Nobel Ideas to Study Financial Law

IN A FORTHCOMING BOOK, FILIPPO ANNUNZIATA APPLIES BEHAVIORAL FINANCE THEORIES TO THE ANALYSIS OF EUROPEAN REGULATION ON MARKET ABUSE

Richard Thaler’s vision for incorporating insights from psychology into economics earned him the Nobel Prize in 2017. But what would happen if such an approach were applied to the law and in particular to subjects such as insider trading and market manipulation? Filippo Annunziata asked himself this question. An associate professor at the Department of Legal Studies, he is authoring the book Behavioral Finance and Market Abuse. A New Approach to EU Regulation 596/2014 that Edward Elgar Publishing will release in 2018. His aim is to read the European regulation on market abuse in the light of behavioral finance theories.
 
The 2009 Larosière Report eventually led to the EU Regulation 596/2014 and the Directive 2014/57/EU on market abuse. “The regulation of market abuse in Europe is a near perfect case of regulatory implementation of the efficient capital markets theory”, Professor Annunziata says. The regulation is divided into two main strands: trading on information and market manipulation. It postulates that investors act in a perfectly rational way. “For instance, according to the regulation, to determine whether an information is subject to insider trading sanctions it has to be determined whether it can be used by a rational investor, according to the concept of an aware and informed investor who makes choices consistent with the paradigm of traditional economics”.
 
According to behavioral finance, however, the investor is not always a rational decision maker. The insider trading regulation can therefore cause overshooting and undershooting problems. In other words, it can classify as irregular cases that are not and, on the contrary, it can ignore cases that should be sanctioned. “Only a regulation aligned with the real behavior of individuals can properly govern the phenomenon. Let’s say, for example, that information disseminated on the market is not considered reliable by a rational investor because it is not accurate or because its source is not trustworthy. A ‘normal’ investor could judge this same information as relevant and he could therefore use it to operate on the market. In this case, there would be an undershooting problem”.
 
Behavioral finance has already been applied to financial regulation, for instance in the area of investment services, where there is the need to protect the weaker party to the contract. “Scholars and economists have been speaking with each other for some years now while lending an ear to the advice of behavioral finance. It did not happen in regulation on market abuse, that has been mostly investigated as a case of realization of the efficient capital markets theory”.
 
Filippo Annunziata invokes caution nonetheless. If he wants his approach to be validated, he must cross legal and behavioral finance analysis on non-controversial grounds. “Applying the Nudge theory, which has made Thaler universally known, would be arduous, at least at the moment. My analysis will be quite conservative and will show a trending line. I will use concepts easy to agree on even for the most skeptical scholar, such as the theory of bounded rationality. I will also analyze the problems that have been faced in the past and the solutions that have been proposed and I will try to assess whether and how we could have improved them by applying a behavioral framework. There will be no revolution: I will move with caution - just like a surgeon in the operating room, but a surgeon that employs a number of interdisciplinary tools”.

by Claudio Todesco