Asking new questions or at least hoping for more useful answers

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4 Responses

  1. A.J. Sutter says:

    Apropos of “Questions or legislation should also address financial innovation or the development of new financial products or uses of products or processes not previously available”: How would you define a “new product” or “use”? And what sort of regulation do you envision, if not just disclosure?

    For example, would you require registration of each type of product and each type of use, like the FDA? If so, should anything be grandfathered in? Does the “sophistication” of the parties involved make an analogy to the FDA less appropriate? Does SEC have staff to review such registrations? What if each firm has its own flavor of a given deal?

    More generally, given that “innovation” has such buoyant connotations in American society, do you think such restrictive legislation has a chance? And (devil’s advocate question) won’t this change lawyers’ roles from being creative and spontaneous in adapting instruments for deals, to being regulatory paper-pushers?

  2. Kristin Johnson says:

    Thanks for the comments A.J. They raise several interesting points. Your first question raises a query that I spend some time discussing in one of my current projects -defining financial innovation. Similar to your comment, scholars like Charles Pouncy have called attention to the use of terms like “financial innovation” or “financial engineering” and challenge the use of these terms in the absence of an effective definition. See Charles R.P. Pouncy, Contemporary Financial Innovation: Orthodoxy & Alternatives, 51 SMU L. REV. 505, 509 (1998) (explaining that “[t]he term ‘financial innovation’ appears with relative frequency in legal scholarship, generally without a meaningful effort to define it”). In the absence of a definition for financial innovation, “legal scholarship has not produced critical examinations of financial innovation as an economic process.” Pouncy’s article on page 508. I agree that legal scholarship should aim to define more precisely what financial innovation means – – particularly if we intend to assign a strong positive or negative connotation to the term. In a current project I explore the development of credit default swaps as financial products; I discuss the process that lead market participants to adapt other forms of swap agreements to fit concerns regarding illiquidity in the credit markets. I leave for a future project an article committed to defining innovation or resolve disputes regarding various uses of the term “financial innovation.” There is, however, in the literature an accepted understanding of financial innovation as a referrence to creative processes leading to the development of financial instruments or investment products that either 1) did not exist in financial markets prior to the introduction at issue or 2) present an adaptation of an existing product that employs the product in manner distinct for previous uses. Many types of swaps have been used in modern markets and I note in the project that well before the emergence of the current market for CDS, we witnessed a burgeoning market for interest rate and currency swaps. In addition, I note in the article that we may find predecessors to several popular credit instruments in ancien markets such as the Dojima Rice Exchange in Osaka, Japan. (Mark West impressively presents a discussion of the Rice Exchange in an article infused with interesting cultural and historical color.) There may be, however, a few points of distinction in the terms, subject, pricing, origination and trading of these examples and the contemporary form of CDS. I like your question on the FDA. In future posts, I will note some reflections on how interdisciplinary approaches may help securities regulators become more effective. I will also offer a few reflections about the need to think about proper regulatory approaches to issues arising in financial markets, particularly questions regarding regulation, globally or at least comparatively across markets. For example, the FSA in the UK has different and some might argue greater authority in overseeing the introduction of new financial products.

  3. A.J. Sutter says:

    Thanks for your reply. My definitional question, though wasn’t directed to legal scholarship, but rather to legislation. Your post suggests that legislation should address new financial products and uses of existing products; I took this (perhaps too narrowly) to mean some kind of regulatory choke-point for their introduction. In that case, the definition of what constitutes “new” becomes very significant, not least because there’s a tradeoff between how finely-grained it is and how many staff you have available to enforce the regulation.

    A pharmaceutical standard of newness is quite narrow: a simple structural substitution like a methyl group for a hydrogen could necessitate a new FDA application. A patent standard, though, is much looser: such a simple change might be deemed obvious or an equivalent rather than novel. (One can make a similar, though maybe weaker, analogy to the two regulatory systems regarding uses.) Given the opacity, complexity and fragility of the financial system, it might be difficult to judge ahead of time that some structural change in the terms of an instrument is too minor to be “new”. One would certainly not want to be the poor staffer who greenlights, or acquiesces as to, something that winds up causing another crash.

  4. A.J. Sutter says:

    PS: In the above, my mixed metaphors might be confusing; better might be to say that the FDA standard is “fine-grained” and the PTO standard is “coarse-grained”; a net metaphor, like ‘-meshed’ would also work. A fine-grained standard entails higher up-front enforcement costs, while a coarse-grained one may have greater risk of unforeseen consequences. As for costs, though, there is the PTO model of being self-supporting from app fees.