Markets in Financial Instruments Directive – MiFID

Analysis of the “Markets in Financial Instruments Directive” [MiFID] purporting to establish a European “single market” in securities by providing increased levels of investor protection, authorisation of investment service providers, and recognition of alternative trading systems requires an understanding of the macroeconomic function of “Financial Markets.”

Financial markets exist primarily, though not exclusively, to facilitate the transfer of funds from “surplus economic units” to “deficit economic units” within a financial system (Gallagher and Andrew, Financial Management and Mastering Finance 24 (3rd ed. 2002) – see reference list). The reason: to finance the factors of production that expand Gross Domestic Product and increase social wealth. Comprehending “financial markets” and financial instruments therefore is required to assess the potential of MiFID to achieve its stated objectives.

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Most societies adopt policies and strategies designed to result in economic growth as measured in the percentage annual increase in real GDP. There are two major components to GDP increase: (1) capital accumulation and (2) technological progress (Olivier Blanchard, Macroeconomics 259 (2006)). Capital accumulation encompasses two factors, taking the form first of increasing the factors of production: land, labour and capital, and taking the form second of applying additional capital per worker to increase productivity growth. Technological progress is the sine qua non of GDP growth. It takes two forms: (1) major discoveries [rare], and (2) research and development.

The economic role of financial markets is to provide the factors of production with the finance essential to make investment decisions that will lead to real GDP increase. Conventional wisdom accepts that “a strong financial sector act[s] as an engine of growth.” (John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156 U. Pa. L. Rev. 229, 247 (2007) – see reference list). That premise follows from the work of Levine and Zervos, concluding that “stock market liquidity – as measured both by the value of stock trading relative to the size of the market and by the value of trading relative to the size of the economy – is positively and significantly correlated to current and future rates of growth, capital accumulation, and productivity growth” (Ross Levine and Sara Zervos, Stock Markets, Banks and Economic Growth, 81 Am. Econ. Rev. 537, 538 (1998)). The ability to “trade ownership of an economy’s productive technologies facilitates efficient resource allocation, physical capital formation, and faster economic growth” (Ibid. at 575).

However, these conclusions are subject to qualification. Equity ultimately may be an unimportant source of capital (Lynn A. Stout, The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation, 87 Mich. L. Rev. 613, 644 (1988) – see reference list). Once stock is issued and used to invest in real resources, it is neither depreciated nor consumed. It does not add one pence of additional investment capital to a company’s capital structure. Rather, trading in the secondary market reallocates wealth among investors buying and selling financial products, “as parimutuel wagering reallocates wealth among bettors at the racetrack” (Lynn A. Stout, supra note 6 at 644). In addition, empirical data proves that unprecedented GDP growth may take place in the absence of a securities market (E.g., the economic performance of Latvia, Lithuania and Estonia, countries that do not have any significant exchanges, have consistently increased GDP by more than 10% for several consecutive years. The economic growth of the United Kingdom, France and Germany combined do not equal these numbers).

The causal role of law in financial development is the subject of numerous studies by finance and legal experts, predicated upon the landmark work of a group of financial economists referred to universally as LLS&V (Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Schleifer, and Robert W. Vishny, Law and Finance, 106 J. Pol. Econ. 1113 (1998) – see reference list. Their work is novel, foundational, and “paradigm-setting”).

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In the European Union context, Elìs Ferran raises identical questions about “law’s role in the building of an integrated EU securities market” (Elís Ferran, Building an EU Securities Market 8-57 (2004) – see reference list). While this website does not examine whether “law matters”, it does touch upon law’s role in the development of institutional infrastructure essential for capital accumulation and technological progress (the causal role of law in market development is beyond the scope of this work except to the extent, without reliance upon empirical or statistical analysis, the merits of MiFID may be measured against its objectives).