License to deal: mandatory approval of complex financial products.

AuthorOmarova, Saule T.
PositionIntroduction through II. Product Approval Regulation in Practice: Pharmaceutical Drugs, Chemicals, and Commodity Futures B. Chemicals Regulation in the European Union: REACH, p. 63-99

INTRODUCTION I. A CASE FOR PRODUCT APPROVAL REGULATION IN THE FINANCIAL SECTOR A. Strategic Complexity and Systemic Risk B. Regulating Complexity 1. From Greenspan to Dodd-Frank: Regulatory Responses to Complexity 2. From Economic to Risk Regulation: Potential Alternatives in the Academic Debate C. The Concept of Product Approval Regulation II. PRODUCT APPROVAL REGULATION IN PRACTICE: PHARMACEUTICAL DRUGS, CHEMICALS, AND COMMODITY FUTURES A. The FDA Model: Focus on Public Safety B. Chemicals Regulation in the European Union: REACH C. Product Approval in Commodity Futures Regulation: Focus on Market Manipulation and Speculation 1. Commodity Futures Regulation-Overview 2. Pre-CFMA Regulatory Regime: Contract Designation and the Concept of Economic Purpose 3. The CFMA and the Demise of the Mandatory Product Approval Regime D. Learning from Experience: Politics, Precaution, and Efficiency III. MANDATORY APPROVAL OF COMPLEX FINANCIAL PRODUCTS: CONSIDERING THE POSSIBILITIES A. Licensing of Complex Financial Products: Could It Work? 1. Purposes and Criteria of Product Approval a. The "Economic Purpose" Test b. The "Institutional Capacity" Test c. The "Systemic Effects" Test 2. Scope and Structure a. "Covered Products" b. "Covered Institutions" c. The Financial Product Approval Commission 3. Procedural Issues; Enforcement. a. Review Process b. Public Advisory Council c. Enforcement B. But Would It Work? Potential Challenges and Criticisms 1. Financial Innovation and Global Competitiveness 2. "Command-and-Control" Regulation 3. Feasibility Challenges 4. Informational Screening as a Potential Alternative CONCLUSION INTRODUCTION

"There is definitely going to be another financial crisis around the corner because we haven't solved any of the things that caused the previous crisis," said hedge fund legend Mark Mobius, speaking in Tokyo nearly a full year after the United States officially embarked upon the greatest reform of financial services regulation since the New Deal. (1) Today, the world is still reeling from the recent financial crisis, which ravaged even the strongest economies and left them battling recession, budget deficits, soaring unemployment, and political discontent. (2) Facing another financial crisis in this situation is a frightening prospect. National governments, individually or in any G-denominated combination, may simply be out of magic bullets--as well as money and goodwill of their citizens--with which to fight the next war.

In this context, preventing the next financial meltdown becomes a survival imperative. To be effective, however, crisis prevention efforts must be comprehensive and coherent, and target the fundamental problems in financial markets instead of getting mired in the sea of small "fixes" to the system. One of the fundamental causes of the recent crisis was the unprecedented degree of complexity and interconnectedness in modern financial markets, and the woeful inability of both private market actors and public authorities to understand and manage the risks these factors posed to systemic financial stability. (3) Complex financial instruments, markets, and institutions create levels of opacity, interdependence, and unpredictability which significantly increase the potential for market inefficiency and systemic failure of dangerous proportions. (4) Complexity enables private market actors to engage in excessive financial speculation and tax and regulatory arbitrage, which further increase systemic risk and contribute little to productive economic growth. Despite their ambitious reach, post-crisis regulatory reforms do not appear to offer effective solutions to the fundamental dilemma of regulating complexity and systemic risk (5) in financial markets. (6) Much of the current academic and policy debate tends to focus on discrete reform measures, mostly aimed at enhancing or finessing the same regulatory tools and approaches that failed to prepare us for the devastating effects of the latest crisis. (7) Ultimately, these measures fail to answer directly the fundamental normative question: how much financial risk is too much for society to bear?

