Modern society depends on the financial markets. They facilitate the flow of capital, allowing businesses to fund growth and investors to allocate capital profitably. Law supports markets, among other things, by enforcing contracts that underlie exchange.
Regulation can also curb market excess, promote transparency, and limit volatility. But does law create markets, or do markets drive the need for law?
“It’s both,” says Charles K. Whitehead, Law, and founding director of the Law, Technology, and Entrepreneurship Program at Cornell Tech. “It’s a symbiotic relationship. Without law, markets would fail to develop or would develop less efficiently. Law doesn’t exist in a vacuum, however. Markets with weaker laws are less efficient, less attractive to investors. Consequently, market discipline can drive the need for law as a lower-cost means of transacting.”
How Law Helps Manage Financial Risk—And the Mythological Story of Theseus
Whitehead’s expertise centers on understanding corporate structure, transactions, and the financial markets, and how law affects each of them. An important focus of his research is the management of financial risk: a law and finance approach to considering risk around the corporate form, in deals and the financial markets, as well as when and how law can help manage that risk.
Whitehead’s background gives him a unique perspective on financial risk. For 20 years, he worked in law, banking, and the financial markets before coming to academia. Leveraging that experience, he has been looking at financial risk in diverse ways, including a current project that assesses the impact on capital markets and their regulation of recent activities, separating financial instruments and risk. “The capital markets provide one means to disperse financial risk across society,” Whitehead says. “And as the markets have changed, so has how we should understand and regulate their risk management function.”
A simple way to illustrate that change, according to Whitehead, is the story of Theseus, the mythical king of Athens who sailed to Crete to slay the Minotaur. According to the historian Plutarch, for centuries after Theseus’ return, his boat remained in the Athens harbor as a memorial. To keep the boat seaworthy, caretakers replaced old planks, sails, and ropes with new ones as the originals wore away. Little by little, new materials were substituted for old. Over the years, it became unclear how many of the boat’s original parts remained, prompting Plutarch to ask, was the boat in Athens’ harbor still Theseus’s boat?
That story helps frame change in today’s capital markets. Many of the United States securities laws were drafted in the 1930s, when most securities were stocks, bonds, notes, or convertible bonds. Trading, however, has evolved since then.
Innovations in Financial Risk Management
“We see that change in new risk management techniques and tools,” says Whitehead, “including derivatives that enable the transfer of risks (the planks) that comprise an interest in common stock (the boat), rather than the transfer of bundled risk through a sale of the stock itself.”
New risk management techniques also enable today’s institutional investors to manage trading activity, based on aggregate—portfolio-level risk. Traders are less focused on the merits of any one security (the boat) and more interested in managing the risks comprising that security (the planks).
“Owners today can transfer risk in discrete slices to counterparties who can diversify or transfer away risks they choose to forego, arguably at lower cost than investing in the security itself,” says Whitehead. “That drop in cost suggests that change in the capital markets—the shift away from broad-based risk instruments (like stock) toward more discrete means of holding and transferring risk—is likely to stay.”
In other words, rather than buying and selling boats, traders increasingly buy and sell the planks comprising those boats. The question, according to Whitehead, is whether and under what circumstances should the two be regulated the same. What should guide Congress, the regulators, and the courts—the boats or the planks?
“My work requires an understanding of markets, risk-sharing, and the role of regulation. It requires diving into the black box of what market actors really do and how changes in law affect their activities.”
Whitehead sees his experience on Wall Street as a key driver behind his research and expertise. “But for that experience, I could not work on the kinds of projects I’ve had the chance to pursue,” he says. “My work requires an understanding of markets, risk-sharing, and the role of regulation. It requires diving into the black box of what market actors really do and how changes in law affect their activities and what risks they take on. There’s a role for law there. But there’s also a role for markets. It’s often a question of the right balance.”
Ukraine, an Ideal Research Undertaking of a Startup Ecosystem
Recently, Whitehead combined his interests into a project in Ukraine. “Ukraine has serious problems, among them being weak enforcement of its laws, including in business,” Whitehead explains. “Often, the laws are on the books, but they are weakly enforced or not enforced at all. Consequently, Ukraine’s markets are inefficient or nonexistent. It has no capital market, a weak banking system, and no real way to manage or disperse financial risk. The question is whether a market discipline can be introduced to Ukraine, and if so, whether it will affect Ukraine’s approach to the rule of law. For someone like me who studies law, risk, and markets, it’s perfect.”
Whitehead’s connection with Ukraine goes back to 2014, when he lectured at the Yaroslav Mudriy National Law University in Kharkiv. He was struck by Ukraine’s inability to commercialize its technological expertise, as well as by the country’s lack of a financial infrastructure.
“The prevailing wisdom was, if we build new laws, the markets will come, but very little had happened since the fall of the Soviet Union,” Whitehead says. “Even though the laws were on the books, there was no interest in enforcing them because no real markets were affected by non-enforcement. And yet, there were no real markets precisely because there was only limited or no enforcement.”
In 2017, Ukrainian academics and regulators approached Whitehead and asked him to help find a way to bring capital into the country. The result was creation of Ukraine’s first American–style startup incubator, which launched in early April 2019—a global platform to commercialize Ukrainian innovation, as well as to encourage foreign investment.
“It’s one thing to read about how a startup ecosystem, like Silicon Valley, grew up; it’s quite another to help engineer an ecosystem as it’s being developed. That alone has been a learning opportunity,” Whitehead says. “The question now is whether introducing a new market, as foreign investors look to invest in Ukraine, will force the creation and enforcement of new laws. And over time, whether new investment will cause greater interest in regulation that supports the management and distribution of risk—an example of a market shaping law and not the other way around. I’m hopeful it will succeed.”