Streetwise Professor

February 18, 2012

A Bad Metaphor That Puts Your Financial Health At Risk

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

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  1. As the risk of sounding like a broken record, the financial services industry doesn’t need to be emulating the FDA, they need to be emulating the FAA. Full public disclosure for violations and enforcement actions as well as suspension of licenses for individuals and supervisors pending show cause hearings after enforcement actions will do a lot to changing behaviors in the industry.

    Comment by Charles — February 19, 2012 @ 3:05 pm

  2. You put your finger on a major theme of my writing going back into the 1990s–whether it is better to rely on “ex ante” regulation (i.e., prevention) or “ex post” regulation (i.e., deterrence). The FDA model is prevention. The FAA model is ex post. So if you’re a broken record, I am too.

    Sometimes prevention is preferable to (more efficient than) deterrence: the correct approach is not the same for all problems. But in many financial market regulatory issues, the ex post approach is decidedly superior.

    The ProfessorComment by The Professor — February 19, 2012 @ 6:56 pm

  3. Agreed, enforcement is good, but it is usually after the fact. That will not satisfy the regulators. The regulatory instinct is to act ahead of the fact – in other words to reduce risk to 0 by gaining control. The natural tendency is to freeze change and maximize their power. As the Prof pointed out in better terms than I can, this is ridiculous. It is also incredibly dangerous.

    The danger is that this tendency is a profound challenge to our way of being. Too oversimplify, there are two ways to organize behavior economic or otherwise in society: what is not forbidden is allowed versus what is not allowed is forbidden. By and large the first principle is liberating, and has been our historical norm. The second logically leads to a kind of Pol Pot Year Zero regime, or at least a North Korea.

    Getting back to finance, in particular, it cannot be overstated that the response of a market to a rule can be very creative and often beneficial. Call this part of the Law of unintended consequences. The best example of this is the creation, sort of by accident, of dollar roll financing. Briefly, one sells MBS or loans now and simultaneously buy them back in the forward market for settlement one, two or three months from now. This must be accounted for as a loan or a financing. Let’s see how this was created.

    In the really bad old days of 1979-1981, interest rates skyrocketed, the value of Thrifts’ portfolios collapsed, the rise of money market funds and other unregulated investment vehicles triggered an huge outflow of funds from the thrifts, and they were going broke borrowing at 11 to 16% to fund the outflows, or worse selling securities and realizing tremendous losses.

    In response many began to speculatively trade – when they lost money the securities went into portfolio, when they made money the securities were sold, a gain booked and then the same security was bought back. The AICPA said no, if you buy back the same securities, you haven’t sold anything, there is no gain. They then tried this trick by buying back in the forward market. The accountants then ruled that there was still no sale because the institution was still at risk; it must be treated as a financing. This rule was extended to mortgage trading – if you sell particular MBS and buy back generic MBS via to be assigned trades (TBA’s), this too is a financing because you may not get back the same securities, but you are getting back substantially similar ones.

    The unintended consequence of this was that if you did these transactions, you couldn’t book a gain, but also, being merely financings, you wouldn’t book a loss. Suddenly all the underwater residential loans and securities could be used for financing, getting much more efficient execution than was available in the FHLB system. It bought quite a few institutions a lot of time. Secondly a lot of securities became available for the new GNMA and Agency MBS mutual funds that by reg had to buy in the current month due to leverage rules. It also created a strong demand for securities for forward delivery (to close the financings), thus creating demand for the Mortgage bankers who forward sold their in process loans for delivery as a hedge. Later the players changed from mutual funds (which had largely been sold to the public using an inflated, fraudulent “cash flow yield” – don’t ask) to warehousing for CMO issuers. The inside market for current coupon MBS collapsed from up to a point to one or two ticks, reflecting greater liquidity and efficient execution.

    Compare this beneficial accident to the official response to the thrift crisis: by weakening capital standards, letting in whole sets of cowboys and builders into the market with denovo institutions, using unsupportable yield maintenance agreements by FSLIC, our government turned an yield mismatch into a horrendous bad asset problem, which cost many times more to unwind than the yield mismatch would have. We also created the seeds of shadow banking system, and markets for bad assets, and a transaction oriented culture that has come to bite us on the ass this time around.

    The neo regulators, who want to forbid that which is not allowed, have never shown that their regime works, indeed, the history of regulation in the last 30 years has been disastrous. It is a joke to say that CDS developed in an unregulated market: I have seen several speeches by “Wrong Way” Greenspan stating that CDS were the greatest thing since sliced bread. The Rating Agencies themselves are a creation of regulation – their position has been BY STATUE part of insurance and pension investing since the 1930’s, and were an integral part of both Basel I and II. The anger at the RA’s is misplaced – we should be angry at those that gave them the power in the first place.

    A priori denial of innovation is not the answer, as the great French economist Bastiat said in the 1840’s, what proof do we have that the regulators (then the socialist theorists) would do a better job than the market? Their record to date has been disastrous. They are used by those with pull to create special rules that favor those in power, guaranteeing them jobs in the so called private sector once their “public service” is done.

    Instead I would argue that what is needed is a return to first principles. Namely:

    1. Disclosure of risk in an easily understood way, that mirrors the internal measures used (e.g. VAR and assumptions used, etc.)
    2. A true at risk rule stating that if there is a risk of loss or dilution of equity, one owns something.
    3. Claw back for a couple of years on senior officers’ compensation.
    4. Enforce the law.

