An FDA for Derivatives?

Reviving the ‘insurable interest doctrine’ to ban financial WMDs

You may say “What”? — but two professors at the University of Chicago’s Institute for Law & Economics are calling for new financial derivatives to be subjected to the same type of regulatory review as pharmaceuticals.

In a recent research paper entitled “A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation“, Professors Eric Posner and Glen Weyl argue that each new derivative product developed by an investment bank or other financial innovator should be pre-screened by a federal government agency on the basis of its net utility to society.

In their paper, Posner and Weyl divide derivatives into hedging instruments and speculations. In a hedge, the “[i]ndividuals on the two sides of a trade should be differentially exposed to some source of risk and the trade they undertake should mitigate [that risk].” Speculative investments on the other hand are either pure gambles or regulatory arbitrages that produce no social gain and arguably increase systemic risk.

A good example of a socially-useful hedge that reduces systemic risk is health insurance which benefits each insured by reducing his or her risk of catastrophic loss while the insurer reduces its financial risk by expanding its pool of covered persons. A pure speculation is, for example, a naked credit default swap (CDS) in which both parties are gambling on an event in which neither has an underlying interest. To Posner and Weyl, naked CDSs are among the “financial weapons of mass destruction” that unleashed the global financial crisis.
An FDA-style review would evaluate new derivatives by weighing their hedging (risk-reducing) benefits against their speculative costs, and approving only those financial products found to impart net benefits to society. Posner and Weyl liken the proposed evaluation process to the cost/benefit analysis undertaken by the Department of Justice or Federal Trade Commission in approving a corporate merger or acquisition. Their proposal effectively revives the ‘insurable interest doctrine’ which, they claim, “helped control financial speculation before deregulation in the 1990’s.”

Posner and Weyl believe that our current efforts to reduce systemic risk in the financial system (through Dodd-Frank) rely too heavily on disclosure regimes and clearinghouses, when we should be focused on the derivative instruments themselves. According to them, “the current challenge for public policy is to develop a regulatory regime that preserves beneficial financial innovation while eliminating harmful products.”

If Wall Street hasn’t already been chastened enough, how will its otherwise irrepressible financial engineers react to even the remotest prospect of an FDA? Gasp.