Financial innovation
Encyclopedia
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing
of new types of securities
.
") but little to say about why new types of securities should come into existence.
One interpretation of the Modigliani-Miller theorem
is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth (absent taxes, etc.). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.
Furthermore, there should be little demand for specific types of securities. The capital asset pricing model
, first developed by Markowitz
, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll
argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those risks in their portfolio).
If the world existed as the Arrow-Debreu model
posits, then there would be no need for financial innovation. The Arrow-Debreu model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance
states that the price of assembling such a portfolio will be equal to its expected value
under the appropriate risk-neutral measure
.
The extensive literature on principal–agent problems, adverse selection
, and information asymmetry
points to why investors might prefer some types of securities, such as debt, over others like equity. Myers and Majluf (1984) develop an adverse selection model of equity issuance, in which firms (which are trying to maximize profits for existing shareholders) issue equity only if they are desperate. This was an early article in the pecking order
literature, which states that firms prefer to finance investments out of retained earnings first, then debt, and finally equity, because investors are reluctant to trust any firm that needs to issue equity.
Duffie and Rahi also devote a considerable section to examining the utility and efficiency implications of financial innovation. This is also the topic of many of the papers in the special edition of the Journal of Economic Theory in which theirs is the lead article. The usefulness of spanning the market appears to be limited (or, equivalently, the disutility of incomplete markets is not great).
Allen and Gale (1988) is one of the first papers to endogenize security issuance contingent on financial regulation—specifically, bans on short sales. In these circumstances, they find that the traditional split of cash flows between debt and equity is not optimal, and that state-contingent securities are preferred. Ross (1989) develops a model in which new financial products must overcome marketing and distribution costs. Persons and Warther (1997) studied booms and busts associated with financial innovation.
The fixed costs of creating liquid markets for new financial instruments appears to be considerable. Black and Scholes (1974) describe some of the difficulties they encountered when trying to market the forerunners to modern index fund
s. These included regulatory problems, marketing costs, taxes, and fixed costs of management, personnel, and trading. Shiller (2008) describes some of the frustrations involved with creating a market for house price futures.
Futures, options, and many other types of derivatives have been around for centuries: the Japanese rice futures market started trading around 1730. However, recent decades have seen an explosion use of derivatives and mathematically-complicated securitization
techniques. MacKenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new assets.
explicitly considered taxes as a reason to prefer one type of security over another, despite that corporations and investors should be indifferent to capital structure in a fractionless world.
The development of checking accounts at U.S. banks was in order to avoid punitive taxes on state bank notes that were part of the National Banking Act
.
Some investors use total return swap
s to convert dividends into capital gains, which are taxed at a lower rate.
Many times, regulators have explicitly discouraged or outlawed trading in certain types of financial securities. In the United States, gambling
is mostly illegal, and it can be difficult to tell whether financial contracts are illegal gambling instruments or legitimate tools for investment and risk-sharing. The Commodity Futures Trading Commission
is in charge of making this determination. The difficulty that the Chicago Board of Trade
faced in attempting to trade futures on stocks and stock indexes is described in Melamed (1996).
In the United States, Regulation Q
drove several types of financial innovation to get around its interest rate ceilings, including eurodollar
s and NOW accounts
.
suggested that for most people, the creation of the ATM
was a greater financial innovation than asset-backed securitization
. Other types of financial innovation affecting the payments system include credit
and debit card
s and online payment systems like PayPal
.
These types of innovations are notable because they reduce transaction cost
s. Households need to keep lower cash balances—if the economy exhibits cash-in-advance constraint
s then these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi (2009), using data on Italian households' use of debit cards, find that ownership of an ATM card results in benefits worth €17 annually.
These types of innovations may also have an impact on monetary policy
by reducing real household balances. Especially with the increased popularity of online banking
, households are able to keep greater percentages of their wealth in non-cash instruments. In a special edition of 'International Finance' devoted to the interaction of electronic commerce and central banking, Goodhart (2000) and Woodford
(2000) express confidence in the ability of a central bank to maintain its policy goals by affecting the short-term interest rate even if electronic money has eliminated the demand for central bank liabilities, while Friedman (2000) is less sanguine.
states that "the rapid growth in finance since 1980 has largely been a matter of rent-seeking, rather than true productivity."
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...
of new types of securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
.
Why does financial innovation occur?
Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incompleteIncomplete markets
In economics, incomplete markets refers to markets in which the number of Arrow–Debreu securities is less than the number of states of nature...
") but little to say about why new types of securities should come into existence.
One interpretation of the Modigliani-Miller theorem
Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth (absent taxes, etc.). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.
Furthermore, there should be little demand for specific types of securities. The capital asset pricing model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
, first developed by Markowitz
Harry Markowitz
Harry Max Markowitz is an American economist and a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences....
, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll
Richard Roll
Richard Roll is an American economist, best known for his work on portfolio theory and asset pricing, both theoretical and empirical....
argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those risks in their portfolio).
If the world existed as the Arrow-Debreu model
Arrow-Debreu model
In mathematical economics, the Arrow–Debreu model suggests that under certain economic assumptions there must be a set of prices such that aggregate supplies will equal aggregate demands for every commodity in the economy.The model is central to the theory of...
posits, then there would be no need for financial innovation. The Arrow-Debreu model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance
Fundamental theorem of arbitrage-free pricing
The fundamental theorems of arbitrage/finance provide necessary and sufficient conditions for a market to be arbitrage free and for a market to be complete. An arbitrage opportunity is a way of making money with no initial investment without any possibility of loss...
states that the price of assembling such a portfolio will be equal to its expected value
Expected value
In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...
under the appropriate risk-neutral measure
Risk-neutral measure
In mathematical finance, a risk-neutral measure, is a prototypical case of an equivalent martingale measure. It is heavily used in the pricing of financial derivatives due to the fundamental theorem of asset pricing, which implies that in a complete market a derivative's price is the discounted...
.
Academic literature
Tufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.The extensive literature on principal–agent problems, adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
, and information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
points to why investors might prefer some types of securities, such as debt, over others like equity. Myers and Majluf (1984) develop an adverse selection model of equity issuance, in which firms (which are trying to maximize profits for existing shareholders) issue equity only if they are desperate. This was an early article in the pecking order
Pecking Order Theory
In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984...
literature, which states that firms prefer to finance investments out of retained earnings first, then debt, and finally equity, because investors are reluctant to trust any firm that needs to issue equity.
Duffie and Rahi also devote a considerable section to examining the utility and efficiency implications of financial innovation. This is also the topic of many of the papers in the special edition of the Journal of Economic Theory in which theirs is the lead article. The usefulness of spanning the market appears to be limited (or, equivalently, the disutility of incomplete markets is not great).
Allen and Gale (1988) is one of the first papers to endogenize security issuance contingent on financial regulation—specifically, bans on short sales. In these circumstances, they find that the traditional split of cash flows between debt and equity is not optimal, and that state-contingent securities are preferred. Ross (1989) develops a model in which new financial products must overcome marketing and distribution costs. Persons and Warther (1997) studied booms and busts associated with financial innovation.
The fixed costs of creating liquid markets for new financial instruments appears to be considerable. Black and Scholes (1974) describe some of the difficulties they encountered when trying to market the forerunners to modern index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s. These included regulatory problems, marketing costs, taxes, and fixed costs of management, personnel, and trading. Shiller (2008) describes some of the frustrations involved with creating a market for house price futures.
Examples of spanning the market
Some types of financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.- The development of interest rate swapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
s in the early 1980s after interest rates skyrocketed. - The development of credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s in the early 2000s after the recessionEarly 2000s recessionThe early 2000s recession was a decline in economic activity which occurred mainly in developed countries. The recession affected the European Union mostly during 2000 and 2001 and the United States mostly in 2002 and 2003. The UK, Canada and Australia avoided the recession for the most part, while...
beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great DepressionGreat DepressionThe Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
.
Examples of mathematical innovation
- The market in optionsOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
exploded after the development of the Black–Scholes model in 1973. - The development of the CDOCollateralized debt obligationCollateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
was heavily influenced by the popularization of the copulaCopula (statistics)In probability theory and statistics, a copula can be used to describe the dependence between random variables. Copulas derive their name from linguistics....
technique (Li 2000). - Flash tradingFlash tradingFlash trading, otherwise known as a flash order is, according to industry trade publication, Traders Magazine, defined as “a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety...
exists since 2000 at the Chicago Board Options ExchangeChicago Board Options ExchangeThe Chicago Board Options Exchange , located at 400 South LaSalle Street in Chicago, is the largest U.S. options exchange with annual trading volume that hovered around one billion contracts at the end of 2007...
and 2006 in the equities market. In July 2010July 2010July 2010 was the seventh month of that year. It began on a Thursday and ended after 31 days on a Saturday.- International holidays & observances :* 1: Canada Day * 1: July Morning * 1: Republic Day...
, Direct EdgeDirect EdgeDirect Edge is a Jersey City, NJ-based stock exchange operating two separate platforms, EDGA Exchange and EDGX Exchange. Since March 2009, Direct Edge has had a market share in the range of 9%-12% of U.S. equities trading volume, regularly trades 1 billion to 2 billion shares per day...
became a U.S. Futures ExchangeU.S. Futures ExchangeU.S. Futures Exchange was a Chicago-based, electronic futures exchange that terminated all exchange operations effective December 31, 2008. On December 17, 2008, MF Global had announced USFE was for sale or would be closed by December 31, 2008. USFE was originally Eurex US who bought BrokerTec,...
