Governing Shades of Grey : The Emergence of Market Governance in the Absence of a Formal Institutional Environment Todd

1. Governing Shades of Grey: The Emergence of Market Governance in the Absence of a Formal Institutional Environment Todd Arthur Bridges, Ph.D. Center for the Study of Economy and Society (CSES) Governing Shades of Grey: The Emergence of Market Governance in the Absence of a Formal Institutional Environment Todd Arthur Bridges, Ph.D. Center for the Study of Economy and Society (CSES)

2. Phenomenon: Changing Institutional and Governance Structure of Markets • Since the 1980s, a market-based financial system has been developing in parallel with the traditional bank-based system and has supplanted the traditional system as the dominant source of credit and liquidity for the US economy • The growth of this new parallel system, however, has not been accompanied by a corresponding expansion of the formal laws and regulations that govern economic action • As a result, large sectors of the US economic system operate beyond the formal laws and regulations that govern the traditional system, and pose systemic risks to the broader Economy and Society • IMPORTANT: Social scientific research needs to investigate and conceptualize how governance has emerged in this new institutional structure in the absence of formal law and regulation, which is often assumed to be the key order-inducing and institutionalizing force in modern capitalism.

3. Emergence of US Parallel Financial System Traditional Bank-Based Structure Vs. Market-Based Structure • IMPORTANT: the new market-based financial system has become the dominant source of capital and credit for the U.S. economy with approx $16-18 trillion. The traditional bank-based institutional structure has increasingly been supplanted by market-based institutional structure. The two institutional structures are similar but have important differences.

4. Competing Governance Structures Traditional Bank-Based Structure Vs. Market-Based Structure • IMPORTANT: 1) the new market-based institutional structure centers on networks of nonbank financial organizations; 2) the networks coordinate their actions to circumvent the traditional credit intermediation processes and avoid costly banking regulations; and 3) the networks are not “formally” regulated.

5. Theoretically Lead Empirical Research How do governance structures emerge in the new institutional structure of the financial system--wherein there is an absence of a formal institutional environment and the state has limited authority to regulate new organizational forms? • Neoclassical Failures: the neoclassical rationality postulate fails to explain why institutions and hierarchical organizations such as firms exist in economic markets (Commons 1934; Coase 1937, 1960; Chandler 1962, 1977) • Institutional Economics Advancements: market imperfections can be solved—or at least mitigated—by creating rationally designed institutions and collective norms to monitor inappropriate self-interested behavior (Williamson 1975, 1985; North 1990; Ostrom 1990, 2000) • New Economic Sociology Response: Institutions in actual markets do not predominantly arise through rational design, but rather emerge because they fulfill social requirements for economic exchange; • from how social networks establish trust and shape the economic actions of individuals and firms (White 1970; Granovetter 1974, 1985; Burt 1982; Baker 1984) • to the ways in which institutional environments and cultural beliefs shape the rules and legitimate practices of organizations and their organizational fields (Meyer and Rowan 1977; DiMaggio and Powell 1983; Scott and Meyer 1983; Powell and DiMaggio 1991) • IMPORTANT: contemporary theoretical models need to place greater importance on: (1) market-based governance mechanisms emerging within entrepreneurial financial organizations and the networks of innovators who are changing the institutional structure of markets (Nee and Opper 2012; Nee and Ingram 1998; Nee 2005); (2) on the notion that governance structures must include both the formal laws promulgated by the state and the reactions of market actors to the formal laws governing the economy (Swedberg 2003, 2005; Edelman and Stryker 2005)

6. Empirically Grounded Investigation • The Strategic Research Site • This investigation does notattempt to explain the entire governing architecture of the US parallel financial system. Rather,it investigates the emergence of governance in one key market within the new institutional structure: US Hedge Fund Market. • BACKGROUND: What is a Hedge Fund (Alternative Investment Fund)? • Hedge funds are legally defined investment vehicles that actively manage “unregulated” pools of capital contributed by high- net-worth investors • Organizations are distinguished from other investment vehicles by their relationship to formal securities law • In order to maximize the range of financial techniques/strategies/tools at their disposal, hedge funds are legally structured to limit participation to high net-worth “accredited investors” and cannot advertise to the general public

7. Importance of the Empirical Research Site IMPORTANT:Hedge funds play three important roles in the new market-based institutional structure: (1) they deposit organized savings into the network of nonbank financial organizations—by purchasing the sophisticated financial instruments being created (repos, CDS, etc.); (2) they help structure the financial products by guaranteeing a market for esoteric and risky financial instruments; and (3) they ensure a secondary market for the products that are created and issued by the network of nonbank financial organizations

