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Matthew F. Kluchenek and Jacob L. Kahn*

Almost three years ago, in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended section 4c(a) of the Commodity Exchange Act (CEA), to add three types of prohibited transactions deemed to be “disruptive of fair and equitable trading”—trading that violates bids and offers, trading with reckless disregard for orderly executions during the closing period, and so-called “spoofing.”^[1] The enforcement division of the Commodity Futures Trading Commission (CFTC) trumpeted its new authority, claiming that the Dodd-Frank Act had given the agency a “bigger arsenal of weapons.”^[2] Nonetheless, in the more than eighteen months since amended section 4c(a) became effective,^[3] the CFTC has yet to file or settle a single enforcement case alleging violations of amended section 4c(a).

Market participants in the ever-growing commodities and swaps markets should not take comfort in this delay. As demonstrated by the cases discussed in this Article, the lack of CFTC enforcement of amended section 4c(a) appears to be a function of timing rather than a reflection of regulatory disinterest. Indeed, the CFTC has brought charges in the past based on all three types of trading activity that the CEA now expressly prohibits. These prosecutions are likely to continue, and the CFTC will probably pursue them with more frequency as a result of the amendments under Dodd-Frank.

The amendments to section 4c(a) generate two principal questions: first, what types of trading activity will the CFTC likely target as violations of the amended statute? Second, what must the CFTC prove to establish those violations? This Article attempts to answer these questions by explaining the key language in the amendment, including how the CFTC plans to interpret it, and by examining recent enforcement activity in the commodities industry to identify trends in the cases, including defenses the CFTC is likely to reject.

I. THE CFTC’S NEW AUTHORITY UNDER SECTION 4c(a) OF THE CEA

As amended by Dodd-Frank, section 4c(a) of the CEA (entitled “Prohibited Transactions”) includes the following section:

(5)  Disruptive practices.—It shall be unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that—

(A)   violates bids or offers;

(B)    demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or

(C)    is, is of the character of, or is commonly known to the trade as, “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution).[4]

The CFTC was not required to promulgate rules to make these provisions effective, and it has not done so. Instead, it sought public comments on a list of questions related to the scope and nature of the prohibitions,^[5] and then issued a proposed interpretive order (Proposed Interpretive Order) to explain how it intends to enforce amended section 4c(a).^[6] A final interpretive order has not been released, but the Proposed Interpretive Order is effective until superseded by a subsequent order.

As explained below, although two of the three sub-parts under amended section 4c(a) appear to refer to specific trade practices, the boundaries for all three prohibitions remain largely undefined.

A. A Trader Who “Violates Bids or Offers” Faces Strict Liability under Section 4c(a)(5)(A)

Unlike the latter two prohibitions in amended section 4c(a)(5), each of which specifies a level of intent necessary to establish a violation, the prohibition of trading that “violates bids or offers” appears to create a strict liability offense because it does not indicate whether a trader must act with any degree of culpability.^[7] The CFTC has adopted this same reading of the statute, and plans to bring enforcement actions for violations of section 4c(a)(5)(A) regardless of the trader’s intent.^[8] In other words, traders who violate bids or offers may face regulatory enforcement regardless of whether they do so intentionally or negligently (or even through no fault of their own). The CFTC’s stance reflects its opinion (and its interpretation of Congress’s apparent opinion) that there is no legitimate reason for a trader to violate bids or offers.

But what exactly does it mean to “violate[] bids or offers”? Although the statute does not provide a definition, the CFTC plans to interpret this phrase as prohibiting a person from “buying a contract at a price that is higher than the lowest available offer price and/or selling a contract at a price that is lower than the highest available bid price.”^[9] The CFTC, however, does not view section 4c(a)(5)(A) as creating a “best execution standard across multiple trading platforms and markets,” some of which may have different bid-ask spreads for the same contracts.^[10] Thus, for example, even if the lowest offer for a near-month WTI Crude Oil futures contract on the Chicago Mercantile Exchange (CME) is below the lowest offer for the same contract on the IntercontinentalExchange (ICE), buying the contract on ICE would not constitute a violation of the prevailing offer on CME.

Two other key limitations help clarify this offense. First, the CFTC does not intend to apply the prohibition on violating bids and offers to traders’ attempts to “buy the board.”^[11] That is, a trader legitimately may enter an order to purchase or sell such a large quantity of contracts, and at prices either higher or lower than the best existing bid or offer, that the trader’s order executes against all resting quotes, provided that the trader does so in accordance with the exchange’s rules.^[12] Second, the CFTC’s Proposed Interpretative Order suggests that the prohibition on violating bids and offers applies only when a trader has control over the bids or offers she selects.^[13] Thus, trades made on an electronic trading platform that uses automated order-matching software should not give rise to liability under this section to the extent that such software precludes parties from buying higher or selling lower than prevailing market prices.

Based on these final two limitations, it would appear that the majority of traders operating on electronic exchanges need not be overly concerned about inadvertently violating section 4c(a)(5)(A). The same cannot be said in the over-the-counter (OTC) markets, where traders may seek to negotiate privately with a counterparty for various reasons, including the size of the trader’s position or a past business relationship. If a negotiated transaction in these markets occurs outside the range of current bids or offers, one of the two parties may be in violation of section 4c(a)(5)(A). Despite acknowledging the public’s concern about how this provision will be applied in OTC markets,^[14] the CFTC has declined to offer guidance on this point. Thus, the risk of strict liability remains for traders in OTC markets.

B. The Prohibition of Conduct that Disregards “Orderly Execution” under Section 4c(a)(5)(B) is Akin to a Stripped-Down Ban on Manipulation

The second “disruptive practice” added by the Dodd-Frank Act—trading that demonstrates “intentional or reckless disregard for the orderly execution of transactions during the closing period”—creates the most risk for market participants of the three new prohibitions for several reasons. First, it focuses specifically on trading activity during the closing period, which is one of the most actively traded periods during the trading day.^[15] The concentration of trades at the end of the trading day leads to greater movements in price, which in turn attracts the attention of regulators. Now that the CEA expressly targets trading misconduct during the settlement period, the CFTC may be more willing to issue section 4g requests for information in the wake of large price movements.^[16]

Second, and more importantly, the amendment to section 4c(a) does not define the phrase “orderly execution of transactions” or identify examples of activities that “disregard” such executions.^[17] The CFTC likewise does not offer any definitions or examples in its Proposed Interpretive Order.^[18] It merely identifies the “parameters” that exist in an orderly market, including “a rational relationship between consecutive prices, a strong correlation between price changes and the volume of trades, levels of volatility that do not materially reduce liquidity, accurate relationships between the price of a derivative and the underlying” and “reasonable spreads between contracts for near months and for remote months.”^[19] Yet none of these “parameters” appears logically to relate to a specific type of conduct. They are closer in kind to the factors courts consider in manipulation cases in deciding whether “artificial prices” existed in the market.^[20] Unlike in manipulation cases, however, a trader need not specifically intend to cause artificial prices^[21] to violate section 4c(a)(5)(B). It is enough if the trader recklessly disregards the risk that her trades could cause disorderly executions—that is, the defendant is so careless as to the risk of causing disorderly executions that it is difficult to believe she “was not aware of what [s]he was doing.”^[22] As a result, this section presents a more appealing enforcement option for the CFTC in manipulation cases that lack an obvious price effect or contemporaneous evidence of manipulative intent.

