Private and Public Ordering in Safe Asset Markets

An influential literature in economics explores the phenomenon of “safe assets” – when participants across financial markets act “as if” certain debt is risk free – as well as its role in the global financial crisis and its implications for post-crisis reform. We highlight the role of private ordering in constructing safe assets. Private ordering, including contractual devices and transaction structures, contributes to the creation of these debt contracts, to their collective treatment in financial markets as low risk investments, and to the making of deep and liquid markets in them. These contracts and transaction structures also provide a template for understanding the role of government regulation in constructing safe assets. Safe asset supply and demand does not occur organically. Rather, whether through private or public ordering, three types of legal tools operate to construct safe assets: 1. Making Assets Safe: one set of tools contributes to the production of safe assets by regulating the cash flows into and out of an issuer of safe assets to increase the likelihood of full and prompt payment to investors. These tools might take the form of: engineering the asset side of an issuer’s balance sheet to reduce the risk of inputs in safe assets; engineering the liability side of an issuer’s balance sheet to give holders of safe assets priority over other claimants on the issuer; or creating and regulating the secondary market for safe assets. 2. Labeling Assets Safe: another set of legal tools focuses on the demand for safe assets by granting special status to these contracts when held on the books of investors. These tools create liquid markets for certain assets by either: signaling the low risk of default by issuers of those assets; or coordinating the collective treatment of those assets as having low risk and high liquidity. 3. Guaranteeing Asset Safety: financial intermediaries and governments can also guarantee the performance of safe assets, putting their own credit on the line. Guarantees may be ex ante or ex post, explicit or implicit. A comparison of private and public ordering in safe asset markets reveals how difficult it is to separate the two. Indeed, much of private ordering relies on statute and regulation. Public ordering succeeds at creating safe assets when it enables private ordering and herding by investors into safe asset markets. Understanding this complex interplay between public and private tools becomes vital for understanding how safe asset markets operate, how they fail, and how they must be reformed. The Article concludes with two lessons. First, it deconstructs the notion that there is purely private or public ordering in safe asset markets. Second, it underscores a kind of first law of thermodynamics for safe assets: neither private nor public ordering can banish risk altogether from safe asset markets or financial markets in general. They merely move risk around or, worse, obscure risk until it rematerializes