Part One

A. Introduction

Is it true that the pursuit of private interests produces not chaos but coherence, and if so, how is it done? - Frank Horace Hahn1

This book is about the crisis of the risk- and information-based regulation of the capital market. "Disclose and self-regulate" only works when the capital market and its agents can be seen as evolving and adapting in an optimal efficient manner, rather than simply evolving away from external constraints. The phenomenon described in this book as disruptive change casts serious doubt over this assumption. Technological advancements, regulation, climate change and the recent COVID-19 pandemic - these, amongst others, are the drivers of what shall be called disruptive change.

Economic agents are subject to constant environmental change. The emerging environmental discontinuities, however, affect entire industries in a way that the very principles that underlie them are called into question. Statistics show that environmental change is starting to affect the lifespan of publicly traded companies. The lifespan of companies in the Standard & Poor's 500 Index, has reduced dramatically.2 In 1958, companies were looking at an average of 61 years in the index. By 2012, this span reduced to 18 years. By 2027, 75 per cent of these companies listed in the Standard & Poor's 500 are forecast to be replaced.

Economic change, especially technological change has been addressed by economic theory in multiple ways. This work can build on these approaches even though the focus of the analysis is a different one. It is not concerned with the regulation of new business models in themselves. This book sets out to show that these environmental discontinuities share common features that pose a threat to the capital market and its participants, one that goes beyond the "normal" cyclicality of markets. In order to do so, regulation is in need of a phenomenology that can provide the basis for a meaningful debate. Unfortunately, the formulation of a phenomenology faces difficulties, given the current framework's inaptness to reflect the system's movement through time. The inflexibility of the regulatory framework makes it hard to even think about the effects of environmental change.

Regulators have adopted the mathematically sound model of the efficient market which offers a neat role for regulation, the "market failure metaphor". The assumption of a hyperrational representative agent (the "EMH-investor") allows regulators to reconcile macro market behavior with micro behavior (and vice versa). Regulation is hence mainly concerned with the arrival and distribution of information as the determinant of market behavior. Talking about disruptive change, however, requires the analysis of processes that are uncertain, i.?e. where only insufficient information is available and optimal individual behaviour cannot be specified. The discontinuities discussed in this book are on the "edges of the distribution" of expectations for the future. Instead of founding regulation on the statistical "norm", adaptation processes call for an integration of low-probability high-impact events into legal reasoning. A regulatory agenda informed by the concept of risk only, is bound to neglect these processes.

Against this background, it is the goal of this work to capture a stream of literature emerging from econophyscis and econobiology. This emerging literature can be used to provide a new market ontology that is fit for the integration of the effects of disruptive change into market behavior. The alternative ontology distinguishes between "levels" of the system's architecture - micro, macro and meso. On micro-level, behavioral alternatives ("heuristics") to the hyperrational agent can be integrated. On macro-level, alternating system configurations ranging from an efficient market to less efficient and more deterministic, chaotic configurations can be considered. The meso-level is a previously not reflected level of the system's architecture. Rather than through linearity and staticism, the market is assumed to rely on complex endogenous processes to resolve exogenous change constraints.

The alternative ontology warrants the introduction of informational regulation which is directed at impacting economic processes, rather than achieving (static) optimal efficient outcomes. This "process view" does not make regulation informed by the static "equilibrium view" superfluous. Rather, it provides an addition to the existing framework seeking to reflect a more complete image of market behavior. The current informational regulation is ill-equipped to respond to the challenges of disruptive change. A categorically different approach which acknowledges the existence of uncertainty in financial reporting is set forth. Informational regulation is facing the challenge to guide market participants' decision making amid unprecedented environmental discontinuities, aiming to prevent market turmoil.

This book has four parts. The remainder of this part introduces the reader to the argumentative challenge that regulators face in formulating their response to environmental discontinuities. Prudential regulation has to deal with the limitations of the market's self-correcting forces which become apparent with respect to environmental discontinuities. An epistemological gap between observable real-world market phenomena and neoclassical market theory emerges.

Part two provides a phenomenology of disruptive change which shall serve as a working hypothesis for the following chapters. A three-stage life cycle model that captures how issues arrive, mature and materialize is provided. An approach which treats adaptation processes as an issue of information dissemination is juxtaposed with an alternative approach which treats adaptation processes as an issue of "mass psychology".

Part three turns to the implications of disruptive change for the formulation of legal rules, especially informational regulation. Starting with an analysis of how neoclassical market thinking informs existing regulation today, conclusions from the alternative ontology are drawn. The alternative framework, a complex adaptive system architecture, enables legal researchers to incorporate adaptation processes into their thinking. Rationales of capital market regulation are revisited. Informational regulation which appears beneficial under the neoclassical regime could hamper the evolution of a complex adaptive system.

Part four proposes the introduction of an European framework for scenario analyses. In addition to the existing periodic disclosures, Public Interest Entities could be required to produce an uncertainty and transitions report. Superfluous under the assumptions of neoclassical market theory, such a report could be the starting point for adaptive informational regulation. The uncertainty and transitions report shall provide market participants with a tool to reflect on a discontinuous reporting environment. At the same time, it does not burden the disclosing entities with unrealistic assumptions about their ability to predict the future.

B. A Thought on Optimal Regulation

Capital markets regulation is inherently concerned with questions of allocation. The regulatory framework rests on the assumption that the market is the best solution to society's problem of scarce resources. Due to environmental discontinuities, a relevant share of the economic funds in the capital market can be expected to shift from maladaptive business models to others, more adaptive ones, in a relatively short period of time. Regulation has the potential to play a key role in shaping this adaptation process. Unusual enough for capital markets regulation, the process of allocation rather than the outcome of such processes is the subject of this work.

Environmental discontinuities will introduce dynamics to the capital market which are so far unprecedented. The emergence of long-term discontinuities puts the existing framework for informational regulation to a serious test. The emerging phenomenon is hard to reconcile with the models that neoclassical economics provides.

Both, regulators and the market as a spontaneous order, are facing substantial amounts of uncertainty. A regulatory framework which worked in a more static market environment in the past, must not be operable under changed circumstances in the future. To discuss the role that regulation plays in the market's response to the environmental discontinuities, this work looks beyond neoclassical market theory. This leads to the question how regulators should gather and interpret information about the financial system and its environment and how insights from other disciplines, most importantly economics, can be incorporated into legal rationalizing.

1. The Epistemological Gap

The overarching theme of this work is the existence of an epistemological gap in capital markets regulation. How can regulators make sense of non-simple behavior on micro-level and complex system behavior on macro-level? Capital market...