Usually, discussions of the risks posed by complex financial products focus on the people and institutions that invest in those products. This ensures that the regulatory debate about complex financial products is largely preoccupied with matters like disclosure and suitability – and largely neglects the externalities that complex products can generate for third parties. This article will instead discuss the indirect harm that complex financial products can generate for large swaths of the population – people who have no recourse under any investor or consumer protection regime.
Our financial system is already exceedingly complex, and that complexity is exacerbated when new and complex financial instruments are developed and sold. It is well understood that complexity can undermine the efficacy of disclosure-based investor protection regimes,1 but it is less well appreciated that complexity also creates problems for financial stability. For example, complexity facilitates the increasingly speedy transmission of shocks through the financial system by increasing the number of interconnections between financial institutions that can serve as transmission belts for such shocks.2 The quicker shocks are transmitted, the more limited the ability of regulators to respond to crises in a deliberate and thoughtful way. Furthermore, without sufficient time to make informed decisions about how to react to such shocks, market participants are forced to rely on heuristics that tend to correlate their behavior – the result being that the more complex the system, the more likely we are to see panicked herd behavior like fire sales of distressed assets.3 In addition, by making the performance of financial products dependent on layers of other financial products, complex financial engineering ensures that there is less flexibility to vary the terms of the building block products (such as the mortgages that are the eventual asset base for a synthetic CDO squared), when such variation may be needed to avert a crisis.4
Returning to the problems that complexity poses for disclosure-based investor protection regimes, the failure of these regimes generate systemic consequences that go beyond individual harms. When a product is too complicated for its risks to be accurately communicated to market participants, investors may underestimate the risks involved, with the result that the product is “over-issued relative to what would be possible under rational expectations.”5 When bubbles in financial instruments develop and pop, the result can be broad macroeconomic distress: A financial crisis will have a far-reaching impact, not just on those who have invested in the product itself, but also on those who lose their jobs and see their retirement income erode in the economic contraction that follows. These indirect harms that can flow from complexity-induced systemic failures justify moving beyond a pure disclosure regime for addressing complex financial products.
To that end, there have been a number of academic proposals made for a regime that would require a financial institution to approach a financial regulatory agency for approval before it launches a new financial product.6 To the extent that a product appears problematic from a financial stability perspective, the financial regulatory agency could ban it, putting a brake on the increasing complexity of the financial system. Indeed, the very existence of such a pre-approval regime may cause financial institutions to abandon innovations that have little to recommend them other than their “newness,” knowing that such products are unlikely to receive regulatory approval. But where new products appear to make meaningful contributions to capital intermediation or risk management – sufficient to justify the attendant increase in complexity – those products would be permitted (although they would be subject to ongoing monitoring in case problems should arise in the future). Importantly, such a process would go toward mitigating the challenges (in terms of information and resources) that regulators face in keeping up with the financial industry by requiring the industry to approach the regulators, and conduct some preliminary tests, before being permitted to launch any new product.
Although there is much to recommend a pre-approval regime for financial products, there are a number of technical issues that must be addressed before any such regime could be implemented. The threshold question for product pre-approval is “when does a financial product stop being one type of product and become a new one?” For the purposes of a preliminary determination of whether a new product category should be permitted or banned, it is undesirable to categorize financial products at such a granular level that each individual transaction is viewed as its own product that requires review. Instead, we should seek to strike a balance between specificity and generality: Agreement (ideally at the international level) on the axes along which financial products should be distinguished is therefore required as a precondition to instituting a pre-approval regime for complex financial products. For example, we might want to distinguish products depending on the type of investor being targeted, the intended use of the product, the payment structure, and the underlying index or reference asset.7
Ideally, an international body (such as the Financial Stability Board) would take ownership of the catalogue of financial products, which would highlight both the similarities and differences between the various products. In developing such a catalogue, we can look to biology – a science that must embrace and classify ever-evolving complexity – for guidance. We can use synthetic CDO8 squareds as an example of how a catalogue might be structured to follow the hierarchical classification structure of a biological taxonomy. The kingdom would be “financial product,” the phylum “security.” The class could be “bond” or “note” (depending on whether investors in the synthetic CDO squared receive a bond or a note), and the order could be “asset-backed” (meaning that investors are repaid solely from the income stream generated by assets owned by a special purpose vehicle, as distinguished from bonds and notes that are to be repaid by an operating firm). The family could reflect the type of assets owned by the special purpose vehicle – a CDO involves the securitization of debt instruments. Different CDOs could be broken down into genus – including CDOs that have been squared, or even cubed (a CDO squared involves the securitization of other CDOs, a CDO cubed involves the securitization of other CDO squareds). Finally, the species could reflect whether the transaction is synthetic or not. The non-synthetic versions would be backed by actual debt instruments or CDOs (as the case may be), while the synthetic versions would be backed by credit default swaps that have debt instruments or CDOs (as the case may be) as reference obligations.
