Reputation in the Operation of Competitive Markets
Paper Accepted at Austrian Economics Conference - Vienna Austria Nov 2019
Markets are an archetype of contest in a public arena. Whether a contest is commercial, financial, political, athletic or scientific, the core elements of measurement, timing and outcome are strong candidates for analysis by game theory. Markets add the element of mutual exchange, which narrows our focus to the reputation and trust areas of game theory. The promise of progress from well-functioning markets comes not only from the selection of the best choices from competing alternatives, but also the urgency to act and move to the next decision point which is aided by strong reputation and trust game dynamics.
Markets mix evaluation and action and entice our emotions to act because of the drama inherent in the duel between anticipation and the catharsis of resolution. If possibility is the fuel, consequence is the throttle, and the twin tyrants of Wall Street -- greed and fear -- reach very deep into the fight or flight fulcrum in our brains. Importantly, in the post-Victorian and Great War environment, it was conceivably difficult for economist such as Keynes to see rationality in emotion. Reflexively, these economists sought refuge from the “animal spirits” in the calm of a wood paneled study and the symmetric corridors of a bureaucracy – an illusion of order doomed to profound failure.
For all the outward symmetry, cold-calculation and order of a bureaucracy, a resolution is often the last think it wants to produce, particularly if resolution threatens the very existence of the organization and its actors. This is increasingly the case in an environment where industries rise and fall within years, not decades, and very often a bureaucracy’s instinct to preserve itself fails to produce any outcome, much less one that would be arrived at through rational consideration. This paper is part of a broader project (The Arena Project) to introduce the game theory principles needed to build reputable, healthy arenas for decision-making that do not lean on a shaky and delusional bureaucratic foundation; and the first order of business is to embrace as thoroughly as possible the market’s emotional barometer and decision-oriented power.
A healthy commercial market in mobile operating systems tells us via sales figures how Android is faring against IOS and which one should gain our favor. A well-functioning financial market tells us via share price whether we should believe more in the future of Tesla or Volkswagen AG and which leadership team should get access to our investment dollars on more favorable terms. Similarly, election contests set the direction of our public policy and allow us to evaluate performance against promises. Sports playoffs crown athletic champions. Pressure to act resolves contradictory viewpoints, and that is essential for societal progress.
Given the centrality of markets in building human civilization and the rewards for successfully navigating them, it is not surprising that humans are adept at calculating possible outcomes in real time and making approximate decisions in the aggregate. Notwithstanding the fascination behavioral economists have with decision anomalies, there is a consensus that our subconscious is surprisingly adept at accurately calculating possible outcomes in real time when something vital is at stake. The gift of value approximation is particularly efficient in collective judgements of interest to game theorists.
But the fear of facing a negative outcome causes us to seek comfort in a decidedly anti-dynamic mentality - the idea of “regulation”, which denotes ordered, sequential repetition at regular intervals (like marks on a ruler or a heartbeat). Regulation may feel more rational, but all the reasoning and rules in the world do not move the pieces on a chess board or decide the next tournament pairing. Only action makes that happen. Markets, like all public arenas, are a social phenomenon and thus sit between cooperation (agreement to exchange) and competition (need to establish hierarchy of priorities). We are wired do just about anything to win a competition because we are status / hierarchical animals and being on top provide perks. The allure for healthy, well-functioning and fair markets comes from our need for social belonging, as well our rational realization of their net advantages; however, the individual instinct to cheat in order to come out ahead has an equal, if not greater, pull. Therefore, rules are required, which is where reputation theory can replace the creaky ghost-like apparatus of bureaucratic prescriptions.
If a market has too many disreputable elements, it will fail to produce valid outcomes. Without valid outcomes, participants leave and any broader benefits from the markets are diminished, if not extinguished. While new, more productive markets invariably arise, blackout periods can prove long and painful for the great mass of people formerly benefitting from exchange and proof of concept, and progress is naturally diminished in those periods of failed markets. Failed commercial and product markets slow consumer spending and delay, if not reverse, product and service innovations. Failed financial markets strand capital. Capital that is not recycled cannot be relied upon to fund new opportunities with a higher potential for return. We witness similar dynamics when failures in journalism and political arenas stymie obvious and necessary public policy course corrections resulting in dissatisfied voters and the rise of zero-sum ideologies. Eventually risk taking and innovation stall to the detriment of current and future generations. These consequences are not lost on the social side of our nature, which pines to make a lasting difference in face of the reality of our own mortality.
