An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to Twenty-First- Century Financial Markets

ABSTRACT-The financial crisis of 2008 was caused in part by speculative investment in complex derivatives. In enacting the Dodd-Frank Act, Congress sought to address the problem of speculative investment, but it merely transferred that authority to various agencies, which have not yet found a solution. We propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for insurance than for gambling. Other factors-such as a financial product's effect on the efficient allocation of capital-may be addressed if the answer is ambiguous. This approach would revive and make quantitatively precise the common law insurable interest doctrine, which helped control financial gambling before deregulation in the 1990s.Derivatives are financial weapons of mass destruction.-Warren BuffettINTRODUCTIONFinancial products are socially beneficial when they help people insure risks, but when these same products are used for gambling they can instead be socially detrimental.1 The difference between insurance and gambling is that insurance enables people to reduce the risk they face, whereas gambling increases it. A person who purchases financial products to insure herself essentially pays someone else to take a risk on her behalf. The counterparty may be better able to absorb the risk, typically because she has a more diversified investment portfolio or owns assets whose value is inversely correlated with the risk taken on. By contrast, when a person gambles, that person exposes herself to increased net risk without offsetting a risk faced by a counterparty: she merely gambles in hopes of gaining at the expense of her counterparty or her counterparty's regulator. To be sure, a person on one side of the transaction may be gambling while the person on the other side of the transaction may be insuring; then the question is whether the transaction on net reduces risks, increases them, or has no effect. In general, when we refer to insuring and gambling, we mean these net effects rather than the position on one side of the transaction. As we discuss below, gambling may have some ancillary benefits in improving the information in market prices. However, it is overwhelmingly a negative-sum activity, which, in the aggregate, harms the people who engage in it, and which can also produce negative third-party effects by increasing systemic risk in the economy.This basic point has long been recognized,2 but has had little influence on modern discussions of financial regulation. Before the 2008 financial crisis, the academic and political consensus was that financial markets should be deregulated.3 This consensus probably rested on pragmatic rather than theoretical considerations: the U.S. economy had grown enormously from 1980 to 2007, and this growth had taken place at the same time as, and seemed to be connected with, the booming financial sector, which was characterized by highly innovative financial practices. With the 2008 financial crisis, this consensus came to an end, and since then there has been a significant retrenchment, epitomized by the passage of the DoddFrank Act,4 which authorizes regulatory agencies to impose significant new regulations on the financial industry.But the Dodd-Frank Act is an empty vessel: it authorizes agencies to regulate without giving them much guidance as to how to regulate.5 So numerous questions remain open as to how the agencies should use their authority, and indeed whether the Dodd-Frank Act creates the proper regulatory structure.In this Article, we propose a new approach to financial regulation that addresses the problem of financial gambling. We make two contributions. …