Applying the Pharmaceutical Approval Model to Over-the-Counter Derivatives

Abstract

The recent global financial turmoil and economic recession have exposed the serious shortcomings of the current U.S. regulations for over-the-counter (OTC) derivatives. Drawing upon the arbitrage economic theory and the spirit of the U.S. Food and Drug Administration model, we propose a model assuming that the market will not behave rationally and efficiently when investors or consumers do not completely understand the risks associated with the financial products they hold. Therefore, it is essential for the Securities and Exchange Commission (SEC), as a designated regulator, to demand a full disclosure from issuers of new OTC derivative innovations and to evaluate and approve them before they are released to the market. This suggested model will not only enable efficient risk allocation in the market but also take a proactive approach in addressing the problem of unregulated OTC derivatives. The suggested model, if successfully implemented, will significantly improve the efficiency and stability of the U.S. financial markets both now and in the future. This commentary should be of interest to investors, regulators, financial institutions, and academicians.

Keywords: over-the-counter derivatives, U.S. Food and Drug Administration model

JEL Classification: G18