The Case for Treating Big Finance Like Big Pharma

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A pair of University of Chicago law professors say the federal government needs to regulate new financial products the same way it tests new drugs for safety
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Jeremy Irons captured a new Wall Street's moral ambiguity in the 2011 film "Margin Call" when his fictional chief executive lectured his investment bank staff on the three ways to make money.

"Be smarter. Be first. Or cheat. I don't cheat, and while we have a lot of smart people in this organization, it's a hell of a lot easier just to be first."

That moment is central to a distinctly non-fictional proposal by two University of Chicago law professors which will cause dyspepsia among their famous free market colleagues at the university and the well-heeled leaders of Chicago's booming and path-setting exchanges, where many of the most important financial products of the past 20 years have been born, including derivatives.

They want to dramatically re-regulate new financial products, including sophisticated derivatives, that they assert "facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities."

In sum, authors Eric Posner and E. Glen Weyl want to return to the 1990s, when those same exchanges, and much of the financial world, were far more closely regulated. Their article's title underscores their policy urging: "A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation."

"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 pair writes. "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?"

The professors open by arguing that financial products are "socially beneficial" when they help us insure or hedge against risk. When they're used for speculation and regulatory arbitrage, they're "socially detrimental." That's because the "difference between hedging and speculation is that hedging enables people to reduce the risk they face whereas speculation increases it."

The most vivid recent example of what they deem socially destructive speculation involves the investments in derivatives that played an important role in the financial crisis of 2008. "The costs of speculation are now widely recognized, and it is clear that speculation was facilitated by the financial innovations of the last thirty years."

The authors fully concede the many benefits of financial innovations, notably when it comes to hedging and insurance, as well as allocating capital. But financial markets also produce speculation, exposing speculators to risk without fully compensating them, and "informational racing," with a vivid example being the high-speed trading in which hedge funds make big bets to procure information a split second earlier than rivals, just like Jeremy Irons' firm in "Margin Call."

That informational racing is what the authors deem one of several basic problems with a lack of regulation. There are two others.

One is regulatory or tax arbitrage, where a bank uses derivatives to heighten its exposure to risk beyond what's allowed by law, with regulators often largely ignorant about those derivatives and thus not given to stop them.

The other is what they deem useless gambling or speculation. Two traders wager on whether a derivative is higher or lower than their market price; a bet that the academics feel doesn't add anything of value to the real economy.

"There are products that appear to have no social value," they write, including naked credit default swaps (CDSs) which were once illegal in most jurisdictions until regulatory restrictions were lifted in 2005 and they inspired a boom industry. They then played a role in the instability of the financial markets in the credit crisis.

So they urge either a new agency with the power to screen new financial products or taking an existing agency, such as the new Consumer Financial Protection Bureau, and give it the authority.

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James Warren is the Chicago editor of The Daily Beast and an MSNBC analyst. He is the former managing editor of the Chicago Tribune.

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