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Abstract

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” said hedge fund legend Mark Mobius, speaking in Tokyo nearly a full year after the United States officially embarked upon the greatest reform of financial services regulation since the New Deal. Today, the world is still reeling from the recent financial crisis, which ravaged even the strongest economies and left them battling recession, budget deficits, soaring unemployment, and political discontent. Facing another financial crisis in this situation is a frightening prospect. National governments, individually or in any G-denominated combination, may simply be out of magic bullets—as well as money and goodwill of their citizens—with which to fight the next war.

In this context, preventing the next financial meltdown becomes a survival imperative. To be effective, however, crisis prevention efforts must be comprehensive and coherent, and target the fundamental problems in financial markets instead of getting mired in the sea of small “fixes” to the system. One of the fundamental causes of the recent crisis was the unprecedented degree of complexity and interconnectedness in modern financial markets, and the woeful inability of both private market actors and public authorities to understand and manage the risks these factors posed to systemic financial stability. Complex financial instruments, markets, and institutions create levels of opacity, interdependence, and unpredictability which significantly increase the potential for market inefficiency and systemic failure of dangerous proportions. Complexity enables private market actors to engage in excessive financial speculation and tax and regulatory arbitrage, which further increase systemic risk and contribute little to productive economic growth. Despite their ambitious reach, post-crisis regulatory reforms do not appear to offer effective solutions to the fundamental dilemma of regulating complexity and systemic risk in financial markets. Much of the current academic and policy debate tends to focus on discrete reform measures, mostly aimed at enhancing or finessing the same regulatory tools and approaches that failed to prepare us for the devastating effects of the latest crisis. Ultimately, these measures fail to answer directly the fundamental normative question: how much financial risk is too much for society to bear?

This Article pushes the boundaries of the debate by directly confronting that fundamental policy issue. It starts with a simple premise: if we cannot effectively regulate and control systemic risk associated with the increasing complexity in financial markets, we need to reduce and control the overall level of complexity in the system. Because much of that risk-generating complexity is a result of strategic efforts of financial intermediaries that structure, market, and deal in complex financial instruments, the most radical and direct method of reducing systemic risk is to insert regulatory controls at the point of product development, before the risk is introduced into the financial system. This Article argues that one potentially effective form of such ex ante regulatory control is pre-market government licensing of complex financial instruments—including derivatives, asset-backed securities, and other structured products.

Product approval has long been the model of pharmaceutical drug regulation in the United States and has recently been introduced in the European Union’s chemicals regulation. It is not commonly known, however, that a similar system of pre-trading “contract designation” also existed in the area of the U.S. commodity futures regulation prior to 2000. Building on these three examples, the Article offers the first comprehensive examination of whether, and how, the concept of product approval regulation can be applied to reduce systemic risk posed by complex financial instruments.