Water policy in the western states has historically evinced a number of problems. These include inadequate conservation incentives, lack of adequate environmental protection, inflexibility in meeting changing needs, and excessive mining of groundwater aquifers. The author argues that the traditional focus on common law and statutory remedies to these problems has failed to give adequate consideration to the important role of institutions in both shaping and impeding solutions. As an illustration, the Article closely examines the growing movement towards using markets to promote both efficiency and environmental goals in the distribution of water. Local institutions have often created internal markets that enable their members to transfer water among themselves more readily than traditional state transfer procedures would permit. Yet, institutions have also served as a significant barrier to external transfers of water. The author explores the underlying reasons institutions have served as a barrier to more active interregional water markets. Some of those reasons are found to be legitimate while others are not. The author concludes that legislatures should remove legal restrictions on external transfers by institutions and create financial incentives for such transfers by providing for a clear flow of the profits from such transfers to the membership. The author suggests that legislatures may also wish to strip local institutions of control over external transfers if institutions continue to block external transfers unjustifiably. Any such reform, however, must be carefully drafted to preserve the valuable role that institutions can play and have played in regulating water use.