatory tools. However, it would require additional research to function effectively.
Erik F. Gerding is a Professor, the Associate Dean for Academic Affairs, and a Wolf-Nichol Fellow at the University of Colorado Law School.