Finally, the CFTC’s Proposed Interpretive Order expands significantly the scope of trading that could violate section 4c(a)(5)(B) by suggesting that offending transactions could include (1) the mere submissions of bids and offers,^[23] (2) trades done outside of the closing period,^[24] and (3) cash market transactions in physical commodity markets where the contracts in question are used to establish a settlement price for a futures contract or swap.^[25]

C. The Prohibition of “Spoofing” under Section 4c(a)(5)(C) Targets Order-Entry Misconduct, but May Cover Legitimate High-Frequency Trading Activity

The final disruptive practice added by the Dodd-Frank Act—so-called “spoofing”—is the only one defined in the CEA. According to section 4c(a)(5)(C), spoofing occurs when a trader enters a bid or offer “with the intent to cancel the bid or offer before execution.”^[26] In other words, to establish a violation of this provision, the CFTC apparently must prove that a trader did not intend for her order to be filled. Whether the order is eventually filled is irrelevant; it is the trader’s intent at the time the order is submitted that determines the violation.^[27]

But how can the CFTC prove the necessary intent given that every order, once submitted, is at risk of being executed? In certain cases, the CFTC may be able to rely on contemporaneous evidence of the trader’s intent, such as emails, instant messages, or phone recordings in which the trader confirms that she plans to submit and cancel her orders before execution. If no such evidence exists, the CFTC likely will rely on circumstantial evidence of the trader’s intent. Such evidence could include the number and pattern of orders submitted, the length of time orders remained active before being cancelled, the nature of the trading methodology, or the viability of the order in the first place (that is, whether the price of the order was close to the market price at the time of submission). Moreover, as discussed below, in cases involving automated trading, the CFTC is likely to demand that algorithmic code be provided for purposes of ascertaining intent. In essence, the CFTC will need to show that the most logical inference to be drawn from the trader’s activity is that she entered orders with the intent to cancel them before execution.

The intent calculus is clearly more difficult in the case of high-frequency traders. According to the CFTC’s draft definition from October 2012, high-frequency trading is a form of automated trading that uses computer algorithms to produce a high rate of orders, quotes or cancellations.^[28] Mary Schapiro, the former chairman of the U.S. Securities and Exchange Commission, has estimated that high-frequency traders cancel “at least 90 percent of their orders.”^[29] As such, these traders undoubtedly know at the time they submit their orders that they will cancel many, if not most, of them before execution. Knowledge of a high likelihood of cancellation is not the same as intent to cancel, but it could come close. Consider, for example, a high-frequency trading algorithm (controlled by an individual trader) that submits a large group of orders at one time at varying price points, some of which have no reasonable chance of being executed based on market prices at the time of entry. Why has the trader (or the algorithm) included orders unlikely to be filled? Did they enter the orders to provide cover for other, illegitimate trading activity? In a slightly different scenario, what if the trader programs the algorithm to immediately cancel all outstanding orders after a certain number of executions have occurred? In that case, is the trader not entering orders with intent to cancel most of them before execution? To answer some of these questions, the CFTC may need to review the computer code behind the trading algorithm, which, from the CFTC’s perspective, could provide more circumstantial evidence of intent. For these reasons and others, high-frequency traders could become a frequent target for the CFTC in enforcing the prohibition on spoofing in section 4c(a)(5)(C).

In addition, though this section specifically bans “spoofing,” it also prohibits a more general category of conduct that is “of the character” of spoofing.^[30] In an apparent attempt to give meaning to this phrase, the CFTC in its Proposed Interpretive Order provided examples of conduct that does not necessarily fit the “intent to cancel” definition of spoofing but will still violate section 4c(a)(5)(C), including:

(i) Submitting or cancelling bids or offers to overload the quotation system of a registered entity, (ii) submitting or cancelling bids or offers to delay another person’s execution of trades; and (iii) submitting or cancelling multiple bids or offers to create an appearance of false market depth.^[31]

Again, however, these are only examples. By prohibiting conduct “of the character” of spoofing, the Dodd-Frank Act left it to the CFTC to determine what other types of order-entry misconduct to prosecute under section 4c(a)(5)(C).

II. DRAWING GUIDANCE FROM PRIOR ENFORCEMENT ACTIONS INVOLVING CONDUCT NOW PROHIBITED BY SECTION 4c(a)

Although the Dodd-Frank Act added three new prohibited practices to CEA section 4c(a), the practices themselves are not new, nor is the CFTC’s stance on their legality. As discussed below, both the CFTC and self-regulatory agencies have brought charges in the past based on the same conduct now expressly prohibited under Dodd-Frank. These cases provide additional insight into the type of conduct the CFTC may prosecute in the future under CEA section 4c(a)(5).

A. The CFTC Believes the Violation of Bids and Offers is a Serious Enough Offense to be Charged as Market Manipulation

The CFTC has filed just one enforcement action based on a trader’s violation of bids and offers—In the Matter of Anthony J. DiPlacido^[32]—but that case is also the only market manipulation case the agency has ever successfully litigated to final judgment. In DiPlacido, the CFTC accused the respondent, a registered floor broker on the New York Mercantile Exchange (NYMEX) trading on behalf of his client, Avista, Inc., of attempting to manipulate and successfully manipulating the price of certain electricity futures contracts traded on NYMEX in violation of sections 6(c), 6(d) and 9(a)(2) of the CEA.^[33] In particular, the CFTC alleged that DiPlacido traded in large quantities during the closing period and either offered at prices below the prevailing bid price in the pit (i.e., violated bids), or bid at prices higher than the prevailing offer prices (i.e., violated offers).^[34]

The Administrative Law Judge found DiPlacido liable for attempted and actual manipulation,^[35] and the CFTC affirmed. The U.S. Court of Appeals for the Second Circuit later affirmed the CFTC’s decision by summary order.^[36] Among other things, the CFTC concluded that DiPlacido’s repeated violation of bids and offers was sufficient to establish (1) that he acted with manipulative intent because his conduct had “no apparent economic rationale,”^[37] and (2) that his conduct produced artificial prices because he necessarily “paid more than he had to” for the contracts and thus injected artificial forces in the market.^[38] The CFTC relied on a 1971 decision by its predecessor agency as support for both of these conclusions even though the respondent in that case was not found to have violated any bid or offer.^[39]

The CFTC’s decision in DiPlacido supports its stated intent in the Proposed Interpretive Order to treat the offense of violating bids and offers in section 4c(a)(5)(A) as a strict liability offense. Indeed, the CFTC can point to an adjudicated decision by the full Commission—affirmed by the Second Circuit, no less—holding that there is no legitimate reason for a trader to violate bids or offers.^[40] DiPlacido tried to challenge this presumption in his case, arguing that his conduct did have a legitimate purpose: he was trading aggressively in order to help his client quickly unwind its hedge of positions in other markets.^[41] But the CFTC and the Second Circuit rejected this argument without any discussion, and likely will do so again in the future if it is raised in defense of charges that a trader violated bids or offers under section 4c(a)(5)(A). In other words, although a single transaction may be part of a much larger, complicated trading strategy, that does not excuse the trader from liability for violations arising out of the transaction.