. NasdaqNASDAQThe NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
and Bats Exchange, IncBats Exchange, IncBATS is a stock exchange based in Lenexa, Kansas, a satellite city of Kansas City, Missouri. BATS was founded in June 2005 as an ECN and its name stands for Better Alternative Trading System....
created their own flash market in early 2009.
Futures, options, and many other types of derivatives have been around for centuries: the Japanese rice futures market started trading around 1730. However, recent decades have seen an explosion use of derivatives and mathematically-complicated securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
techniques. MacKenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new assets.
Examples of innovation to avoid taxes and regulation
Miller (1986) places great emphasis on the role of taxes and government regulation in stimulating financial innovation. Modigliani and Miller (1958)Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
explicitly considered taxes as a reason to prefer one type of security over another, despite that corporations and investors should be indifferent to capital structure in a fractionless world.
The development of checking accounts at U.S. banks was in order to avoid punitive taxes on state bank notes that were part of the National Banking Act
National Banking Act
The National Banking Acts of 1863 and 1864 were two United States federal laws that established a system of national charters for banks, and created the United States National Banking System. They encouraged development of a national currency backed by bank holdings of U.S...
.
Some investors use total return swap
Total return swap
Total return swap, or TRS , or total rate of return swap, or TRORS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.- Contract definition :...
s to convert dividends into capital gains, which are taxed at a lower rate.
Many times, regulators have explicitly discouraged or outlawed trading in certain types of financial securities. In the United States, gambling
Gambling
Gambling is the wagering of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods...
is mostly illegal, and it can be difficult to tell whether financial contracts are illegal gambling instruments or legitimate tools for investment and risk-sharing. The Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
is in charge of making this determination. The difficulty that the Chicago Board of Trade
Chicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
faced in attempting to trade futures on stocks and stock indexes is described in Melamed (1996).
In the United States, Regulation Q
Regulation Q
Regulation Q is Title 12, part 217 of the United States Code of Federal Regulations. It prohibits banks from paying interest on demand deposits in accordance with Section 11 of the Glass–Steagall Act ....
drove several types of financial innovation to get around its interest rate ceilings, including eurodollar
Eurodollar
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term...
s and NOW accounts
Negotiable Order of Withdrawal account
In the United States, a Negotiable Order of Withdrawal account is a deposit account that pays interest, on which checks may be written....
.
The role of technology in financial innovation
Some types of financial innovation are driven by improvements in computer and telecommunication technology. For example, Paul VolckerPaul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...
suggested that for most people, the creation of the ATM
Automated teller machine
An automated teller machine or automatic teller machine, also known as a Cashpoint , cash machine or sometimes a hole in the wall in British English, is a computerised telecommunications device that provides the clients of a financial institution with access to financial transactions in a public...
was a greater financial innovation than asset-backed securitization
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
. Other types of financial innovation affecting the payments system include credit
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
and debit card
Debit card
A debit card is a plastic card that provides the cardholder electronic access to his or her bank account/s at a financial institution...
s and online payment systems like PayPal
PayPal
PayPal is an American-based global e-commerce business allowing payments and money transfers to be made through the Internet. Online money transfers serve as electronic alternatives to paying with traditional paper methods, such as checks and money orders....
.
These types of innovations are notable because they reduce transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
s. Households need to keep lower cash balances—if the economy exhibits cash-in-advance constraint
Cash-in-advance constraint
The cash-in-advance constraint is an idea used in economic theory to capture monetary phenomena...
s then these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi (2009), using data on Italian households' use of debit cards, find that ownership of an ATM card results in benefits worth €17 annually.
These types of innovations may also have an impact on monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
by reducing real household balances. Especially with the increased popularity of online banking
Online banking
Online banking allows customers to conduct financial transactions on a secure website operated by their retail or virtual bank, credit union or building society.-Features:...
, households are able to keep greater percentages of their wealth in non-cash instruments. In a special edition of 'International Finance' devoted to the interaction of electronic commerce and central banking, Goodhart (2000) and Woodford
Michael Woodford (economist)
Michael Dean Woodford is an American macroeconomist and monetary theorist who currently teaches at Columbia University.-Academic career:...
(2000) express confidence in the ability of a central bank to maintain its policy goals by affecting the short-term interest rate even if electronic money has eliminated the demand for central bank liabilities, while Friedman (2000) is less sanguine.
Criticism
Some economists argue that financial innovation has little to no productivity benefit: Paul Volcker states that "there is little correlation between sophistication of a banking system and productivity growth," that there is no "neutral evidence that financial innovation has led to economic growth", and that financial innovation was a cause of the financial crisis of 2007–2010, while Paul KrugmanPaul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
states that "the rapid growth in finance since 1980 has largely been a matter of rent-seeking, rather than true productivity."