This Article pushes the boundaries of the debate by directly confronting that fundamental policy issue. It starts with a simple premise: if we cannot effectively regulate and control systemic risk associated with the increasing complexity in financial markets, we need to reduce and control the overall level of complexity in the system. Because much of that risk-generating complexity is a result of strategic efforts of financial intermediaries that structure, market, and deal in complex financial instruments, the most radical and direct method of reducing systemic risk is to insert regulatory controls at the point of product development, before the risk is introduced into the financial system. This Article argues that one potentially effective form of such ex ante regulatory control is pre-market government licensing of complex financial instruments--including derivatives, asset-backed securities, and other structured products.

Product approval has long been the model of pharmaceutical drug regulation in the United States and has recently been introduced in the European Union's chemicals regulation. It is not commonly known, however, that a similar system of pre-trading "contract designation" also existed in the area of the U.S. commodity futures regulation prior to 2000. (8)

Building on these three examples, the Article offers the first comprehensive examination of whether, and how, the concept of product approval regulation can be applied to reduce systemic risk posed by complex financial instruments. (9)

The core of the proposal advanced in this Article is the process for product approval, which would require financial institutions to make an affirmative showing that each complex financial product they intend to market meets three statutory tests: (1) an "economic purpose" test, which would place the burden of proving the social and commercial utility of each proposed financial instrument on the financial institutions seeking its approval; (2) an "institutional capacity" test, which would require a review of the applicant firm's ability to effectively manage the risks and monitor the market dynamics of the proposed product; and (3) a broad "systemic effects" test, which would require a finding that approval of the proposed product would not pose an unacceptable risk of increasing systemic vulnerability and otherwise will not raise significant public policy concerns.

The proposed approach does not prohibit any financial activities. It merely imposes the duty to provide information necessary for evaluating potential risks and benefits of a specific financial product on the party that has the best access to such information and the greatest incentives not to disclose it voluntarily. The proposed approval process would provide a mechanism for ensuring that financial innovation and the creation of complex financial instruments actually advance productive economic enterprise and offer real public benefits. By eliminating socially counterproductive complexity, this approach would also potentially enhance the efficiency of financial markets and the reliability of traditional mechanisms of private market discipline.

The proposed model of mandatory approval of complex financial products is bound to generate controversy and invite criticism. It raises many legitimate questions about the proper scope, feasibility, and potential consequences of instituting such an intrusive regulatory scheme. This Article does not purport to give complete answers to all of these questions. Rather, it offers an intellectual experiment, an exploratory attempt to flesh out an idea that may appear too radical and politically untenable today. The next big crisis may very well change that perception.

The Article is structured as follows. Part I sets forth a normative justification for an ex ante approach to managing complexity and reducing systemic risk in financial markets. Part II examines key features of three historical experiments with product approval regulation: pre-approval of new drugs by the U.S. Food and Drug Administration ("FDA"), the new system of registration and authorization of chemicals in the European Union, and a mandatory contract approval scheme administered by the Commodity Futures Trading Commission ("CFTC") from 1974 to 2000. Part III outlines a proposal for product approval regulation of complex financial instruments and transactions. It also discusses some of the key criticisms and challenges of implementing this idea in practice.

  1. A CASE FOR PRODUCT APPROVAL REGULATION IN THE FINANCIAL SECTOR

    1. Strategic Complexity and Systemic Risk

      The financial crisis of 2007-09 was the first truly global and systemic crisis. (10) Many factors contributed to the accumulation of excess risk and hidden leverage in the financial sector, which led to massive near-failure and taxpayer-funded bailouts of the world's largest financial institutions. (11)

      One of the fundamental causes of that crisis, however, was the unprecedented level of complexity of financial products and markets, which resulted from the great successes of financial innovation of the pre-crisis decades. (12)

      Since the 1980s, rapid proliferation of increasingly complex financial instruments, including over-the-counter ("OTC") derivatives, asset-backed securities, and other structured products, transformed the dynamics of the financial sector's operation and created a qualitatively new source of systemic instability in financial markets. (13) Derivatives are financial instruments whose value derives from the value of other assets, referred to as underlying or reference assets. (14) Anything that has a quantifiable value subject to fluctuation can serve as a reference asset, either alone or in an endless variety of combinations: interest and currency exchange rates, prices of securities or...

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