Armed with the lessons of the current crisis, a brand new regulatory regime is set to emerge. Much of it will focus on reducing financial complexity, with an eye towards eliminating bizarre derivatives that "nobody" can value. Lenders will face new regulations so that we don't have the subprime mess again. Hedge funds will be forced to disclose what they own.
Some of it may be helpful, and eventually we'll return to a new normal. The crisis will past. But people are wily. As Richard Bookstaber, author of Demon of our own Design, is fond of pointing out, when you design safety measures for a nuclear plant, the machinery doesn't sit there, trying to come up with ways to deceive safety officials. Sure, sometimes it breaks in unexpected ways, but not because it schemes.
People do scheme, however. And in the end, no matter how much pressure we put on people, they'll find ways to make money by engaging in regulatory arbitrage and other forms of squirming around. That's not an indictment of financial people. That's just how people are. To a large extent, they won't even realize they're doing it.
So rather than wait around for people to come up with the next credit default swaps or CDO-squareds, let's plan the next meltdown ourselves. Let's intentionally come up with the products that will blow up horribly, leading to a total collapse of the system.
Here's an example of a product we came up with:
Hedge fund redemption insurance. A hedge fund could advertise a guarantee to its investors that it would never halt redemptions, by buying this type of insurance. The insurer would pay the fund the difference between the market value of its assets, and what it could collect in a "firesale," so that forced selling never required the fund to take an untenable hit. What could go wrong?
Realistically, this product alone might not destroy the economy or the financial system, so we need something better. Some new derivative. Some new insurance product. Something that if the hairpin were triggered, the whole damn thing would come down.
We'll be collecting your ideas in the comments and we'll post and highlight our favorite ones.
