Can Network Effects Impede Optimal Contracting in Debt Securities?

We examine network effects as an impediment to optimal financial contracting. In devising the terms of their transaction, the parties may prefer to conform to a market standard rather than matching their own contracting needs. To study this possibility, we investigate choice of contract law provisions in European debt securities. In order to disentangle network effects from the effects of substantive differences of contract laws, we take advantage of a natural experiment: In 1999, eleven countries adopted the Euro as an official currency. As a consequence, the investor base of European issuers expanded beyond their respective home states. We hypothesize that the demand for an international standard contract law increased as the national securities markets converged into a single Euro area market. Using a difference-in-difference approach, we show that there is a strong and significant shift to English law for debt securities in Euro area member states as compared to other European countries. Our results are robust to alternative hypotheses and various statistical tests. Choice of law in debt securities may follow a market standard rather than quality differences among the competing contract laws.