The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation

Abstract

Influential economists argue that government regulation of manipulative practices in financial markets is unnecessary because exchanges have incentives to take nearly first-best precautions against the exercise of market power. This article shows that the theoretical arguments underlying this proposition are weak because exchange members are likely to ignore the effects of manipulation on inframarginal traders and price informativeness, competition between exchanges may be limited, and collective action problems preclude efficient exchange intervention. For these reasons, exchanges will likely take few precautions against market power. An examination of the history of self-regulation at 10 exchanges prior to the passage of laws proscribing manipulation shows that they took few, if any, measures to curb manipulation. Since the characteristics of manipulation imply that it can be deterred efficiently through the use of harm-based sanctions, this theory and evidence strongly suggest that self-regulation is an inefficient means to reduce monopoly power in financial markets.