At its most basic level, reputation is built on trust and the decision to choose and interact with an exchange partner based upon perceptions about reliability, veracity and intentions. Without reputation, markets grind to a halt because it is simply too burdensome to complete thorough due diligence on a potential partner and their offering within normal price, timing and settlement constraints. The scalability and speed of reputation-based decision-making accelerates actionable knowledge within a community and enhances efficiency. So, what makes public arenas reputable? That inquiry breaks into two parts: (1) what elements does a reputable public arena require to function well as informed by game theory dynamics, and (2) what threats do they face along the way that they must guard against?
Where’s the Party?
The first order of business for any functioning arena is ensuring verified, reliable counter-parties that are willing and able to participate (and exchange) and can do so on the basis they represent to others. This may seem trivial and obvious, but we repeatedly witness situations where this simple rule is ignored, disaster ensues, and observers appear stumped and cast blame elsewhere. Part of the difficulty is that counter parties can be inadequate for any number of reasons that are not always obvious at the time.
They may simply be too young to adequately participate in a market, such as children in a market for healthcare – a notable argument for significantly expanding the Children Health Insurance Program (CHIP). They might not exist and/or be one identity under multiple disguises (Sybil attacks), such as Russian-generated Twitter bots or Facebook pages created to promote agitprop in US elections. They might be impossible to hold to account or minimally identified, such as a crypto-currency counter party that can disappear into the ether after one order of an exchange. They may not have the resources or intentions they represent having, or perhaps they have taken on far more risk and liability than they can responsibly cover, as we saw with default insurance providers, such as AIG, during the Global Financial Crisis (GFC). OR they might have access to practically unlimited funds, but can avail themselves of sovereign immunity, thus also making them effectively judgement proof and as unreliable a counter-party as any shifty street hustler. Third party agents with moral hazard, as we see in insurance markets and government schemes common in the health care and education arena, present another more complex challenge. They may be decently functional counter-parties, but face demands outside the confines of market exchange given their ability (and often incentives) to pass along the costs of misjudgments.
Identity and access management is a multi-billion market in the world of information security, garnering no small part of the total pie, which provides some window into depth of the thinking which has been applied to this area of systems theory and possibilities for the development of effective rules.
The Off Switch
Arena contests are most successful (in finding an optimal outcome and continuing to attract participants and spectators) when the rules are simple, easy to discern, readily verifiable by officials and spectators alike, and function mostly as off switches. To bring an analogy from the electric engineering discipline, rules function best as simple single function discrete, rather than complex application specific circuits or ASICs. Complex behavioral directives that require expert interpretation and adjustment to generate a specific outcome are ill suited to real life arenas where it is extremely challenging to predict the dynamism of the actors and their interactions with one another. What we do know is incentives to collude and subvert the rules of the game are a persistent part of any arena of contest and the best route is not to dictate what should be, but rather what should not be and quickly work to stop those practices. In game theory, the “off switch” principle was an essential piece of Turing’s initial design principles, and it has continued to be an intensely explored component of computer simulations since that time. The tiers of chaos that might require and off-switch are only exacerbated in today’s information- and attention-flooded environments.
Moreover, the circuit breaker principle is foundational for much of what we view as successful modern institutions. The genius of democracy is not that it consistently chooses the finest in its leaders with great deliberation. Democracy occasionally produces remarkable people, but, more importantly, it can be counted on to replace choices that have veered so far off track that an apparently cost-free action (voting) is finally understood to have punitive consequences. Similarly, the genius of capitalism is not that it produces the most exquisite products (cloistered monks or indentured court artisans can accomplish that task), but its ability to reject horrible value propositions and satisfy a broad range of tastes at a competitive price.