8. Research Design: Multi-Stage, Multi-Method Research was primarily a two-stage qualitative investigation complemented by legal analysis and quantitative data set: • STAGE 1—focused on the analysis of 20 expert informant interviews from the hedge fund market—consisting of both hedge funds and their network partners—and the applicable legal regulations • MID-STAGE—to insure a well-balance and representative sample, the second stage of the qualitative investigation was informed by a mid-stage robustness check using a quantitative data set—organizational attributes and network position • STAGE 2—focused on the analysis of 20 expert informant interviews from representative organizations throughout the larger hedge fund market • Final Sample Characteristics—organizations based in New York, Boston, Chicago, San Francisco, Los Angeles, and Greenwich. Organizations range from $1 million to $15+ billion

9. Targeted Empirical Research Questions Investigation was organized around four empirical research questions: • How do hedge fund organizations in the parallel financial system purposefully avoid the formal laws and regulations that operate in the traditional institutional environment? • What are the consequences of purposefully avoiding formal law, and does the purposeful avoidance of law lead to disorder within the organizations and the organizational field? • If avoidance of law does not lead to a lack of order, then what social governance mechanisms are responsible for creating and maintaining order, and how do these mechanisms vary within the organizational field? • Do governance failures arise at specific locations where the formal and informal governance mechanism converge? If so, where are the social structural and institutional failures in the governing architecture?

10. General Theoretical Model Central Finding—the emergence of a governing structure or architecture results from the interactions between: (1) Distal Causal Mechanism: the formal institutional environment in the traditional financial system (2) Proximate Causal Mechanism: the social relations, informal norms, and institutionalized practices of interest-driven parallel financial organizations Theoretical Lineage—the best existing explanatory framework is the multi-level causal model developed for new institutionalism in economic sociology (Nee and Ingram 1998; Nee 2005; Nee and Opper 2012; Nee and Swedberg 2005) Mechanism: Formal State Regulation Incentives: Endogenous Preferences Institutional Framework Mechanism: Informal Social Norms and Group Compliance

11. Advancements of Theoretical Model New Institutionalism in Economic Sociology (NIES): “integrate a focus on social relations and institutions into a modern sociological approach to the study of economic behavior by highlighting the mechanisms that regulate the manner in which formal elements of institutional structures in combination with informal social organization of networks and norms facilitate, motivate, and govern economic action” (Nee 2005: 49). • Theoretical Advancements: #1. this investigation specifies how the formal and informal governance mechanisms converge to govern the ambiguously regulated space and the economic actions of organizations within #2. this investigation specifies how the distal causal mechanism (traditional institutional environment) is interrelated with the proximate causal mechanisms (social norms and networks) #3. this investigation specifies how interests and power affect the type of proximate causal mechanisms that develop and aggregate to the broader organizational field

12. Avoidance of the Formal Institutional Environment Hedge funds avoid the formal-law-on-the-books by taking advantage of well-established regulatory exemptions and loopholes in the institutional environment governing financial markets. Specifically, they maneuver around three regulatory acts—Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act 1940 Example #1: Regulation D of the Securities Act of 1933 • The Securities Act regulates the issuance and sale of securities to the general public and prohibits the public offering or sale of securities without registration • A security is broadly defined in the Securities Act to include instruments such as stocks, bonds, mutual funds, notes, certificate of deposit, etc. • Interests in partnerships and limited liability companies—the interests sold to investors in hedge funds—are not specifically identified in the definition • Hedge funds avoid the expensive and time-consuming registration process, and its associated disclosure requirements, by structuring offerings as a private placement—which is exempt from registration

13. Avoidance Leads to Institutional Consequences The formal avoidance of law creates a number of unintended consequences in the market. In particular, a number of institutional voids (absence of rules and guidelines) are created and force the organizational field to respond. • Formal Institutional Void #1: additional risk is created in the market as a result of the lack of formal requirements on disclosure and transparency in esoteric, complex, and unregulated investment products. • There is no formal mechanism in place to force hedge fund managers to disclose information to their investors and protect their interests. • Formal Institutional Void #2: the ambiguously regulated institutional space gives minimal assurance that hedge fund managers are who they say they are OR that the organization will do as it says with investors’ capital. • There is no formal mechanism in place to verify the credentials of hedge fund managers or their organizations. That is, there is no formal institution or administrative body to check, verify, and monitor the hedge fund field.