B. The CFTC Faces a Much Easier Route to Prosecuting Disorderly Trading during the Closing Period

The most reasonable interpretation of the new prohibition of trading that disregards orderly executions during the closing period is that Congress was trying to make it easier for the CFTC to prevent conduct more commonly known as “marking” or “banging” the close. According to the CFTC, “banging the close” is

[a] manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract (that is, the period during which the futures settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative that is cash settled based on the futures settlement price on that day.^[42]

The CFTC previously charged this type of activity as manipulation.^[43] For example, in its case against the now-defunct Amaranth Advisors LLC, the CFTC alleged that the hedge fund, its affiliates, and a key employee sold an excessive number of natural gas futures contracts during the closing period with the intent of lowering the futures settlement price because they knew that a lower settlement price would benefit the defendants’ even larger short position in natural gas swaps.^[44] The CFTC charged the defendants with attempted manipulation, and eventually settled those charges for $7.5 million after the court denied the defendants’ motion to dismiss.^[45]

The Amaranth settlement, though a positive result for the CFTC, did not improve the agency’s record in adjudicated manipulation cases, ^[46] where the CFTC has prevailed just once in its nearly 40-year history.^[47] As explained by CFTC Commissioner Bart Chilton in 2009, prior to the enactment of the Dodd-Frank Act:

Proving manipulation under current law is so onerous as to be almost impossible. Under current law, the CFTC is required to prove “specific intent” to create an artificial price—a price not responsive to the forces of supply and demand. . . . Specific intent to manipulate is not always equivalent to intent to deceive—it requires something more, and it’s also very difficult to prove the existence of an “artificial price.” All in all, it makes for a very difficult legal burden, not to mention that it leaves a lot of wiggle room for mischief that is clearly prohibited by the Act.^[48]

In contrast to the specific intent standard described by Commissioner Chilton and required in “banging the close”-type cases brought prior to the Dodd-Frank Act,^[49] the CFTC can now prosecute disorderly trading during the closing period under section 4c(a)(5)(B) and establish a violation by showing that the defendant acted recklessly.^[50] The difference between these two standards of intent cannot be overstated. Whereas recklessness requires proof that the defendant’s conduct was highly unreasonable, specific intent requires proof that the defendant’s subjective goal was to bring about the prohibited result. Thus, for example, while a defendant carrying out a legitimate trading strategy cannot, as a matter of law, act with the specific intent to cause disorderly executions during the closing period, the same strategy could be deemed reckless—thereby satisfying section 4c(a)(5)(B)—if the defendant ignored the likely effect of her conduct.^[51] For this reason, the CFTC is likely to file far more cases based on misconduct during the closing period than it has in the past.

It should also be noted that the CFTC has not restricted its authority under section 4c(a)(5)(B) to “banging the close” cases. Though several market participants suggested in response to the CFTC’s notice of proposed rulemaking that the prohibition under section 4c(a)(5)(B) be limited to manipulative conduct similar to “banging the close,”^[52] the CFTC declined to adopt such a limitation. Thus, while prior “banging the close” cases are instructive, they do not cover the range of possible violations of section 4c(a)(5)(B).

C. The CFTC has Charged “Spoofing” under Two Other Sections of the CEA, but Neither Section Clearly Fits the Violation

Of the three new prohibited practices under amended section 4c(a)(5), the prohibition on “spoofing” is arguably the one with the clearest history of prior enforcement by the CFTC, as well as by exchanges. In the past two years, the CFTC has settled two enforcement actions based on conduct now defined in the CEA as spoofing,^[53] and the CME and Chicago Board of Trade (a designated contract market within CME Group) have settled three such actions.^[54] In all but one of these matters,^[55] the conduct in question occurred prior to the enactment of the Dodd-Frank Act—that is, prior to the time the CEA specifically prohibited spoofing.^[56]

The alleged spoofing violations in all of these cases occurred during the pre-opening session on CME’s electronic trading platform, Globex. Orders cannot be executed during this pre-opening session. However, except for the last 30 seconds before the market opens, orders can be cancelled at any time. At pre-determined intervals, CME calculates what is known as an Indicative Opening Price (IOP) using data from the unexecuted orders sitting in Globex. Once the market opens, trading will begin at a price somewhere in-between the unexecuted bids and offers, and the IOP provides a running estimate of this figure. The IOP is sent to Globex users and recipients of CME’s data feed, and becomes available to the public shortly thereafter.^[57]

The traders sanctioned by the CFTC and CME Group each sent (and later cancelled) large orders into Globex during the pre-opening session at varying prices. The orders moved the IOP up or down, depending on the prices in the orders. Although other market participants could see the movement in the IOP, they had no way of knowing how many orders were being entered into Globex and at what prices. The sanctioned traders, on the other hand, were able to discern the depth of support at different price levels because they knew the IOP had moved in response to their orders. If, for example, the sanctioned trader sent an order to purchase 100 contracts at $1.00 and saw that the IOP moved less for that order than it had for an order at $1.05, the trader would know that there was more market depth at $1.00. The traders then used this information to make trading decisions after the market opened.^[58]

In the two CFTC enforcement actions, Bunge Capital Markets and Gelber Group, the CFTC charged the respondents with violating sections 4c(a)(2)(B) and 9(a)(2) of the CEA.^[59] Section 4c(a)(2)(B) makes it unlawful to cause a non-bona fide price to be reported,^[60] and section 9(a)(2) makes it unlawful to cause false, misleading or knowingly inaccurate reports to be delivered that affect the price of a commodity.^[61] Neither of these sections, however, clearly fits the charge of spoofing. In particular, section 4c(a)(2)(B) requires a “transaction,”^[62] and an unexecuted order does not clearly constitute a “transaction.” Similarly, section 9(a)(2) requires that the inaccurate reports “affect or tend to affect the price of any commodity in interstate commerce,”^[63] and though the IOP does relate to the price of the underlying commodity to be traded, once the offending orders are cancelled, the IOP no longer reflects those orders. Thus, more so than with the other new disruptive practices added to the CEA, the new prohibition on “spoofing” provides a cleaner path for CFTC enforcement than existed prior to the Dodd-Frank Act.

