Financial products need an FDA-style regulator

By Eric Posner and Glen Weyl

In February, Mary Schapiro, chairwoman of the Securities and Exchange Commission, said the agency is looking for ways to rein in high-frequency traders, who use computer algorithms to buy and sell derivatives at lightning speed to make instantaneous profits. High-speed trading can waste resources and disrupt markets, so the commission is right to look into it. But this is only one issue at the edge of a bigger problem requiring significant government intervention.

The larger challenge is that much of the U.S. financial system is devoted to wasteful activity - useless trading that advances no important economic interest but, at the same time, creates a dangerous risk of economic crisis. The way to control this wasteful speculation is to require government approval of all new financial products, subjecting them to the same sort of examination and regulation that the Food and Drug Administration applies to new medicines.

Before there was an FDA, quacks peddled useless, and sometimes dangerous, tonics like radium water. Yet for all the harm such concoctions caused, they may never have matched the risk and waste of some financial derivatives - what Warren Buffett has called "financial weapons of mass destruction."

A credit-default swap, a financial product that pays off if a bond defaults, might seem sensible. If you own a Greek sovereign bond and a CDS, when the bond defaults, the CDS pays you. But if what you are trying to do is make money with little risk, you could buy U.S. Treasuries rather than Greek bonds.

Normally, the buyer of a CDS on a Greek bond doesn't buy the bond itself (making it a "naked" purchase). Such a transaction cannot reduce risk in the financial system, as neither party is hedging a risk it already faces. Instead, they are seeking to evade capital-adequacy regulations that aim to limit institutions' risk exposures, or to gamble more cheaply than would be possible if they had to take a real position on the bond.

In the years leading up to the 2008 crisis, traders commonly used CDSs to gamble on default by a country, corporation, or package of mortgages, and to evade financial regulations associated with such bets.

From 2000 to 2007, the notional size of the CDS market ballooned from zero to $62 trillion. Little if any of this activity served legitimate hedging purposes; almost all of it was tax and regulatory arbitrage or speculation. When the financial crisis hit, we all paid a steep price for the risks that this speculation had concentrated in a few institutions.

Not all financial innovations are this bad. Retail-index mutual funds, created in the 1970s, have helped businesses obtain financing and have enabled people to diversify their investments across a range of stocks. And most mutual funds are useless for speculation, because they are designed to be less volatile than the underlying stocks or bonds.

Creative economists have recently invented other derivatives that enable homeowners to protect themselves from a decline in housing prices.

So the federal government should address the risk posed by derivatives not by taxing or banning them uniformly, but by regulating them selectively, as it does with beneficial but risky medical drugs. Before pharmaceutical companies can sell their drugs to the public, they have to prove they are safe.

Likewise, the SEC, the Commodity Futures Trading Commission, or a whole new federal agency could require financial innovators to prove the safety and efficacy of new derivatives. Their analysis could be done far faster and more cheaply than a typical drug review, because they could base it on existing economic data - the same data companies use to project demand for a product. The Federal Trade Commission and the Justice Department use similar procedures to project the likely effects of proposed mergers.

Regulators would distinguish the demand for the derivative's beneficial uses - diversification and insurance, supplying information to the market - from the demand for its harmful uses - avoidance of taxation and regulation, speculation and high-frequency trading. These assessments would help the agency determine whether the financial instrument should be licensed, restricted, or prohibited.

If such a review had existed in the 1970s, the retail-index mutual fund would have passed with flying colors. On the other hand, the reviewing agency would have seen that CDSs would be used not so much to reduce risk as to enable speculation and arbitrage. Traders might have been permitted to buy CDSs only if they owned the underlying bond, and naked CDSs would never have existed.

If our proposal seems radical, that is only because the deregulatory fervor of the past 20 years has created an atmosphere of lawlessness. Before Congress lifted restraints on the derivatives market in 2000, many new financial products were subject to review by the CFTC, in the understanding that speculative financial trading produces limited benefits and subjects the economy to great risks. That is a bit of wisdom we must now rediscover.

Eric Posner is a professor at the University of Chicago Law School and a coauthor of "The Executive Unbound: After the Madison Republic" and "Climate Change Justice." Glen Weyl is an assistant professor of economics at the University of Chicago.

Chat live with Illinois poet laureate Kevin Stein about his Sunday Currents column at 1 p.m. today at www.philly.com.