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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.