In financial markets, you witness off switches in market hours, trade circuit breakers, and margin limitations. In sports, you find red cards, game suspensions, and time clocks. In democracy, you witness term limits. Problematically, in surfeit economies, where political parties are simply so many sports teams and allegiances are perceived as discretionary luxury items, it may well be time to seek even more off mechanisms. Gerrymandering and recycling tax dollars has dramatically lowered accountability and consequences, so mandatory sunset provisions for legal and regulatory measures could bear more consideration. Idaho recently experimented with this topic by eliminating its entire statutory regime in one action. The argument for this circuit breaker is compelling. In his seminal book Open Society and Its Enemies, Karl Popper makes a powerful case for what he terms “piecemeal engineering” as opposed to the utopian certitude of schemes built around idealizations of who should rule and what end state society will achieve. The piecemeal approach suggested by Popper fits well with sunset provisions. Once a risk is identified and the government passes a law or regulation to address, the action has either worked within the specified sunset, no longer necessitating the action or making it an obvious candidate for renewal OR the action has failed … in which case the law should be ended, and something new should be attempted. Sunset requirements would have the ancillary benefit of making it easier to pass necessary laws, as the fear of entrenched interests developing or unintended consequences arising would be reduced.
No Free Lunch (or Market)
Markets, like any other social endeavor, must manage the allocation of shared resources and provide an effective service at a price above cost. The term “free” applied to markets is an unhelpful misnomer. While it is alluring to imagine a world of wide-open, unimpeded interchange, effective markets require many elements that have a cost -- in time or money -- that must be paid by someone, somewhere, at some time. Quite apart from the cost question, effective markets, and certainly truly efficient ones, are far more difficult to achieve in practice than we generally perceive because it is often difficult to ascertain and allocate the basic costs or running a market. As a result, a simplified acceptance of the efficient market hypothesis (EMH) can do a disservice to market theory by building on the false dichotomy. Defenders of EMH downplay the cost and fragility of a market and detractors notice dislocations, but jump to wrong answer that markets should be regulated as if they are bi-polar individuals in need of medical intervention and not institutions that simply require the type of rules and cost allocations outlined here.
Negotiating and settling on an effective cost-allocation arrangement is a crucial foundation for any market institution be it formal or ad hoc. Equally as crucial is retaining the ability to modify cost sharing arrangement as technology, participant dynamics and regulatory externalities shift the fragile negotiated working balance. It is important to note that I am referring here to the cost of operating the market infrastructure on terms attractive enough to draw participants with a sufficient level of information, settlement, policing and market maker offerings. This does not even include the additional costs that market participants may incur to gather proprietary information to gain advantage over other participants.
The first unavoidable cost besides the obvious contest facility (think of a virtual or physical arena) is recruiting, vetting and educating market participants -- not the observers who may be more into the drama than the outcome but those who win or lose daily. These are the gladiators in the arena, and while they often bring their own gear and endure their own expenses (particularly if the arena has a good reputation), costs cannot be. The participant cost hurdle can be trivial, such as with a contest like American Idol, where they must buy a nice pair of clothes and spend rehearsal time to learn an existing melody. Or they can be extensive, such as the analysis and selection of investment securities that rely on the maintenance of a large enough corporation with enough capital needs to require access to capital markets.
Market agents are expensive, and so is policing. Effective markets must solve not only the question of who pays the cost of policing, but how to police the police. The constant care and feeding of watchdogs seem relatively obvious. Anyone who has organized a youth basketball league understands that after securing court time, the next order of business is paying the referees. Spectators are one way to “police the police” and often quite effective, but you still need to plan for an effective feedback loop to inform decisions and empower actors. Accounting for basic costs for running an effective arena becomes even more poignant in a democratic political process. Notably, there is a large and unavoidable cost in making the citizenry fluent in the key ideas and principles that animate the political process, without which failure is inevitable.
Blessed are the Market Makers
By many measures, broad swaths of the financial markets, politics and other public arenas are in deep dysfunction … and this makes no sense. The cost of capital of in public markets is markedly lower than in private markets, and this differential has only grown in recent years. One would assume in this information rich environment that democratization of the markets would have a full head of steam. The evidence, however, discards this hypothesis. The number of public companies in the US financial markets has fallen steadily from almost half of its turn of the century peak, while the number of private equity managers has risen from 800 to over 8000 – a tenfold increase. The sizable shift from assets that face daily accounting of value and high levels of liquidity to ones that might take years, if not decades, before they face scrutiny and/or liquidity bottles up enormous amounts of risk capital, the lifeblood of a dynamic economy, and reduces accountability.
