Market Efficiency and Financial Market Regulations - An Experimental Approach

The enormous turmoil during the financial crisis and the tremendous costs imposed on society highlight the importance of understanding conditions under which markets are efficient and when they are not. Obviously, in this context, it is of great importance to understand market regulations and interventions like financial transaction taxes, short selling restrictions, and margin buying (i.e., buying financial assets on loan). With the research agenda outlined in this proposal I explore the impact of regulatory instruments and possible bubble drivers on market efficiency and price volatility. The innovative aspect of this application is to use laboratory experiments for the three following research fields: Model Design and Bubbles; Incentives and Risk; Trading Regulation. The research questions in "Model Design and Bubbles" tackle a primarily methodological motivated issue, namely whether different fundamental value regimes per se trigger different levels of market efficiency. In research field "Incentives and Risk" I study the impact of market participants` incentive structures on mispricing and bubble formation. Specifically, the heavily discussed role of bonuses and tournament systems for traders and funds managers and their impact on collective risk-taking and bubble formation will be analyzed. Research field "Trading Regulation" deals with the impact of margin buying and short selling on market efficiency. Both issues are analyzed under linear and convex incentives. Furthermore, I plan to explore the pros and cons of introducing financial transaction taxes (as e.g., recently proposed by the president of the EU-commission, Jose Manuel Barroso) on market efficiency and price volatility in financial laboratory markets. With the setup of artificial close-to-reality markets I can expose real humans to the market situation in controlled environments. The interplay of subjects` behavioral biases and various market institutions provides a more comprehensive picture about the dynamics at work in financial markets. The experimental approach thus can provide insights other approaches cannot deliver. The findings from these experiment have strong implications for people working in the finance industry, political decision makers and the society in general. The research will increase our understanding of the origins of the recent financial crisis and it will improve our knowledge about potential improvements of the financial system in the future.

By means of laboratory and field experiments, we investigate the efficiency of financial markets and analyze whether certain regulatory approaches can foster markets to become less prone to bubble formation and consequently to be more efficient. In the course of the project, we have shifted our focus on running experiments with finance professionals in the lab and on implementing natural field experiments in finance. We find that the "success" of a financial transaction tax on financial markets strongly relies on how it is implemented - i.e., whether it is set up as a tax on markets, on residents, or a combination of both. We show that a tax on markets has negative effects on volatility and trading volume, whereas a tax on residents shows none of these effects. Moreover, we show in several experimental studies that option-like (bonus-type) incentive structures trigger inflated prices on experimental asset markets. With both strands of literature, we contribute to the understanding of the role of bonus-like or tournament incentive structures and financial transaction taxes in financial markets. With respect to the important role of financial professionals' behavior for financial market stability, we show that finance professionals very much care for social comparison and rankings in investment decisions leading to rank-dependent risk taking. This finding even holds when professionals invest for third parties rather than for themselves. In addition, we observe that finance professionals exhibit bubbles less likely (compared to student participants) and that the magnitude of bubbles is reduced once finance professionals are part of the market. To conclude, investigating the behavior and the personality traits of finance professionals is a novel methodological advancement and we believe to stimulate new research on this topic in the future. Finally, during the project, we have identified the importance of replication studies and meta-scientific approaches in Economics and Finance. We were inspired by the replication studies in Psychology and in the Medical Sciences. In particular, we replicated major studies in Experimental Economics and we find important insights on the replication rates of these studies. We show that replication rates of studies are around 60% and that certain characteristics of the original studies like low p-value and large sample sizes explain the replication success. This basic work of members of the START grant in the area of metascience also led to ideas that were incorporated into the SFB F63, "Credence Goods, Incentives, and Behavior", which was prolonged in 2021. These studies are also the basis for some of our recent projects in this area like www.narps.info, www.fincap.academy and www.manydesigns.online. We believe that these metascience studies have had a significant impact on other areas such as psychology and the medical sciences.