Opinion: Make new investments prove safety

Eric Posner, a professor at the University of Chicago Law School, is a co-author of "The Executive Unbound: After the Madison Republic." Glen Weyl is an assistant professor of economics at the University of Chicago. This is from Bloomberg News.

Mary Schapiro, chairman of the Securities and Exchange Commission, said in February the agency is looking for ways to rein in high-frequency traders. Those are the people who use computer algorithms to buy and sell derivatives at lightning speed to make instant profits.

High-speed trading can waste resources and cause market disruptions, so the commission is right to look into it. But there's a vaster problem that requires government intervention.

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 the 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.

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 you could buy U.S. Treasuries instead of the Greek bonds. In fact, 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 it already faces. Instead, each is seeking to evade regulations that aim to limit institutions' risk exposures -- or to gamble more cheaply than would be possible if it 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.

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 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 -- 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 -- not all financial innovations are bad. 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 this seems radical, that's 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, in the understanding that speculative financial trading produces limited benefits and subjects the economy to great risks.

That's a bit of wisdom we must now rediscover.