The authors believe that a proximate cause of the collapse in public arenas is the failure by public leadership to appreciate the presence and role of market makers – or specialized agents in game and reputation theory and trust analysis. Market makers have a native incentive to battle two key enemies of markets as an efficient pricing mechanism: transactional apathy and algorithmic trading. Exchange traded funds (ETF) have, along with other factors, produced a remarkable correlation between the movement of individual stocks and the movement of the overall market. In July of 2010, this correlation sat at over 80 percent -- a stunning figure that has made the public marketplace all but irrelevant as a pricing mechanism for individual equities. The burst in algorithmic trading masks more meaningful malaise and transaction apathy which unsurprisingly drives people away from a market that is no longer particularly good at asset pricing.
Political journalists are the equivalent for a political democracy of market makers in the equity capital markets. Their job is fundamental to preventing political apathy AND putting facts into their proper context or slowing down the algorithmic (aka automatic) rush to judgement. They have every interest in the world to keep the market for new ideas constantly churning and not just descending into a rehash of memes on social media. It is not surprising then that with the demise of independent political journalism, we are witnessing a deterioration of political ideas and solutions. The deteriorating number and quality of these actors as pressures to feed micro-markets of followers (spectator interests) and the lack of a compensation system undermine their roles as effective advocates against apathy.
While the internet has significantly lowered the cost of delivering relevant information, it must be accompanied by the promotion of differentiated viewpoints, which are the lifeblood of market makers. The well-intentioned Regulation FD (for Full Disclosure) and Sarbanes Oxley, were meant to provide higher quality information to a broader set of actors, yet we have witnessed the evaporation of information from the public equity markets. Rule 2711, which prevents research analysts from gaining compensation from primary securities issuances, has created a shortage of information flow in the marketplace from broadly available sources. Not surprisingly, the public equity markets in the United States, once the most thriving in the world, have withered. Convincing statistical and practical evidence exists that efficient markets require six independent specialized agents to create an optimal market outcome.
Truth or Consequences
The solution rests in finding new and innovative ways to invigorate the economics of market makers, who were ravaged by decimalization and algorithmic trading, or those with an interest in transactional intensity and reducing algorithmic apathy. The first order of business for market makers is to return to roots of the trade and hew to their purpose. A market maker serves two masters, but ultimately answers to only one god -- the deity of evidentiary veracity. Unlike spectators or even regular market participants, persistent or specialized agents (another term for market makers) have a unique duty to tell the truth, to be the honest broker in traditional parlance. They are assumed to be in the game all the time and are relied upon by the other participants in a way that is unique to the health of the arena.
As an example of going awry in this regard, the United States political system provides an object lesson. Two structural flaws have hampered to role of market makers: one is the nature of the defamation laws for public figures after Sullivan v. NYT which immunizes journalists who make false statements, which is further compounded by the bias for spectators over participants in an advertising model for funding journalism. Reputation networks do not work in the presence of these biases, which prevent sanctioning dishonesty. US financial market, by contrast, fare better. Sanctions for misrepresentation are at the foundation of securities laws that have lasted nearly a century. The Fraud on the Market (FOTM) theory is a pillar of the EMH. A traditional fraud claim requires a plaintiff to prove they knew of the specific misrepresentation causing the harm and reasonably relied upon it. FOTM requires only evidence of a loss and evidence that misrepresentation was being made “on the market” at the time of the purchase. Proximate cause is implied by the simple presence of fraud in the market system and reliance is implied by participation in the market. In legal parlance, the act of participating in the market creates the necessary privity for a fraud claim.
Trust mechanisms to get out ahead of fraud in other arenas are no longer effective. In the traditional family-based and social world, ostracism borrowed heavily from religious belief, shared sacrifice and ancestral affiliation (real or mythologized) to create a web of social sanctions. The risk of getting excommunicated from the tribe was a powerful trust mechanism when group expulsion could mean the difference between life and death or procreation and no creation. The “market makers” in those instances are the priests, rabbis, tribal elders and other arbiters. But these mechanism face limitations in modern society, and arguably with Bernie Madoff-style affinity fraud and ever-shifting sands and pathologies of tribal (my team) movements, these old trust mechanisms have become a negative externality. Whatever the spiritual or other rewards of group membership may bring, as trust mechanisms they are no different than any other adaptive social innovation that has mirrored the advancement of human civilization … and they must change accordingly.