In terms of conduct that the CFTC might charge as being “of the character of” spoofing, cases from the securities industry may offer some guidance. Spoofing in the securities industry is a bit different than in the commodities industry in that it is considered a form of market manipulation and requires that certain orders be executed.^[64] In particular, a securities trader engages in spoofing when she “creates a false appearance of market activity by entering multiple non-bona fide orders on one side of the market, at generally increasing (or decreasing) prices, in order to move that stock’s price in a direction where the trader intends to induce others to buy (or sell) at a price altered by the non-bona fide orders.”^[65] Often, the trader will cancel any orders that have not been filled after she sells (or buys) at artificially high (or low) prices.^[66] This activity is different than the offense of spoofing now prohibited in the CEA because it does not necessarily require a trader to enter orders with the intent to cancel them before execution. Nevertheless, the activity appears sufficiently related to fall under the category of conduct “of the character of” spoofing. The activity thus may give rise to a violation of section 4c(a)(5)(C) if it occurs in the commodities industry.

CONCLUSION

Although it remains to be seen exactly how the CFTC will enforce the new prohibitions of disruptive trading practices found in section 4c(a)(5) of the CEA, the CFTC’s Proposed Interpretative Order and past record of enforcement activity together provide some answers. Congress clearly intended to make it easier for the CFTC to police disruptive trading activity in the derivatives industry, and appears to have accomplished this goal. It is only a matter of time until the CFTC puts its new authority to work.

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David S. Miller*

I.      Introduction

Our federal income tax system, a hundred years old this year, was conceived in an age of nascent capital markets, characterized by illiquidity^[1] and high volatility.^[2] Time value concepts were little understood,^[3] options could not be priced,^[4] and the concept of economic income was still decades away.^[5]

The tax system revolved around cash, and realization was the guiding principle—the concept that income is not earned, and therefore not taxed, until a taxpayer actually sells property for cash or exchanges it for materially different property.^[6] The realization requirement was viewed as so fundamental to our income tax system that for some time it was imbued with constitutional significance.^[7]

However, taxpayers soon realized that financial and commercial transactions revolve not around cash and realization, but around economic income, and this allowed them to exploit the artificial realization requirement, again and again. Each time, eventually, Congress or the Internal Revenue Service (IRS) reacted.

After a century, our federal system for taxing financial instruments is truly Ptolemaic.^[8] Realization remains at its center, but Congress and the IRS have again and again attempted to adjust it to function in a world that truly revolves around economic income. The wash sale rules, the straddle rules, the capital loss limitation rules, the contingent payment debt instrument rules, the constructive ownership rules, the constructive sale rules, and the contingent swap rules are the epicycles of our tax system. And yet we retain our realization tax system as stubbornly as Europe retained Ptolemy’s geocentric system through the Middle Ages.

But perhaps this will change. On January 24, Congressman Dave Camp (R-MI), the Chairman of the House Ways and Means Committee, released the discussion draft of a bill that would tax derivatives under a mark-to-market system of taxation.^[9] This truly Copernican proposal would replace our entire federal system of taxing derivatives with a radically different but infinitely simpler model that would finally correspond to economic reality. If it were enacted, it would represent the most significant change in the history of our federal tax system. But, by shattering the realization paradigm, the Camp proposal suggests the possibility of something even more revolutionary: a fundamental reformation of our entire concept of taxable income.

Part II of this Article briefly recounts the history of the federal taxation of financial instruments with a series of vignettes. Part III discusses the Camp proposal and the hope it offers for our federal income tax system.

II.    A Brief History of the Federal Income Taxation of Financial Instruments

A.   The Wash Sale Rules

The federal income tax was enacted on October 3, 1913 but didn’t take effect until 1916.^[10] Within five years, wealthy taxpayers had already learned how to use the realization requirement to generate “paper” tax losses while deferring their real economic gains. At hearings before the Senate Finance Committee on October 1, 1921, T.S. Adams of the Treasury Department testified:

Men are now selling securities at 10 o’clock in the morning and buying them back at 12 o’clock. In order to claim a loss. The House believed that that should not be permitted. We have had considerable trouble with it, where the taxpayer does that and gets back identically the same securities at the present time.^[11]

Senator Charles Curtis from Kansas interjected.

The men doing that are men with enormous incomes . . . One man told me—who was many times a millionaire—that he did that, and that that year he made over $1,000,000; and yet he deducted from his tax where he sold his stock at a loss, gave himself what he was allowed for the loss and turned around a short time later and bought the same stock back at about the same price he sold it for.^[12]

Senator Curtis was describing the “timing option” inherent in the realization rule: taxpayers can accelerate their losses by selling at a loss but can defer their gains indefinitely by simply holding. The timing option is most blatant when the taxpayer sells a security at a loss, simultaneously repurchases the very same security, and then retains it as it appreciates.

That year, Congress enacted the wash sale rules, which prevent a taxpayer who sells stock or securities at a loss and also acquires substantially identical stocks or securities within a specified period of time from claiming that loss.^[13] The wash sale rules do not modify the realization requirement; instead, they simply defer the taxpayer’s loss.^[14]

The initial wash sale rules proved ineffectual and were amended substantially in 1988 and again in 2000 to address increasingly sophisticated derivative transactions.^[15] Despite these changes, the wash sale rules present insufficient barriers to abuse. For instance, David Schizer has listed seven “perfect end runs” around them.^[16]

B.   Straddles

Revenue Ruling 77-185 describes a transaction in which a taxpayer on August 1, 1975 simultaneously sold silver future contracts for July delivery and purchased an identical number of silver futures contracts for March delivery, effectively hedging her economic exposure.^[17] Three days later, after the March contracts depreciated, the taxpayer sold them at a loss and purchased an identical number of May contracts.^[18] The taxpayer reported a loss from the sale of the March silver contracts in 1975.^[19] On February 18 of the following year, the taxpayer simultaneously sold the May contracts and purchased July contracts to cover the short position.^[20] That year, the taxpayer reported a long-term capital gain.^[21]

While a wash sale allowed a taxpayer to recognize a tax loss without changing her economic position, at least the taxpayer experienced an economic loss. The straddle transaction described in Revenue Ruling 77-185 had no appreciable effect on the taxpayer’s economic position (because the taxpayer remained completely hedged), the taxpayer had no reasonable expectation of deriving an economic profit, and the transaction was consummated only to generate a current short-term capital loss offset by a future long-term capital gain.^[22] Although the transaction was a tax shelter,^[23] the realization rule made it possible.