The initial compilation of this catalogue would be a time- and resource-intensive exercise. However, once established, maintaining the catalogue as new products are developed and approved would not be as arduous. There are also some projects afoot that would make the initial compilation less onerous. For example, the Enterprise Data Management Council is developing a “Financial Industry Business Ontology” or “FIBO™”9. Its definitions of financial products can serve as a starting point for creating the taxonomy. The catalogue would ideally organize these definitions in a way that makes clear not only the defining features of different financial products, but also the features that distinguish them or liken them to other financial products. In order to do so, the regulators compiling the catalogue would need to be empowered to gather information on products (particularly regarding their intended uses) from multiple sources – including exchanges, clearinghouses and the IRS, as well as the issuers and purchasers of the products. Much of the necessary information can be gleaned from the contracts themselves. For example, many complex financial transactions are already conducted using (reasonably) standardized form agreements – the ISDA Master Agreement used for the overwhelming majority of swap transactions being a prime example.
Variations in the documentation used to support the Master Agreement for different types of transactions could be used to help distinguish the different kinds of swaps. Innovations in the field of smart contracts (contracts that are represented as machine-readable code) could be particularly help ful in organizing financial products in a more relational manner. If, in the future, financial contracts can be transposed using computer code,10 then a computer algorithm could easily sort large volumes of contracts to determine their similarities and differences.
As technology improves, the creation of such a catalogue becomes less daunting. However, even as the technical barriers are scaled, it is likely that political barriers to implementing a pre-approval process for financial products will remain. Nonetheless, the catalogue recommended in this article would be extremely helpful to regulatory authorities monitoring the build-up of systemic risks in the financial system. And we should not entirely give up on the idea of a pre-approval regime – it may find more political support after a future financial crisis. Given the widespread harm that financial crises can cause, counterparties to complex financial products should not be the only arbiters of whether such products proliferate in the marketplace.
- See, for example, Henry T.C. Hu, Too Complex to Depict? Innovation, “Pure Information” and the SEC Disclosure Paradigm, 90 TEXAS L. REV. 1601 (2012).
- Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 WASH. U. L. REV. 211, 215 (2009).
- The Pathologies of Banking Business As Usual, 17 U. PA. J. BUS. L. 861, 872 (2015).
- Katharina Pistor, A Legal Theory of Finance, 41 J. COMP. ECONOMICS 315, 329 (2013).
- Nicola Gennaioli, Andrei Shleifer and Robert Vishny, Financial Innovation and Financial Fragility, FONDAZIONE ENI ENRICO MATTEI NOTA DI LAVORO 114.2010, 5 (May, 2010).
- Eric A. Posner & E. Glen Weyl, An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to Twenty-First-Century Markets, 107 NW. U. L. REV. 1307 (2013); Saule T. Omarova, License to Deal: Mandatory Approval of Complex Financial Products, 90 WASH. U. L. REV. 64 (2012); Hilary J. Allen, A New Philosophy for Financial Stability Regulation, 45 Loy. U. Chi. L.J. 173 (2013).
- Saule T. Omarova and Peter Simon, Towards the Mandatory Approval of Complex Financial Instruments (Sept. 22, 2014) (available at http://www.socialeurope.eu/2014/09/complex-financial-instruments/).
- This acronym is short for “collateralized debt obligation.”
- Enterprise Data Management Council, Financial Industry Business Ontology (available at http://www.edmcouncil.org/financialbusiness).
- For a discussion of financial instruments as smart contracts, see Mark D. Flood & Oliver R. Goodenough, Contract as Automaton: The Computational Representation of Financial Agreements, 3 (Mar. 26, 2015) (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2538224).