If there are few bumps in the road in maintaining transparency, simplicity, integrity and actionability in the public financial markets, the increasingly vast private markets have become truly troubling. There are proxies in the private markets for the formal market makers and policing schemes witnessed on the public side, but these are relatively haphazard and underwhelming and while sanctions for dishonesty in this realm remains strong, there are few outside observers to help police the police. Powerful gatekeepers such as Cambridge Associates provide independent assessment services to asset allocators, such as insurance companies, endowments, family offices, sovereign wealth funds and pensions; however, their role is a mish mash of advisor services, self-reported numbers, oversight of audit activities and conflicted asset accumulations.
What a Coincidence
Turning conflict to consensus in markets requires coincidence of timing. Nothing is more certain and consistent in the evolution of markets than coincidence in timing, which accounts for the phenomenal growth in markets (and human cultural evolution) from the invention of the first portable time piece in the 15th century. Our modern infatuation with asynchronous systems from email in business communications to high frequency, algorithmic trading, and self-marking in financial markets to the morass of derivative and illiquid risk instruments wrapped around market traded instruments (and which settle in no relation to those markets) to inverted yield curves and other tools of monetary authorities living in a timeless/riskless stasis is no small contributor to the current dysfunction in public arenas that we are witnessing.
Reputation theory and trust have had a long dance with asynchronous v. synchronous resolution, but when it comes to the point of decision few doubt the value of synchronous systems, even if some downshifting from asynchronous systems can provide important value. In addition to the befuddlement that reigns in the world of capital allocations due to asynchronous systems and the rise of black box allocations, elections in the United States have become problematic and our democracy has been challenged by the onset of timeless electoral campaigns. Endless fundraising and electioneering, early voting, mail in ballots, ballot harvesting, delegitimization memes (from Obama born in Kenya to Trump installed by Putin to Brexit chicanery) and the now expected legal challenges at every corner have undermined the integrity and belief in the electoral process. People no longer wait for the next election, but rather litigate and relitigate political alignment daily. As a result, social problems and risks remain unaddressed and recriminations replace the experimental ethos of trial and error that is so healthy in the democratic system.
Cronies, Cartels and Cons
Markets that do not line up price and value well generally suffer from one of three broad camps of dysfunction: cronies, cartels or cons. While the authors put forth some rules of thumb founded on reputation theory to address these pathologies, we are also guided by Karl Popper’s admonition to focus on piecemeal engineering. The wisest path for a public leader is this regard is not to get wedded to an idealized schema of the perfect marketplace and follow rules slavishly in hopes to achieve it, but rather to focus on the specific pathologies that appear repeatedly when people work to take advantage of the power of public arenas. Humans will almost always gravitate toward some form of market arrangement, because we have witnessed so much success in that regard. Our view, paraphrasing the classic mathematical quote, is that it is better to get an approximate answer to the right question, than a precise answer to the wrong question.
Arenas may not be built into our nature, but they are certainly built into our culture from ancient Greece to the Tokyo fish market, and represented a persistent meme along the lines of fire. Forays into behavioral economics have introduced us to testable cognitive fallacies that demonstrate that in certain instances market actors act inconsistently with their own rational self-interest, and yet effective markets work precisely because of their capacity for criticism and ability to create a cost for cognitive fallacies. Even behavioralists do not discount the EMH as a portfolio management theory, because market participants have the benefit of mis-pricings caused by fallacies and fraud in both the up and the down direction. In other words, individual cognitive fallacies are offset by other fallacies, creating an institutional outcome superior to both delusions. I suggest that for academics that even more critical than studying the cognitive fallacies of market participants is to study the fallacies of regulators (both private and state) who only face one corrective mechanism – the collapse of the market itself. That is a very heavy hammer and so identifying the sources of institutional inertia that create a failure to address cronies, cartels and cons. I suspect confirmation fallacies, group think, and other defensive psychological methods make people reluctant to accept contest as the best medicine when things have gone bad. But circumstances do change. Technology is introduced. Side negotiations have unintended consequences for other cost allocations. Bad actors undermine reputation systems. All of these eventualities need to be built into developing rules for effective markets.