In 1981, Congress addressed these transactions with a narrow mark-to-market rule in section 1256 that applied a reduced “blended” rate of tax to certain futures contracts and short-term options.^[24] Perversely, by reason of the blended rate, these marked-to-market futures contracts and options are more lightly taxed than they were under realization.^[25] For all other instruments, Congress let realization lie, but attempted to shackle it with the straddle rules, which deny deductions, defer losses, and toll holding periods for positions in straddles.^[26] As was the case with the wash sale rules, however, the collar was too loose and in 1984, Congress tightened it.^[27]

The 1984 Act was not a decade old before taxpayers found a chink in the straddle armor. A new financial product, initially called DECS—for Dividend Enhanced Convertible Stock—allowed corporate taxpayers with appreciated securities to hedge and monetize their economic exposure and claim current deductions for the cost of the financing, seemingly in violation of the rule that denies deductions for positions in a straddle.^[28] The IRS attempted to rein in DECS with regulations in 1995^[29]and more proposed regulations in 2001,^[30] but it finally took an act of Congress in 2004 to unambiguously deny interest deductions on DECS used to hedge appreciated positions.^[31]

C.   Shorts-Against-the-Box: The Lauder Transaction and the “Constructive Sales” Rules of Section 1259

In 1995, Estée Lauder and her sons, Ronald and Leonard, invoked the realization requirement to avoid all tax on their highly appreciated Estée Lauder stock.^[32] Estée loaned her stock to her sons; they loaned theirs to her; and they all sold the borrowed stock into the market.^[33] This transaction was a “short-against-the-box.” Under realization’s great generosity, because none of the three had sold their own shares, all of their tax was deferred indefinitely, even though they were subject to none of their stock’s benefits or burdens, and they received cash. Congress responded in predictable fashion. Realization was retained, but the specific transaction was shut down with the “constructive sale” rules of section 1259.^[34]

These examples are not the only ones. The loss limitation rules,^[35] the original issue discount^[36] and contingent payment debt instrument rules,^[37] the conversion transaction rules of section 1258,^[38] the constructive ownership rules of section 1260,^[39] and the contingent swap rules^[40] were all legislative or regulatory responses to realization rule abuse by taxpayers. Yet these rules still have not thwarted taxpayers and so today, taxpayers remain free to choose a tax treatment that minimizes their taxes. Three examples follow.

D.   The Continued Benefits of Realization

1.    The Taxation of Credit Default Swaps

Credit default swaps can be structured as options for tax purposes or they can be structured as “notional principal contracts.”^[41] If they are structured as options, under the realization rule, the taxpayer can defer tax on the premiums.^[42] If they are structured as notional principal contracts, the taxpayer can rely on the “contingent swap” regulations proposed by the IRS to claim immediate ordinary losses when the risk of default increases.^[43] The proposed contingent swap regulations turn off realization and require a modified mark-to-market system of taxation for these contracts.^[44] Some taxpayers initially took the position that credit default swaps were options and deferred the premiums, and then, after the market turned downward, changed their minds and treated the very same credit default swaps as notional principal contracts to claim immediate ordinary losses.^[45]

2.    The Use of “Variable Prepaid Forward Contracts” To Monetize Appreciated Stock

Wealthy individuals with appreciated stock can enter into variable prepaid forwards that hedge their downside risk, and provide them with cash, all tax-free. ^[46] Although the IRS challenged one variant of this transaction, in Revenue Ruling 2003-7, it declared the basic technique completely legal. ^[47]

3.    Structured Notes and the “Open Transaction” Doctrine

Finally, in the past ten years, over $250 billion in structured notes have been issued in public transactions registered with the SEC.^[48] Among these structured notes is a type that promises its holders a relatively secure principal amount at maturity plus contingent interest tied to the return of an equity index like the S&P 500. Notes like these resemble contingent payment debt instruments that would subject an investor to annual original income accruals and ordinary income at maturity.^[49] But these notes are structured as prepaid forward contracts. Under the open transaction doctrine of our realization-based tax system, holders pay no tax until maturity and then, at maturity, are eligible for long-term capital gains rates.

These notes are not tax shelters in any nefarious sense. They are registered with the SEC in public documents, and their beneficial tax treatment is simply the natural consequence of our realization tax system.

The deferral permitted by credit default swaps, variable prepaid forwards, and structured notes is an artifact of our realization system. The ability of taxpayers to choose their tax treatment arises because there is no single guiding principle governing the taxation of financial instruments. Ultimately, our system is numbingly complex because Congress and the IRS must repeatedly correct it because it has no basis in reality.

III.  The Camp Proposal

Chairman Camp’s proposal would require any derivative held by a taxpayer at the end of a taxable year to be treated as sold for its fair market value on the last day of the taxable year.^[50] Any mark-to-market gain or loss (and any gain or loss on an actual sale) would be treated as ordinary gain or loss; the taxpayer’s basis in the position would be adjusted for the gain or loss; and any loss could be carried forward to offset other ordinary income.^[51] Moreover, if a taxpayer uses a derivative to hedge a non-derivative, the non-derivative would also be subject to mark-to-market treatment.^[52] For example, if a taxpayer were to hedge his appreciated stock by buying a forward or a put option, not only would the forward or put be marked-to-market, but also the stock.

The Camp proposal is transformative. In an instant, our federal tax system for taxing derivatives would abandon the realization rule that characterized its first hundred years and begin its second century based on economic income. This paradigm shift would represent the most dramatic reform to our federal tax system since its introduction, and would do what a century of economists and tax lawyers have said would be impossible.

As the brief history in Part II illustrates, Camp’s proposal would replace half a dozen sets of rules with a single rule: mark-to-market. For the derivatives to which it applies, the proposal would obviate the wash sale rules,the straddle rules, the short sale rules, the capital loss limitations, the notional principal contract rules, the contingent swap rules, and the constructive ownership and sale rules. The law would be infinitely simpler and abuse all but impossible.

The key to the provision is its definition of derivative. Derivative includes any “evidence of an interest” in any share of stock, partnership interest, any evidence of indebtedness, any real estate (except for single parcels or inventory), any actively-traded commodity, and any currency.^[53] It also includes any “notional principal contract” (i.e., a swap, as specially but broadly defined) and any “derivative financial instrument” with respect to a derivative.^[54] Finally, if a debt instrument has an embedded derivative component, the debt instrument is bifurcated into two separate instruments: a derivative that is subject to mark-to-market treatment, and a debt instrument that is not.^[55]

This definition of derivative is notable for its breadth. It would cover not only all publicly-traded options, all futures contracts, and all interest rate, currency and equity swaps, but would also include all employee stock options, all stock purchase contracts, and even a home heating oil contract.^[56] The parties to all of these contracts would have to (somehow) value them at the end of the year, pay tax on any gain, and deduct any loss. The Camp proposal does exclude from the definition of derivative any financial instruments that are part of a “hedging transaction”^[57] and, in a different proposal, Chairman Camp would expand the definition of a hedging transaction.^[58]

There are several issues with which Chairman Camp will have to grapple as he refines his proposal in subsequent drafts. These issues, while important, should in no way detract from the overall strength of the proposal.

First, as Chairman Camp acknowledges, the proposal raises serious valuation issues because it applies to privately-held derivatives as well as publicly-traded ones.^[59] Taxpayers are famous for claiming low values and the IRS for claiming high values of non-publicly traded property.

