Newspaper article Pittsburgh Post-Gazette (Pittsburgh, PA)

FDA for Securities Could Avert Crises

Newspaper article Pittsburgh Post-Gazette (Pittsburgh, PA)

FDA for Securities Could Avert Crises

Article excerpt

In February, Mary Schapiro, chairwoman of the Securities and Exchange Commission, said the agency is looking for ways to rein in high-frequency traders. That is, the people who use computer algorithms to buy and sell derivatives at lightning speed to make instantaneous profits.

High-speed trading can waste resources and cause market disruptions. So the commission is right to look into high-speed trading. But it must realize that this is only one issue at the edge of a vaster problem that requires significant government intervention.

The larger challenge is that much of the U.S. financial system is devoted to useless trading that advances no important economic interest but, at the same time, creates a dangerous risk of economic crisis. The way to control this wasteful speculation is to require government approval of all new financial products, subjecting them to the same sort of examination and regulation that the Food and Drug Administration applies to new medicines.

Before there was an FDA, quacks peddled useless and sometimes dangerous tonics like radium water. Yet for all the harm such concoctions caused, they may never have matched the risk and waste of some financial derivatives -- what Warren Buffett has called "financial weapons of mass destruction."

A credit-default swap, a financial product that pays off if a bond defaults, might seem sensible. If you own a Greek sovereign bond and a CDS, when the bond defaults, the credit-default swap pays you back.

But if all you are trying to do is make money with low risk, you could buy U.S. Treasuries rather than Greek bonds. Normally, the buyer of a CDS on a Greek bond doesn't buy the bond itself (making it a "naked" purchase). Such a transaction cannot reduce risk in the financial system as neither party is hedging a risk they already face. Instead, they are seeking to evade capital-adequacy regulations that aim to limit institutions' risk exposures or to gamble more cheaply than would be possible if they had to take an explicit short position on the bond.

In the years leading up to the 2008 crisis, traders commonly used credit-default swaps to gamble on default by a country, corporation or package of mortgages and to evade financial regulations associated with such bets. …

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