It's time to regulate financial instruments

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(MoneyWatch) COMMENTARY The financial crisis of 2008 revealed the dangers of many of the derivative securities created by Wall Street, such as credit default swaps. The transactions were often so complex that the managers didn't have a handle on their risk exposure. And regulators had no handle at all on the systemic risks created by trading these securities.

Supposedly sophisticated financial institutions also made massive blunders, with devastating impacts on whole economies. Making matters worse was that these instruments often served no useful purpose -- they don't contribute to economic activity, help to efficiently allocate capital, nor aid investors in hedging their bets. (You can always sell an investment instead of using a credit default swap.)

There's also a whole array of "innovative" products, such as leveraged and inverse ETFs, that serve no useful societal function. They're purely speculative vehicles, contributing nothing to society. They just generate lots of fees for their creators, transferring wealth from those buying them to those creating them.

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In their working paper, "An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets," law professor Eric A. Posner and economist E. Glen Weyl, both of the University of Chicago, propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a new government agency. That watchdog, which they call the "Financial Products Agency," would be designed along the lines of the FDA, which among its functions is responsible for screening pharmaceutical innovations.

This approach would ensure that before a financial product could be marketed, the originator would have to demonstrate that it would satisfy a social utility -- allocate capital more efficiently or hedge (reduce) risks -- instead of being used solely for speculation (increase risk). Before expenses, speculation is a zero-sum activity. After expenses, it harms those who engage in it. And it can produce negative third-party effects -- what economists call "exernalities" -- by increasing systemic risk in the economy. Rational people don't engage in speculation unless it has entertainment value to them. And society doesn't gain from permitting speculation.

The test for approving a financial innovation should be simple: Does it advance social welfare and generate costs beyond the benefits? One good test is whether there's a legitimate demand for such a product. Although it's easy to identify who can use a wheat or oil futures contract to hedge risks, who exactly is the natural user of, say, a triple inverse ETF? And what benefit to society do credit default swaps (in which the seller agrees to pay the buyer the value of an underlying bond if the issuer of that bond defaults) provide? These swaps are on debt that already exists. Thus, they play no role in the allocation of capital and add no informational value over what's already reflected in the price of the actual bond. And, as we know, they create systemic risks because of the counterparty risk involved.

While the FDA can often take years to approve a product, reviewing financial innovations should be much cheaper and faster because it would involve assessing readily available public data and employ well-known mathematical calculations. We have seen that investments in derivatives and other innovations can be just as dangerous to your financial health as taking a bad medicine can be to your health. Because of these dangers, society as a whole needs to be protected from what Warren Buffett, in describing derivatives, called weapons of financial destruction. And naive individuals need to be protected from exploitative financial firms who seek not to help investors, but to plunder them, treating them like muppets.

Imagine how different the world might look today if we had a FPA to screen out innovations that added no societal value? That's why such an agency is needed to protect society and guard those who need protection from those organizations that would exploit them.

In my opinion, Posner and Weyl don't go far enough. There's another action that should be taken -- mandating a fiduciary standard of care regarding the sale of all financial products. If a person selling the product can't demonstrate that they believe that its purchase is in the buyer's best interest, why should that sale be allowed? I can't think of a single reason.

This standard should be applied to all products, but especially the whole category of structured products such as equity-linked CDs and equity-indexed annuities that have been created by sophisticated financial institutions to sell to naive investors. Their complexity allows the creators to embed fees that are amoral at best, exploitative at worst. Just as broker-dealers can be fined for excessive mark-ups on bonds, creators of structured products should be held to the same standard, with a clear measure for what constitutes a reasonable fee.

Unfortunately, just as is the case with pharmaceuticals, relying on sellers to disclose such matters is inadequate because the complexity of some financial products is such that there's virtually no chance that the typical investor can determine the nature of the fees or perhaps even the risks involved. How many investors will even read a 70 page disclosure document?

These simple recommendations would go much further to protect individuals and society than the 2,319 page Dodd-Frank Act.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.