A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation

Abstract

The financial crisis of 2008 was caused in part by speculative investment in sophisticated derivatives. In enacting the Dodd-Frank Act, Congress sought to address the problem of speculative investment, but merely transferred that authority to various agencies, which have not yet found a solution. Most discussions center on enhanced disclosure and the use of exchanges and clearinghouses. However, 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. This approach would revive and make quantitatively precise the common-law insurable interest doctrine, which helped control financial speculation before deregulation in the 1990s.

Keywords: speculation, insurance, pre-approval regulation, financial regulation

JEL Classification: D63, G28, K22