Social Policy Bonds: free riding and perverse incentives

The Social Policy Bond principle really needs to be tried, discussed and refined before large-scale implementation. At a recent discussion with a London think-tank, I was asked a couple of questions about free-riding and perverse incentives.

I have in fact written about the possibility of some purchasers of Social Policy Bonds wanting to free ride on the activities of those bondholders who will work to achieve a targeted goal. In chapter 4 of my book, I examine the issue and come to the conclusion that it probably wouldn't do much to undermine the bond mechanism. other purchasers. But, what about a variant in which people would buy a large proportion of the bonds very cheaply and sit on them with the intention of selling them for a higher price to people who are prepared to achieve the goal. This would be counter-productive to the extent that it would deter the would-be goal-achievers from actually working to achieve the goal. How could the issuers prevent this sort of free-riding? They could ensure that the initial price of bonds is not negligible. The choice of objective, the number of bonds issued, and their redemption value could all be chosen with a view to seeing that a bond redeemable for £100, say, could be expected to sell for anywhere between, say, £30 and £90.

• They could give the bonds an expiry date, so that if there were no significant progress toward the objective being achieved, or if the market value of the bonds showed no significant increase, the bonds would become invalid.

• The issuers could retain the power to declare a particular bond issue invalid, either at their discretion or, better, if certain objective criteria, such as each bond’s market price, were not fulfilled.
  

Another question posed was: could people buy the bonds, and do nothing to achieve the targeted goal in the expectation that the issuers are so keen to see the goal achieved that they then will issue more bonds and so boost the value of all the issued bonds, including their passive holding? The possibility of a supplementary bond issue would then have the effect of reducing the motivation of would-be target-achievers to take action. If this were thought to be a significant deterrent to achieving the targeted goal, again, the issuers could:

• Build in an expiry date to the bond issue, and issue a completely new set of bonds targeting the same goal, so that holders of the first bond issue would lose their investment.

• Retain and, if necessary, exercise the power to declare the first bond issue invalid.
  

For large-scale issues of Social Policy Bonds then, the conclusion is that issuers should retain the right to declare bond issues invalid if bondholders don't comply with the spirit, as well as the letter, of the bonds' redemption terms.