Second, marking-to-market non-publicly traded derivatives raises liquidity issues. It is unclear how taxpayers that hold non-publicly traded illiquid derivatives will pay the tax on their mark-to-market gains without cash and without any means to raise the cash. The proposal may thus effectively outlaw some legitimate business transactions.

The natural way to avoid these two issues would be to limit the proposal to publicly-traded derivatives and derivatives with respect to publicly-traded property. Publicly-traded derivatives and derivatives with respect to publicly-traded property can be valued easily, and are liquid. Publicly-traded for these purposes could be defined broadly to include all derivatives with respect to which fair market value can be reasonably determined. All other derivatives would remain on the realization system, but an interest charge might apply to gain on prepaid derivatives. Chairman Camp has requested comments on the valuation issue.^[60]

Third, as discussed above, the proposal by its terms applies to employee stock options.^[61] Stock options are widely used to compensate middle-income employees who usually cannot negotiate for cash compensation instead of stock options. Subjecting employees who hold stock options to mark-to-market treatment would require the employee to fund his or her tax liability from other sources. For these reasons, the treatment of employee stock options requires serious consideration. The technical explanation of Chairman Camp’s draft does not indicate that the application of the proposal to employee stock options was ever considered.^[62] Because the proposal appears aimed at investors, speculators, and high-income individuals (but not middle-income employees), it would seem more appropriate to exclude employee stock options from the proposal.

Likewise, as mentioned above, the proposal applies to a stock purchase agreement that is expected to close within a reasonable time, and home heating oil and other consumer product contracts.^[63] All contracts entered into by individuals that are not in connection with a business or for investment should be excluded, as should purchase agreements that are expected to close within a reasonably short period of time.^[64]

Fifth, the proposal applies only to positions established after the end of this year.^[65] A less generous grandfather provision may be appropriate. Perhaps all financial instruments that otherwise would qualify as a derivative would be subject to mark-to-market after five years. Otherwise, a mad rush would begin as taxpayers hurry to enter into long-dated derivatives that would be forever grandfathered from the proposal.

Sixth, the proposal does leave open some opportunities for taxpayers to create synthetic derivatives with partnerships and foreign corporations.^[66] These loopholes will have to be closed. For example, assume that a taxpayer contributes $10 to a partnership and an investment bank contributes $90. The partnership then uses the $100 to buy publicly-traded XYZ stock and allocates all dividends, losses and the first $10 of gain to the investment bank, and all gain in excess of $10 to the taxpayer.^[67] Economically, this transaction results in the taxpayer’s holding a synthetic option, but because the taxpayer does not hold a “derivative” (it holds a partnership interest and not an option), it appears that the taxpayer would not be subject to mark-to-market treatment on this synthetic option. An anti-abuse rule would require this taxpayer to mark-to-market its partnership interest.

Seventh, some clarifications are in order. The proposal defines derivative to include “any evidence of an interest in” a stock and a partnership interest, among others.^[68] But that definition would seemingly include actual ownership, which clearly is not intended by the proposal. If the proposal remains limited to derivatives, the definition of derivative should be modified to clarify that it does not apply to ownership of actual stock or an actual partnership interest.

In addition, the proposal should make clear that except for the fact that unrealized gain or loss is recognized at the end of the year, the gain is ordinary gain or loss, and any loss is carried forward, the consequences for taxpayers of holding derivatives should remain the same. Thus, individuals should be subject to the new 3.8% Medicare tax on their net mark-to-market investment gains.^[69] The proposal should not change whether a tax-exempt investor recognizes “unrelated business taxable income” and is taxable on its derivatives.^[70] Likewise, the proposal should not change whether a foreigner is subject to tax by the United States on its derivatives.^[71] Finally, the proposal should not exempt the United States shareholders of a “controlled foreign corporation” from tax with respect to the derivatives held by that corporation.^[72] That is, if gain or loss on a derivative would have been “subpart F income”^[73] of a controlled foreign corporation before the proposal was enacted (and therefore its United States shareholders would be subject to tax on their share of that gain), the mark-to-market gain should also be subpart F income.^[74]

Finally, if enacted, the proposal would accentuate a most curious anomaly. A taxpayer who holds a forward contract on stock would have to mark-to-market the derivative and pay tax on all of her economic income at ordinary income rates.^[75] But a holder of the underlying stock will avoid paying any income tax on his stock by simply holding it until he dies.  And so the Camp proposal is as significant for what it does as for what it doesn’t do: It doesn’t affect stockholders.

The ability of stockholders under our realization system to defer tax indefinitely on their economic income creates horizontal inequity with wage earners, who are taxable immediately on their economic income.  It also exempts significant wealth from any income tax.

The best way to achieve “horizontal equity” for wage earners (who are taxed on nearly all of their economic income) and entrepreneurs and investors (who are taxed on none), and raise hundreds of billions of dollars of new revenue over the next ten years without raising tax rates, hurting job growth, or affecting a single small business owner would be to enact a progressive system of mark-to-market taxation.

For individuals and married couples who earn more than $2.2 million in income, or own $5.7 million or more in publicly traded securities (representing the highest earning and wealthiest 0.1% of families), the appreciation in their publicly traded stock and securities (and derivatives with respect to those securities) would be “marked-to-market” and taxed annually as if they had sold their positions at year end, regardless of whether the securities were actually sold.^[76]

The most serious challenge to a progressive system of mark-to-market taxation is the psychological concern about taxing “paper gains.”

Camp’s proposal is revolutionary but it does not address our tax system’s more fundamental horizontal equity issues. By shattering the psychological hurdle to taxing paper gains, however, Camp’s proposal offers hope that what may once have been considered impossible to enact is now possible: the transition to an economic model for the taxation of financial instruments.^[77]

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Saule T. Omarova*

Introduction: Dilemmas of Regulatory Reform

The global financial crisis of 2008 underscored the importance of reducing and managing systemic risk in derivatives markets. Even though the crisis originated in the U.S. subprime mortgage market, over-the-counter (OTC) derivatives significantly contributed to pre-crisis accumulation of excessive risk and hidden leverage in the global financial system.^[1] Derivatives offer private counterparties an unprecedented degree of flexibility and freedom to achieve desired outcomes by unbundling, reassembling, and trading financial risk. They may, and often do, function as a socially beneficial mechanism of prudent risk management and liquidity provision.^[2] At the same time, by removing some of the traditional constraints on speculative trading—such as the need to purchase, hold, or physically move underlying assets—derivatives have fundamentally altered the nature and dynamics of financial investment and intermediation. By the mid-2000s, increasingly complex and opaque derivatives had become the key tool of financial speculation and regulatory arbitrage, ultimately leading the financial system to the brink of collapse.^[3]