14. Embedded Governance The Importance of Network Ties in Governing Economic Action: • Legitimacy Through Network Structure: a dominant, reoccurring pattern that emerged was that hedge funds struggle for legitimacy in a market that has little legal accountability and federal regulatory oversight • a central goal for hedge fund organizations is to build credibility in the field and signal their trustworthiness to investors by establishing network relations with dominant and well-respected actors • Power Within Network Structure: the second reoccurring pattern that emerge was that specific funds and network partners have significant power to shape the practices of the field • the dominant prime brokers in the market have the capability to affect the organization’s practices and economic actions

15. Embedded Governance Legitimacy Through Network Structure: “In order to have credibility in this industry, you need to be with one of these bulge bracket firms. Whether it’s a Goldman, whether it’s a Morgan Stanley, a UBS, is really important in order to establish credibility, because no successful institutional investor is going to want to talk to you if you are basically running an e-trade hedge fund or some no-name brokerage firm hedge fund.” Hedge Fund Principal and Managing Director Boston, Massachusetts $100 Million Under Management “In the post Bernard Madoff environment, it is absolutely critical that you are with counter parties that are sanctified by somebody, right, so in this case, the top three or four prime brokers are Goldman Sachs, Credit Swiss, JP Morgan, and Morgan Stanley. Those four are the four that people feel, I think, most comfortable with.” Hedge Fund Senior Managing Director New York, New York $7+ Billion Under Management

16. Beyond Embedded Governance Organizations, and the organizational field in which they operate, attempt to mitigate the negative institutional voids in which formal law and the state traditionally function by adopting different institutionalized governance structures: • hedge fund managers who run larger, more bureaucratic organizations with $1+ billion under management have voluntarily registered with the SEC • Formal governance mechanism has strong direct affects • hedge funds managers who run smaller, more entrepreneurial organizations have very limited interaction with formal law and regulators at the SEC, and are governed to a greater degree by informal social governance mechanisms • Informal governance mechanisms have strong direct affect IMPORTANT: Why would one group of hedge funds voluntarily register with the SEC, placing themselves under the watchful eye of federal regulators and incurring the administrative costs associated with registration? Coercive Isomorphism--pressures and demands of large institutional investors (ownership interests)

17. Beyond Embedded Governance… Organizational Forms: there emerges two dominant organizational forms within the field, and each form has a corresponding institutional logic and governance structure • Rationalized Governance Structure: first organizational form observed in the data has the following set of characteristics: operated by more than 25 employees; predominantly owned by institutional investors (pension, endowment, and large family offices); manages in excess of $1 billion in assets; and makes up a small percentage of the overall market in terms of absolute numbers. • Entrepreneurial Governance Structure: second organizational form has the following general characteristics: operated by fewer than 20 employees; predominantly owned by the hedge fund manager or principal (either a limited number of colleagues or family offices funds); manages less than $500 million in assets; and is the most prevalent type of organization in the field.

18. Beyond Embedded Governance… Rational Governance Structure: “We use a rigorous feedback or reprocess. We have training, we have best practices, both for everything from trading to managing people to performance. I think largely speaking, most of the hedge funds are sort of one senior guy and a bunch of monkeys running around, right, whereas we’re much more on the institutional side. I think if you walked into our office and looked at our systems and programs, they’d feel like General Electric, like a big company. [His organization] will be on the extreme of conformity and institutionalization.” Hedge Fund Managing Director Chicago, IL $15+ Billion Under Management “We have very, very tight controls. You have to get preapproval for essentially any trade that you do in advance. And we also verify that by getting the trading statements directly from the brokers, people’s personal brokers sent to the firm directly—not via the person. You depend upon them, but you also check to make sure that it’s in compliance.” Hedge Fund Chief of Staff New York, New York $12+ Billion Under Management

19. Beyond Embedded Governance… Entrepreneurial Governance Structure: “Really at the end of the day, the tone is set by the person or the people who are running the firm. And because there’s certainly, you know, lots of gray areas. There’s a lot of room for people to do stuff that is not quite legal . . . So that ultimately even if you’re taking, regulatory mandated ethics courses those are all so kind of weak and silly that would not be the reason you would choose to do the right thing. You do the right thing because you know that’s part of your organization. ” Hedge Fund Manager and Partner New York, New York < $100 Million Under Management “There are times when it could be some minor, regulatory issue or something like that where, you just say to yourself, oh, boy, I’m not really quite sure what happened there, but let’s just sort of keep moving and not get worried about it. Because every time you call in your legal counsel or your accountant you’re guaranteed to stir up the dust.” Hedge Fund Manager and Partner New York, New York < $100 Million Under Management

20. Argument Summary Flow: Lobby Action Best Practices Mechanism: Formal State Regulation Incentives: Endogenous Preferences Emergence of New Governing Structure Content: Social Norms Powerful Interests Mechanism: Network Legitimacy

21. Concluding Remarks… • Governance Failures: it is important to acknowledge that my investigation exposed a number of governance failures • Governance failures are located at institutional and social structural breakdowns where the formal and informal governance structures intersect • The investigation exposed two governance gaps that are created by a unique set of blind spots and pressure points • #1 failure in the entrepreneurial governance structure that governs large numbers of smaller hedge fund organizations • #2 failure in the overarching governing structure of the network of organizations (no formal actor responsible for monitoring leverage of groups and field) • These Governance Failures provide insight into why organizations in the parallel financial system were allowed to take part in opportunistic behavior and increase systemic leverage and credit in the economy during the 2008 Financial Crisis