Thursday, February 16, 2012

The "drugs test" for financial products

Steve Levitt points to this paper by Glen Weyl and Eric Posner who aadvocate that all financial instruments should be rigorusly screened for their social utility before they can be traded. They claim that enhanced discolusre and the use of exchanges and clearinghouses, which form the centerpiece of most financial regulation proposals, will not achieve the objective of stabilizing financial markets. They write,

"We argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous."

The challenge with this proposal would be the definition of social utility. There is a thin line between gambling and hedging, especially with complex derivative instruments. I am not sure whether it is possible to draw any clear distinction between the two. In the circumstances, there is likely to be litigation and lobbying, which will generate incentive distortions that will benefit lawyers, lobbyists, and unscrupulous regulators.

However, a test to verify the exploitation of regulatory arbitrage stands a good chance of success and may also be socially and systemically desirable. After all, any regulation is put in place to address market failures. If market players are allowed to skirt around those regulations, it does not bode well for the stability and health of that market.

Another touchstone could be an examination of the possible conflicts of interest. This should determine who can buy and sell these products. As the events of the past few years show, regulators failed to control even basic, first-level conflicts of interests. Financial institutions like Goldman were peddling derivative products to unsuspecting clients, even as they themselves were shorting the underlying assets. Is it possible to have a code of conduct underlying the transactions for each product?

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