Not surprisingly, the need to update and strengthen regulatory oversight of derivatives markets has emerged as one of the key themes in post-crisis financial regulation reform. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) contains a wide range of measures designed to increase transparency in derivatives trading and to encourage better risk management on the part of private market participants.^[4] The key element of the new statutory scheme is the mandatory central clearing of standardized derivatives and trading through regulated exchanges and swap execution facilities.^[5] The statute also mandates public reporting of swap transactions^[6] and introduces new regulatory categories of financial actors—swap dealers and major swap participants—that must comply with special business conduct, capital, and margin rules.^[7]

The extent to which these reforms are likely to reduce systemic risk in practice remains to be seen.^[8] Fundamentally, however, the Dodd-Frank Act falls short of radically reshaping the structure or operation of derivatives markets. It does not impose direct, targeted regulatory restraints on the levels of risk, complexity, or leverage in the OTC derivatives market.^[9] Instead, the new law seeks to restrain potential risks posed by derivatives only indirectly, mainly through enhancing informational flow and rationalizing the clearing and settlement process for sufficiently standardized instruments. It leaves intact the monopoly of private actors on deciding which products—and, accordingly, risks—are traded in derivatives markets. In that sense, the Act’s focus is inherently reactive and retrospective rather than proactive and prospective. Ultimately, the new law fails to address the key policy question: how much risk in derivatives markets is too much for the public to bear, and how can we prevent such socially harmful risk from entering the financial system in the first place?

A Paradigm of Prevention: Approval Regulation

This Article explores one possible way to answer this fundamental question. It outlines the rough contours of a regulatory scheme based on mandatory pre-market government licensing of complex financial instruments, including derivatives. An envisioned model of product approval regulation explicitly aims to control the amount and types of risk being introduced into the financial system. In that sense, it is a true gatekeeping mechanism, a form of ex ante regulation of systemic risk in financial markets.^[10]

Generally, approval regulation can be defined as a regime in which “government entities exercise discretion over whether the firm or product can enter the market, such that firms must provide an empirical case for admission that the regulator must accept if legal market entry is to be granted.”^[11] Product approval has long been the model of pharmaceutical drug regulation in the United States and has recently been introduced in the European Union for chemicals regulation.^[12] A similar system of pre-trading “contract designation” also existed in the area of the U.S. commodity futures regulation prior to 2000.^[13] Potential extension of approval regulation to a broad range of financial products became a subject of academic discussion in 2008-09, in the context of the debate on the creation of a new consumer financial protection agency with the power to pre-approve financial products to ensure they are “safe” for consumers.^[14]

Approval regulation, however, may also serve as a potentially effective mechanism for controlling systemic financial risk, not just the risk to individual consumers.^[15] Of course, shifting the focus of the proposed scheme toward systemic concerns—socially unproductive levels of complexity, leverage, speculation, regulatory arbitrage, and interconnectedness in financial markets—complicates the task of designing it. A rigorous product approval regime can inadvertently limit the ability of financial firms to develop and market potentially beneficial financial instruments and impede socially useful financial innovation, which may have serious consequences for long-term economic growth.^[16] In this context, it becomes critical to articulate, in clear and unambiguous terms, the normative basis on which the new scheme would operate. Not only does this task involve making potentially difficult policy choices and trade-offs, but it also elevates the importance of drawing clear definitional and procedural lines, neither of which is an easy undertaking in the world of derivatives.

Regulatory Objective: Reducing Strategic Complexity

As the recent crisis demonstrated, numerous factors contribute to a systemic market failure. In designing a product approval regime, however, it is important to define the scheme’s normative focus as clearly as possible. Which of the well-documented “evils” in modern financial markets should be designated as the primary target of ex ante regulatory intervention? The laundry list of plausible candidates includes, at a minimum, excessive speculation, leverage, regulatory arbitrage, and complexity.^[17] Of course, truly effective regulation should target all of these phenomena in order to prevent an unsustainable level of risk accumulation in the financial system. However, for the purposes of providing clear policy guidance to regulators administering a product approval scheme, sharpening its policy focus may be a more effective strategy.

One potential approach would be to structure the new regulatory regime to target primarily and explicitly what I call strategic complexity in financial markets: constant introduction of new complex financial instruments into the market, regardless of actual demand or true economic need for such instruments.^[18] In general, increasing complexity of financial instruments and institutional structures through which they are traded is one of the key sources of systemic financial risk.^[19] What is particularly insidious in this respect is that much of that risk-generating complexity results from purely strategic efforts of dealers and market-makers—financial intermediaries that structure, sell, and deal in complex financial instruments—seeking short-term, monopoly-like rents.^[20] Dealers derive the highest profits from being the first to design and sell to clients a new financial instrument that is perceived as offering some unique benefits to investors, mostly by enhancing their ability to engage in speculation and arbitrage, and commands a high premium. Once a new product becomes commoditized, the original dealer loses its ability to extract monopolistic rents and seeks to introduce the next innovation to recapture lost rents, without regard to any natural demand for such a product in the marketplace.^[21] In the course of this socially inefficient over-innovation, dealer institutions originate, distribute, and amplify financial risk. That, in turn, enables other market participants to make increasingly risky and levered speculative bets, expands intra-market linkages and interconnectedness, and preemptively defeats regulators’ efforts to exercise effective oversight of the financial system.

It makes intuitive sense, therefore, that limiting financial institutions’ ability to over-supply unnecessarily complex financial products should substantially decrease levels of speculative trading, leverage, interconnectedness, and systemic fragility. The most effective method of achieving this goal is to insert regulatory controls at the point of product development, before financial intermediaries introduce the risk into the system. Under this regime, the regulatory agency would act as a gatekeeper and its primary task would be to vet all new financial products for indicia of strategic complexity and other socially undesirable risk attributes.^[22]

Regulatory Mechanism: The Three-Part Product Approval Standard

The core element of a product approval scheme is the substantive standard for determining whether a particular product should be allowed to enter the market. Fashioning a comprehensive and precise set of standards for licensing derivatives and other financial products is a difficult task. Nevertheless, it is possible to envision key substantive and procedural principles of a viable product approval mechanism. Inevitably, this is more of a thought experiment than a legislative blueprint.

The key aim of the product licensing review should be to evaluate each relevant financial instrument from functional, institutional, and policy perspectives. Regulatory approval should be granted only if the application meets a three-part statutory standard: (1) an “economic purpose” test, which would place the burden of proving commercial and social utility of each proposed financial instrument on the financial institutions seeking approval; (2) an “institutional capacity” test, which would require a review of the applicant-firm’s ability to monitor and manage the risks of the proposed product effectively; and (3) a “systemic effects” test, which would require a finding that approval of the proposed product does not pose an unacceptable risk of increasing systemic vulnerability and does not raise significant public policy concerns.

The “Economic Purpose” Test

First, the financial institution would have to make an affirmative showing that the proposed financial instrument has a bona fide economic purpose that promotes productive enterprise and does not merely provide another means of financial speculation, leverage, or regulatory arbitrage. The goal of the product approval regime is to discourage financial institutions from creating and marketing complex financial instruments, where the benefits of such complexity for the economy and broader society do not outweigh potential increase in systemic risk.

