(Corrects to delete reference to credit-default swaps and collateralized debt obligations in second paragraph. For more Bloomberg View, click on VIEW <GO>.)
April 3 (Bloomberg) -- In February, Mary Schapiro, chairman of the Securities and Exchange Commission, said the agency is looking for ways to rein in high-frequency traders. That is, the people who use computer algorithms to buy and sell derivatives at lightning speed to make instantaneous profits.
High-speed trading can waste resources and cause market disruptions. So the commission is right to look into high-speed trading. But it must realize that this is only one issue at the edge of a vaster problem that requires 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 back. But if what you are trying to do is make money with low 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 they already face. 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 an explicit short 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 the products 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 their 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, a professor at the University of Chicago Law School, is a co-author 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. The opinions expressed are their own.)
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