Both parties to a complex financial instrument are likely to be sophisticated – this has led many to wonder why complex financial products need to be regulated at all. However, when the stability of the financial system is at stake, the parties to the transaction shouldn’t be the primary focus. Policymakers should instead be concerned with the externalities that complex financial products can generate for third parties.

Financial innovation – the process by which financial institutions develop new and complex financial products – increases the complexity of the financial system. Complexity is a destabilizing force: not only does complexity make it difficult for both market participants and regulators to comprehend financial institutions, products, and the linkages between them, it also facilitates the increasingly speedy transmission of shocks through the financial system by increasing the number of such linkages. By making the performance of financial products dependent on layers of other financial products, complex financial engineering also ensures that there is less flexibility to vary the terms of the products at the bottom of the food chain, when such variation may be needed to avert a crisis. Complexity can also be exploited to introduce new and unregulated types of leverage into the system.

Given that opacity is not the only problem posed by complexity, simply mandating more or better disclosure cannot fully address complexity. Instead, several academics have proposed that financial institutions be required to approach a financial regulatory agency for approval before launching a new financial product.[1] 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. Unfortunately, although there is much to recommend such a preapproval regime, such an approach would likely face significant political obstacles in the United States (which tends to be averse to precautionary regulation in circumstances where the cost of such regulation falls on a powerful and highly-organized industry, and the harm that the regulation seeks to avoid is uncertain – but potentially catastrophic). The prospects for the implementation of such a regime are better, although by no means certain, in Europe.

There are also a number of technical barriers that must be overcome before such a regime could be implemented – but these can likely be conquered more easily than the political barriers. The threshold question for any product pre-approval regime is, “when does a financial product stop being one type of product and become a new one?” To even begin to answer this question, we would need a catalogue of existing financial products and their defining features.

Insights from biology, a science that must embrace and classify ever-evolving complexity, could assist in designing a hierarchical catalogue of financial products that highlights both their similarities and differences. We can use synthetic CDO[2] squareds as an example of how such classification might be applied. 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 development of any such taxonomy would require agreement (ideally at the international level) on the axes along which products will be distinguished. The type of investor being targeted, the intended use of the product, the payment structure and the underlying index or reference asset are all important characteristics of financial products that can be used to compare and distinguish products. Importantly, though, such taxonomy should not categorize financial products so granularly that each individual transaction is viewed as its own product that requires review. Instead, we are aiming for a taxonomy that sufficiently balances specificity and generality that it allows for comparison of portfolios across firms, as well as facilitating clear communication between firms and regulators.

The initial compilation of a taxonomy of existing products would admittedly be a costly undertaking – however, once established, maintaining the catalogue as new products are developed would not be as arduous (particularly if, pursuant to a precautionary pre-approval process, developers of new products were required to bring such products to regulators before they could market them). 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™”: its definitions of financial products can serve as a starting point for creating the taxonomy. The FIBO™ project does not, however, seem to involve organizing financial products in any relational way – it instead provides stand-alone definitions. Innovations in the field of smart contracts (contracts that are represented as machine-readable code) may be helpful in organizing financial products in a more relational manner. If, in the future, financial contracts can be transposed using computer code,[3] then a computer algorithm could easily sort large volumes of contracts, assisting with the creation of a taxonomy 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.

Even if there is insufficient political will to implement a preapproval regime for financial products, such a catalogue would be extremely helpful to regulatory authorities monitoring the build-up of systemic risks in the financial system. However, we should not abandon the idea of a preapproval regime. It may find favor in other parts of the world – or in the United States, 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.

ENDNOTES

[1] 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).

[2] This acronym is short for “collateralized debt obligation”.

[3] 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).

The preceding post comes to us from Hilary J. Allen, Associate Professor at Suffolk University Law School. The post is based on her essay entitled “The Road to Precautionary Review of Financial Products”, which is available here.