To meet this test, an applicant-firm will have to (1) identify the intended market for the proposed financial product and describe (with sufficient specificity) potential users; (2) show that the product will fulfill a specific business need of potential product users, which existing financial products fail to fulfill; and (3) demonstrate that this legitimate business need significantly outweighs any potential uses of the product for speculative investment or regulatory arbitrage as the core motivation for the product user (or the applicant firm) to enter into the proposed transaction.^[23]

The economic purpose test is essentially a “facts-and-circumstances” inquiry.^[24] The applications would have to describe the target market for the product and the intended economic purpose of the product in reasonably specific terms, in order to show a relatively direct and meaningful link between the proposed financial instrument and some productive economic activity outside the confines of financial markets.^[25] Applicant-firms would be required to monitor on an ongoing basis the markets for their approved products and report any significant changes in the market composition and uses of the relevant products, as these changes may alter considerations on which the original approval grant was based.^[26]

In effect, financial institutions will have to provide complete ongoing disclosure and analysis of their dealing and market-making activities. This burden-shifting mechanism would begin correcting the informational asymmetries between regulators and industry and the current incentive structure that encourages socially sub-optimal risk-taking by financial market actors.

The “Institutional Capacity” Test

The second part of the statutory standard would require the applicant to demonstrate its internal organizational, operational, and financial capacity to monitor and manage potential risks the proposed product poses to the institution’s own financial health, as well as to the financial well-being of the product’s users and overall market stability.

To meet this test, the applicant would have to satisfy certain capital adequacy or similar requirements limiting its ability to incur leverage.^[27] Additional factors to be considered may include the firm’s overall business and risk profile; the relationship between the proposed activity and the rest of the firm’s business and resources (including human and technological resources); internal systems of risk management and regulatory compliance; previous regulatory and compliance record; and the history of enforcement against the firm or its affiliated entities. It is also important to review and evaluate whether the firm has established effective risk management policies and procedures designed specifically for the proposed activity.

The inquiry at this point should not be limited to the firm’s ability to handle the economic demands of dealing in the specific product. It is just as critical to assess how the proposed activity may alter the firm’s economic incentives and overall business strategy, and whether or not such a change creates potential conflicts of interest, poses reputational risks to the firm, or raises significant concerns about broader market integrity.^[28] To put it simply, the key question has to be, “Do we want this particular institution to trade and deal in this particular product?”

The “Systemic Effects” Test

Finally, the applicant-firm will also have to demonstrate that the proposed product does not pose potentially unacceptable systemic risk or is otherwise likely to increase the vulnerability of the financial system. This intentionally broad requirement gives the regulator statutory authority to consider a wide variety of potentially relevant factors and public policy considerations that may not be directly included in the description of the product or the immediate market needs. Many existing statutes mandate that financial regulators exercise their discretion only if doing so is “in the public interest.”^[29] This aspect of the product approval process is designed to allow for this type of deliberation, where the applicant-firm bears the burden of proving that the financial instrument it seeks to market is not likely to have a negative impact on broader socio-economic policies and political goals.^[30]

Implementing the Mechanism: Operational Design Challenges

This cursory outline of a product approval mechanism raises many legitimate questions about the proper scope, feasibility, and potential negative consequences of instituting such an intrusive regulatory scheme. While it is impossible to answer all of these questions in this short Article, it is useful to sketch out some of the key challenges posed by this proposal.

To function effectively, a product approval mechanism must be embedded in a properly designed regulatory structure. Many operational details of such a structure would require serious thought. Perhaps the most critical—and most difficult—task in this respect is delineating the overall scope of the scheme and defining which classes of financial products and transactions should be subject to regulatory pre-approval. While an over-inclusive definition may have an unnecessary chilling effect on socially beneficial innovation, an under-inclusive definition may allow for the excessive build-up of systemic risk in financial markets and thus undermine the efficacy of the entire regime.

Complex trading strategies and sophisticated structuring techniques raise an even more difficult question: What constitutes a “product” that would require a separate regulatory approval under the new regime?^[31] Thus, one of the critical tasks in designing the new regulatory regime is to develop a set of criteria for determining when a particular instrument has features unique enough to make it a separate “product.” As a first approximation, that list of factors should include key terms related to payment and other significant rights and obligations of the counterparties, the intended uses and target markets of the instrument, and the nature of assets underlying the instrument. A significant change in any of these terms would require the financial institution to apply for a separate regulatory approval.

Finding a workable solution to these definitional problems—where and how exactly to draw the lines between separate “products” and which of those “products” should be subject to mandatory licensing—may be the key to the feasibility of the proposed scheme.^[32] Among other things, these choices would determine the volume of deals to be reviewed and approved by the regulator under the new regime. After all, the viability of any regulatory model depends on the agency’s resources and ability to manage the process in practice.

Beyond these definitional problems, numerous questions arise with respect to structuring the process of approval, assigning regulatory jurisdiction, and enforcing compliance. Developing these operational details requires careful balancing of competing considerations of procedural fairness and efficiency, regulatory flexibility and regime integrity, technical expertise and public accountability.^[33] These difficulties are hardly insurmountable, nor are they unique to this proposal. In any event, envisioning an operational product approval scheme is a valuable intellectual exercise for purposes of shaping the future of regulatory reform.

Conclusion: Redefining What Is Possible

This Article explored the prospect of a fundamental shift in derivatives regulation and advocated an explicitly anticipatory approach to reducing systemic risk in the financial sector. The proposed model of ex ante derivatives regulation does not prohibit any financial activities. It merely imposes the duty to provide information necessary for evaluating potential risks and benefits of a specific financial product on the financial institution seeking to market it. If properly designed and implemented, this regulatory approval process would provide a mechanism for ensuring that financial innovation, in fact, advances productive enterprise in the real economy and offers real public benefits.

As discussed above, executing this idea will likely involve resolving various technical and operational challenges. Because it calls for a radical change in the existing regulatory philosophy, this proposal is also bound to generate criticisms on other grounds. To some, product approval may appear too blunt a tool, liable to cause more harm than good by stifling financial innovation and driving financial activities abroad. Others may see it as unacceptably paternalistic “command-and-control” regulation. Finally, many may doubt the presence of political will to take on such bold and controversial reforms.

This Article does not purport to provide answers to every question and dispel every doubt. It may very well prove too difficult to design and implement a comprehensive and effective mandatory product approval scheme for derivatives (or any other financial products) in practice. Nevertheless, it is critical to give this seemingly radical proposal a full, open-minded consideration as a potentially superior alternative to the current, ex post regulatory approach. At the very least, expanding the range of plausible reform options should lead to more meaningful academic discussions and better informed policy decisions. By making a preliminary case for product approval as a potentially plausible model of derivatives regulation, this Article seeks to enhance our chances of getting it right next time.