    There is a great cry about foreclosures due to false statements mad to the courts. Regulation is not the answer, since this has been illegal in English speaking courts since, say, Alfred the Great, King of Wessex who died in 899 AD. Make a false statement in court, go to prison. No more regulation is needed than that.

    The above would eliminate most of the shadow banking system, prevented most of the frauds such as those by Paul Krugman’s former employer Enron, and generally lead to
    Far better corporate governance than exists today.

    The two battles we face are those we always have faced: prevent overweening power in the hands of regulators, and limit pull by insiders to dilute the law or manipulate regulations for their advantage.

    Comment by sotos — February 19, 2012 @ 7:29 pm

  4. STATUTE not STATUE, sorry.

    Comment by sotos — February 19, 2012 @ 7:59 pm

  5. […] Is approving financial products FDA-style a good […]

    Pingback by FT Alphaville » Further reading — February 20, 2012 @ 2:18 am

  6. Instead of a “financial FDA” hold the people who sell these products to a higher standard. When someone opens up a brokerage account, they inform the broker of their income, goals and years of investing experience. The broker is subject to a “know your customer” rule which means he/she must make suitable investment recommendations or be liable. Financial products should work the same way.

    Comment by Conscience of a Conservative — February 20, 2012 @ 4:43 am

  7. 1. hedging and speculating are indistinguishable in that both involve taking a “view”, except maybe by whos doing it (maybe). Say I am an ore producer, and I hedge my production by selling commodities swaps. I am taking the view that ore prices will not go up (otherwise, if i thought so, i would wait and maximize revenue). my experience is that setting aside other reasons to hedge (debt coverage) commodities producers do adjust their hedge book based on their price view. If I am a utility or steel company I can lock in my costs, but i am also taking a view that prices will not go down much. The view of the producer or utility is no more or less correct than the view of the speculator. (there is also more to it: not only the P but the Q is variable. A steel company may only lock in costs to the extent they expect to have orders, etc.)

    2. lots of producers and utilities (like Glencore) also have trading shops and “speculate”.

    3. Some markets are have an inherent (maturity) mismatch between buyers and sellers. For example, in deregulated power markets, regulations require utilities to buy retail power on certain schedules for a term up to 36 months. On the supply side, merchant utilities have power plants with 30+ year lifetimes, and cannot “hedge” adequately using only the regulated power auctions. “speculators” often step in to take the risk, but even then it may only be speculators with big balance sheets who can survive a 95% confidence interval move and still post margin.

    4. even if 3 is not true, and the market is well designed, there is not expecation that if i am selling (say a 30 year MBB ppool) today, there is a pension fund out there with money to invest today. Hence I may hedge with TBA options until the sale is completed.

    In short, hate to rehash finance 101 for posner, but derivatives and “speculation” are not irrational – they are like money in the financial system: They help alleviate the need for “a coincidence of wants” in the financial system (that is, if i am buying/selling a financial product, there may not be a seller/buyer for than product right this second). Think of it as a medium of risk exchange. Now, they perform a service, because they are taking risk, and hence deserve to be paid accordingly (reducing the shoe leather costs of exchanging risk, if you will, and taking a cut). Yes, the rules should be set up so that the failure of any one entity does not crush the system. But lets not confuse systemic and idiosyncratic risk: systemic risk (i.e. an aggregate demand shortfall) will *always* cause a bunch of financial institutions to fail, because systemic risk by definition cannot be diversified away in the economy as a whole. Whether its 1000 small savings and loans (90s) or a couple giant institutions, an aggregate demand shortfall will have economy-wide repercussions. period, end of story. Their failure is a symptom, not a cause.

    Comment by dwb — February 20, 2012 @ 8:24 am

  8. … also, you sort of say this but the difference between drugs and derivatives is that for drugs, the side effects is (aside from genetic variation and drug interactions) largely predictable regardless of the user and inherent to the drug. Conversely, with derivatives, the “side effect” is largely dependent on idiosyncratic factors (balance sheet size, liquidity, etc.). The same 1 Bn interest rate swap is no biggie to a large bank, but very dangerous to a tiny hedge fund. In other words, the (bad) effects are entirely customer specific (you might be approved for 1 MM notional of swaps, I might be approved for 1 Bn notional of the same swaps, someone else for a lot more – maybe based on something like a 95% confidence interval move vs my liquidity). Buffet sold a 14 BN notional put on stock indices… right after declaring deerivatives are weapons of mass destruction… which only proves they are weapons if you do not have the capacity to post margin when they move against you.

    Comment by dwb — February 20, 2012 @ 8:38 am

  9. […] what are all these people doing? This was already discussed and (to my way of thinking) demolished by Craig Pirrong and quoted by Suzy Khimm back in Feb. As noted by yours truly (I knew there was a reason I […]

    Pingback by “Financial FDA”: Zombie Ideas And Old Media « Rhymes With Cars & Girls — April 3, 2012 @ 3:06 pm

  10. […] I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is. […]

    Pingback by Streetwise Professor » A Track From the SWP Greatest Hits Compilation — April 5, 2012 @ 4:36 pm

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