As shown by the example of credit default swaps, defining the appropriate form of financial regulation is very hard. Yet history shows that simple principles, like ranking financial products on the basis of their social utility, may provide the key. In the 18th century, faced with scandalous abuses on life insurance markets, the British parliament found a clear-cut method of distinguishing insurance contracts from pure bets. Likewise, today, two influential American economists suggest a complete rebuilding of financial regulation based on tests of social utility.
“While the financial services industry performs many economically vital functions, and will continue to play a large and important role in London’s economy, some financial activities which proliferated over the last ten years were ‘socially useless’”. Adai
When Lord Turner made that declaration in 2009, it spurred a huge polemic in England. Opponents to the then-FSA Chairman were appalled: since when did governments have a right to define what is useful, and what is not, in a free economy? For Finance Watch, which aims at “making finance serve society”, reaching the appropriate regulatory framework for derivatives and other financial products will only result from an assessment of the social utility of financial activities.
The example of Credit Default Swaps
Let us take an example: CDS. These products are defined as derivatives that protect against default, paying out like insurance policies if the creditor (normally a company or a country) defaults. In 2011, there was a big debate in Europe about the role of CDS in the Eurozone debt crisis. Finance Watch supported a ban on the “naked” use of CDS, when investors buy CDS to protect against the default of a security they do not own, and continues to follow up on the issue. If you are interested, here is the linkto the dedicated dossier.
It is essential to regulate CDS markets soundly. Qualitative measures like the ban of naked CDS are useful. But many recognize that derivatives regulation will only be effective if quantitative measures are also implemented, for example “position limits” that cap the number of options or futures contracts that a single investor may hold in a given market.
In the United States, Title VII of the Dodd-Frank Act requires the Commodity Futures Trading Commission to establish position limits for certain physical commodity derivatives. Finance Watch supports the same principle for Europe. In 2010, CFTC Chairman Gary Gensler claimed that position limits should also be implemented on CDS markets. But in the meantime, position limits on commodities have been challenged in US courts, so American regulators had to tame their ambitions in respect of CDS.
Yet, in the 18th century, England set the basis for the development of a world-leading insurance industry… by establishing a distinction between useful and superfluous insurance contracts. That is the story of the “legitimate economic interest” doctrine.
Early abuses in life insurance markets
Life insurance was invented in the 15th century. From the very beginning, people have used life insurance as a way to bet on lives, which made catholic powers furious. In 1419, the Venetian Senate banned all bets on the Pope’s life. In most of Europe, there was a blanket prohibition on gambling, which also encompassed life insurance. There were only a few exceptions; for example, merchants were allowed to insure slaves, which fostered colonial trade. Nevertheless, in England, life insurance was never prohibited, partly because it was less developed, partly because of Anglicanism, and partly because of Common Law traditions.
So in the 18th century, England became home to all kind of bets. In 1771, speculation broke out on the true sex of a French soldier and diplomat, the Chevalier d’Eon. Rumors that he was a woman had been circulating since late 1770. Since the Chevalier refused to be examined, two lawsuits were brought by brokers, to determine whether a friend’s testimony constituted a proof. Courts dismissed the brokers’ claims. However, the immorality of bets became more and more blatant. Here is a telling story: “In 1750, a man collapsed at the door to the club and was carried in. The members of the club immediately made bets whether he was dead or not, and when the surgeon made ready to bleed him, the wagerers ‘for his death interposed’, objecting that ‘it would affect the fairness of the bet’” [Clark, 1999].
The insurable interest doctrine
Faced with such scandals, the British Parliament had to react, but without hampering insurance markets, which are an essential step toward an advanced capitalist economy. This resulted in the Gambling Act of 1774, which introduced the “insurable interest doctrine”: insurance contracts that do not aim at protecting a legitimate economic interest shall be annulled. This also helps to address the “moral hazard” problem where the insured person is more interested in seeing the insurance pay out than in preventing the harm it is designed to protect against.
But what is a legitimate interest? In 1777, Mr. Spenser, a rich British soldier, died on his way to the West Indies. A good husband, he had arranged for a £500 annuity to be paid to his wife, Mary Spenser. Cautiously, she also took a £5,000 insurance policy on her husband. The underwriters refused to pay: they claimed that Mary Spenser had no “economic interest in her husband’s life” since he had already provided for an annuity. However, the court held the contract to be valid, and underwriters had to pay the promised amount. Indeed, common law considers that a person has an unlimited interest in their own life, or in that of their spouse. The case was one of the first decisions to elaborate the “insurable interest” doctrine after the adoption of the Gambling Act, the major historical pillar of insurance regulation in England.
The Spenser case illustrates the difficulty of distinguishing economic activity from pure speculation. There is always a speculative element in finance, and it needs to be acknowledged. But one could argue that on insurance policy markets, the balance has been found, thanks to the “insurable interest” doctrine. Everybody now understands the difference between protecting your family through life insurance and betting on a stranger’s life. Historians have argued that the ensuing development of private insurance was a great step forward, which among other things paved the way for the Welfare State. Could better regulation of today’s commodity and credit derivatives markets bring similarly significant contributions to global development?
A modern application of the doctrine
In a recent article from National Affairs, Eric Posner and E. Glen Weyl, two economists from the Chicago school of economics, home to the neoclassical school of thought, argue that the best way to curtail what they call “casino finance” would be to create an agency on the model of pharmaceutical drugs. Before it is sold, every new financial product would have to be approved by the agency on the basis of a test of social utility. Drawing the line between socially useful and not socially useful is equivalent to defining legitimate and illegitimate interests, as British parliament and judges did in the 18th century. The funny thing in the article is that the authors predict that credit default swaps, equity options, statistical derivatives would all be forbidden under their proposal! This goes obviously too far. As if, discovering the reality of free markets, economists would suddenly forget everything they used to advocate when they only had eyes for theoretical models.
Even the most liberal economists now realize the dangers of unregulated finance and support increasingly interventionist measures. At Finance Watch, there is strong support for the idea that research should focus on regulation again, after two decades of domination by the myth of self-regulated markets. Finance Watch has also elaborated many proposals to tame what Posner and Weyl call “casino finance”. For example, consumers should have the right to know whether their money supports the real economy or financial bets (see this link for more information on consumer issues).
What history teaches us here is optimism: armed with sound principles there are ways to regulate harmful practices, like betting on lives, while preserving public good and keeping the social benefits of life insurance. Instead of getting lost in technicalities, keeping in mind the purpose of insurance policies helped the 18thcentury British Parliament to find a solution to a growing concern (we wish today’s British authorities were as conscious of the social impact of derivatives activities in their approach of derivatives regulation). Let us be sure that, with simpler yet clearly defined methods, financial regulators can still manage to regulate complex financial instruments.
- Geoffrey W. Clark, Betting on Lives: The Culture of Life Insurance in England, 1695-1775, Manchester University Press, 1999
- Eric Posner and E. Glen Weyl, “Against Casino Finance”, National Affairs n°14, Winter 2013, available on: http://www.nationalaffairs.com/publications/detail/against-casino-finance
- Posner, Eric A. and Weyl, E. Glen, “An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets” (June 4, 2012). Northwestern University Law Review, Vol. 107, Available at SSRN: http://ssrn.com/abstract=2010606