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Should New Financial Products be Regulated by an FDA-like Agency? 8 Reasons Why Not

By Rosa M. Abrantes-Metz on May 16, 2012

A recent article by Professors Eric Posner and Glen Weyl from the University of Chicago advocates an FDA for Financial Innovation. The authors argue that such an FDA-like Agency should distinguish new financial products that are intended for investment or hedging from those intended for “speculation,” and banish the latter from the market.

Though there is almost universal agreement that some form of enhanced financial regulation should exist, no agreement exists on the form such regulation should take. The current proposal is both bold and controversial, and below I outline some of the major concerns it raises.

First and foremost, the FDA for pharmaceuticals contains a clear objective for approving drugs which meet efficacy and safety standards, and it is capable of making those determinations through clinical trials. How would such a clear objective and testing procedure be designed and implemented for financial innovation and who would be in charge?

The authors suggest a panel of “experts” will make the call on what is “hedging” versus “speculation.” They propose that the new agency’s standard should be whether gains from insurance benefits created by the new product exceed the likely costs created by the speculation it facilitates, meaning that the financial innovation has “social utility.” But how are we going to measure this?

Second, despite hundreds of years of data, there is no consensus on what trading represents “hedging” and what represents “speculation” for existing stocks. So, why would such a consensus exist for newly developed and not yet launched financial instruments?

Third, what will be the empirical evidence to support either an approval or a rejection of a financial innovation which, by definition, has not yet been launched? Who will be conducting these studies, assuming they theoretically could be conducted?

Fourth, speculation is not necessarily and inherently bad, though this proposal seems to accept that premise without question. Speculators enhance price discovery and market liquidity (see my posting in the last FinReg Newsletter on manipulation and speculation in crude oil* ).  What if a significant portion of the stocks and options trading is speculative—should we ban it?

Fifth, investing such authority in political appointees obviously represents its own kind of risk.  Will proper campaign contributions be followed by approval? Even if unfounded, charges of corruption will surely follow some of the decisions by such an expert panel when objective criteria and empirical data are lacking.

Sixth, how long would it take for a decision to be made on the approval or rejection of new products? Presumably, the FDA-like Agency would have to undertake significant studies to try to come up with an empirical basis for its decisions. The pharmaceutical FDA, on which this proposal is at least loosely modeled, takes on average 8 years to ultimately approve a new drug, from the beginning of Phase I to market launch (see Abrantes-Metz, Adams, & Metz, “Pharmaceutical Development Phases: A Duration Analysis**).

Seventh, why would this group of “experts” know better than existing, experienced regulators about what types of innovative financial products should or should not be traded? If our current regulators are not already the best people available for the job, then why not replace them before creating a new regulatory panel?

Eighth, will the FDA-like Agency essentially have to approve every new financial contract between two private parties involving any clause which may be classified as “innovative”? This would represent a dramatic shift in contractual law and significantly restrict market function.

Professor John Cochrane from the University of Chicago provides insightful and detailed comments on all of these reasons and more for why this proposal may not be such a good idea. Both the article and the blog are highly recommended readings.

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*available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2050577)

* *Abrantes-Metz, Adams & Metz, “Pharmaceutical Development Phases: A Duration Analysis,” Journal of Pharmaceutical Finance, Economics & Policy, 14, 19–42, 2006, also available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=607941

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