Sunday, 18 July 2010

Sources and consequences of structural incoherence in financial markets

(to be published in LSE SU Finance Society Magazine 'The Analyst')

We can highlight three important insights sociological studies bring from financial markets. The first is the importance of social relationships (networks) in sensemaking and price-discovery, which undermines the notion of rational unitary actors capable of collecting and processing data/information on their own (Baker, 1984). The second is the demonstration of origins and effects of social and organisational action that are not necessarily utility maximizing by looking at the role of beliefs and culture pertinent to distinctive groups in financial markets (Abolafia, 1996). Related to this is the insight on how markets and politics interact in shaping markets' legal and cultural foundations and social actions that take place in markets (Fligstein, 2002). The third insight is the demonstration of human and non-human actor interaction which includes application of theories and technology to market exchange, and how these transform cognition, calculation and price-discovery activities in financial markets (Millo and Mackenzie, 2003; Mackenzie 2009). In all the three insights that are mentioned here, there is one common theme, namely reduction of uncertainty concerned with; firstly rights and obligations attached to securities and actors that participate in the issuance and exchange of securities; secondly the social value and legitimacy attached to these essential processes and markets in general; and finally subjective judgements about financial value of securities in relation to risks and returns.

In reference to the third insight, recent research on financial markets demonstrate the growing importance of digital representation and calculation technologies which have undermined the network based and face to face relationships in financial markets (Cetina, 2005; Cetina and Preda 2007). In this new environment, flows of funds and information presented on information and trading screens become text-like representations of aggregate market sentiment which market actors read, classify, interpret and contribute to with their trading actions. In this respect, market actors develop market knowledge via observation of market screens rather than by being in a market place physically. The latter in fact had been a privilege for select few market professionals before the digital revolution. The digital revolution can therefore be argued to have brought a new wave of disintermediation to financial markets and enabled lay investors and smaller investment organisations to be more self-reliant in their observation and trading activities in markets.

The digitization of market places and the automation of trading have therefore transformed the ways in which market actors orient themselves to other market actors. More importantly, they have brought a more democratic access for professionals and public alike to information/data and markets. The improvements in access  however does not necessarily bring an uniformity among market actors in their comprehension and interpretation of market screens. As the nature of representation on market screens are now very much dominated by summary proxy figures on anonymised actors, and risks and returns on financial securities, market actors find themselves in a position to having to decode these figures to be able to gauge the direction of markets and the value of their investments. In that process, one's market identity and epistemic, social and economic resources often become the determining factors in how the decoding is performed and results in trading decisions.

Irrespective of the effects of digitization on the generation and coherence of meanings in digitized financial markets, sociological studies on financial markets have pointed to the origins and consequences of different interpretations in markets in the form of conflicting valuation models on securities (Beunza and Garud 2007) or worse, categorical discounts or total avoidance of securities (Zuckerman 1999) which seem not to fit the prevalent perception frames or knowledge standards in distinctive pockets of a market place (White 2000). The main source behind these structural differences in meanings are the multiple roles actors and entities take on, and the understandings of actors about other actors' and entities' roles and functions in the market place. Within a market, one can therefore talk of a division in terms of not only the concrete functions an actor or entity fulfills but also the perceptions that are held by actors about other actors and entities. Although one would assume that over time there should be a convergence between fact and perception as social order is based on the consensus among actors over meanings attached to actions and entities, financial markets undermine such a need for consensus over meanings, especially about the aspects of market which are not directly concerned with the foundational rules, regulations and mores that are necessary to solve the [social] value, cooperation, and competition problems in markets (Beckert 2009). In that sense, price of a security at any point in time need not reflect consensus about the 'right price' in relation to financial risks and returns among different actors for it to be realized and used as a signifier for the exchange of securities. This is despite the fact that there needs to be a consensus about the legitimacy of price discovery mechanisms in a market for it to be perceived as orderly, stable and fair to all the participating parties irrespective of their market identities.

We can therefore identify two planes of order in financial markets. The primary plane of order is comprised of the ground rules and norms about what constitutes a security, how it can be exchanged in a given market, the rights and obligations attached to owning a security, who can own it, who can issue it, and so on. The primary plane gives purpose and role to the constituting elements of a market. It draws the boundaries of competition and cooperation among the participating actors in that market. The secondary plane accommodates the actual practices by market actors as they are informed by the first plane and the theoretical or vernacular constructs about financial valuation. However, the knowledge and value outcomes generated in the second plane may not necessarily conform to the categorical or a priori facts generated in the first plane. Simply put, shares of company A despite being categorically the same entity in the first plane, namely a security that allows investors to become shareholders in a company, may not take on the same meaning in relation to the subjective financial valuations and/or reappraisal of their social worth and legitimacy by different market actors who have distinctive market roles and identities. Consequently, the actual financial and social value and legitimacy evaluations of various market actors may undermine the legitimacy and social value of a given security and nullify a priori truth claims that are made about it. Similar mismatches between a priori truth claims about other components of a market and a posteriori perceptions held by different market participants and the public are probable and prone to create a structural incoherence in the meanings attached to markets and their components. This probability has been exacerbated by the democratisation of access to market data/information and knowledge, which has diluted the network-based and restricted mode of presence in market places. Therefore both planes of social order in a financial market are closely connected to each other in a spectrum of mutually constituting to mutually undermining relationships. The dynamism created by the multitude of actors and entities with diverse social and market identities in constant market interaction leads to reappraisals of a priori and a posteriori claims on securities and markets, and provides the internal and external stimuli for reform and change in financial markets.

References

ABOLAFIA, M. (1996) Making Markets. Opportunism and Restraint on Wall Street. Cambridge, MA: Harvard University Press.

BAKER, W. (1984) ‘The Social Structure of a National Securities Market,’ American Journal of Sociology, Vol. 89, No 4, pp. 775-811.

BECKERT, J. (2009) 'The Social Order of Markets,' Theory and Society, Vol. 38, No. 3, pp. 245-269

BEUNZA, D. and R. Garud (2007) ‘Calculators, Lemmings or Frame-Makers? The Intermediary Role of Securities Analysts,’ Sociological Review, Vol. 55, No.2, pp. 13-39.

CETINA, K.K. (2005) ‘How Are Global Markets Global? The Architecture of a Flow World,’ in K.K. Cetina & A. Preda (editors), The Sociology of Financial Markets. Oxford: Oxford University Press.

CETINA, K.K. and Preda, A. (2007), ‘The Temporalisation of Financial Markets: From Network to Flow,’ Theory, Culture, and Society, Vol. 24, No 7–8, pp. 116–138.

FLIGSTEIN, N. (2002) The Architecture of Markets. Princeton: Princeton University Press.

MACKENZIE D. and Y. Millo (2003) ‘Negotiating a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange,’ American Journal of Sociology, Vol. 109, No. 1, pp. 107-145.

MACKENZIE, D. (2009) Material Markets: How Economic Agents are Constructed. Oxford: Oxford University Press.

WHITE, H (2000) “Modeling Discourse in and around Markets,' Poetics, Vol. 27, No. 2, pp. 117-133

ZUCKERMAN, E. (1999) 'The Categorical Imperative: Securities Analysts and the Illegitimacy Discount,' American Journal of Sociology, Vol. 104, No. 5, pp. 1398-1438

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