Financial innovation is the act of creating new financial instruments as well as new financial technologies, institutions, and markets. Recent financial innovations include hedge funds, private equity, weather derivatives, retail-structured products, exchange-traded funds, multi-family offices, and Islamic bonds (Sukuk). The shadow banking system has spawned an array of financial innovations including mortgage-backed securities products and collateralized debt obligations (CDOs).[1]
There are 3 categories of innovation: institutional, product, and process. Institutional innovations relate to the creation of new types of financial firms such as specialist credit card firms like Capital One, electronic trading platforms such as Charles Schwab Corporation, and direct banks. Product innovation relates to new products such as derivatives, securitization, and foreign currency mortgages. Process innovations relate to new ways of doing financial business, including online banking and telephone banking.[1]
Background
Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incomplete") 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). 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 Jack L. Treynor and William F. Sharpe, 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 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.
Academic literature
Tufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.
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 funds. 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
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.
- Interest rate swaps were developed in the early 1980s after interest rates skyrocketed
- Credit default swaps were developed in the early 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression
Mathematical innovation
- Options markets experienced explosive growth after the Black–Scholes model was developed in 1973
- Collateralized debt obligations (CDOs) were heavily influenced by the popularization of the copula technique[2] However, they also played a role in the 2008 financial crisis.
- Flash trading came into existence in 2000 at the Chicago Board Options Exchange and 2006 in the stock market. In July 2010, Direct Edge became a U.S. Futures Exchange. Nasdaq and Bats Exchange, Inc created their own flash markets 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 techniques. From a sociological point of view, some economists argue 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.[3] See Exotic derivative, Exotic option.
Avoiding taxes and regulation
Miller (1986) placed great emphasis on the role of taxes and government regulation in stimulating financial innovation.[4] The Modigliani-Miller theorem 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 swaps to convert dividends into capital gains, which are taxed at a lower rate.[5]
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 (CFTC) 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 eurodollars and NOW accounts.
Role of technology
Some types of financial innovation are driven by improvements in computer and telecommunication technology. For example, Paul Volcker suggested that for most people, the creation of the ATM was a greater financial innovation than asset-backed securitization.[6] Other types of financial innovation affecting the payments system include credit and debit cards and online payment systems like PayPal.
These types of innovations are notable because they reduce transaction costs. Households need to keep lower cash balances—if the economy exhibits cash-in-advance constraints then these kinds of financial innovations can contribute to greater efficiency. One study of Italian households' use of debit cards found that ownership of an ATM card resulted in benefits worth €17 annually.[7]
These types of innovations may also affect 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 e-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,[8][9] while Friedman (2000) is less sanguine.[10]
A 2016 PwC report pointed to the "accelerating pace of technological change" as the "most creative force—and also the most destructive—in the financial services ecosystem".[11]
Consequences
Financial innovations may influence economic or financial systems. For instance, financial innovation may affect monetary policy effectiveness and the ability of central banks to stabilize the economy. The relationship between money and interest rates, which can define monetary policy effectiveness, is affected by financial innovation. Financial innovation also influences firm profitability, transactions, and social welfare.[12]
Criticism
Some economists argue that financial innovation has little to no productivity benefit: Paul Volcker stated that "there is little correlation between sophistication of a banking system and productivity growth",[6] that there is no "neutral evidence that financial innovation has led to economic growth",[13] and that financial innovation was a cause of the financial crisis of 2007–2010,[14] while Paul Krugman states that "the rapid growth in finance since 1980 has largely been a matter of rent-seeking, rather than true productivity".[15]
Notable historical models
Pre-modern Italian maritime republics and city-states
Dutch Republic
In the 17th century, Amsterdam became the leading commercial and financial centre of the world. It held this position for more than a century,[16][17][18] and was the first modern model of an international financial centre.[19] As Richard Sylla (2015) noted, "In modern history, several nations had what some of us call financial revolutions. These can be thought of as creating in a short period of time all the key components of a modern financial system. The first was the Dutch Republic four centuries ago."[20][21][22] Amsterdam – unlike its predecessors such as Bruges, Antwerp, Genoa, and Venice – controlled crucial resources and markets directly, sending its fleets to all quarters of the world.[23]
Until about the mid-1700s, the Dutch Republic's economic and financial system were the most advanced and sophisticated ever seen in history.[24][25][26][27] For example, as Jacob Soll (2014) noted, "with the complexity of the stock exchange, [17th-century] Dutch merchants' knowledge of finance became more sophisticated than that of their Italian predecessors or German neighbors."[27] Historically, the Dutch were responsible for at least four major pioneering institutional innovations[a] (in economic, business and financial history of the world):
- The foundation of the Dutch East India Company (VOC), the world's first publicly listed company[28][29] and the first historical model of the multinational corporation (or transnational corporation) in its modern sense,[b][30][31][32][33][34][35] in 1602. Historically, the VOC played a crucial role in the rise of corporate-led globalization,[36] corporate identity,[37] corporate governance, corporate finance, and corporate capitalism. The birth of the VOC is often considered by many to be the official beginning of corporate-led globalization with the rise of modern corporations (multinational corporations in particular) as a highly significant socio-politico-economic force that affect human lives in every corner of the world today. As the first company to be listed on an official stock exchange, the VOC was the first company to issue stock and bonds to the general public. With its pioneering features, the VOC is generally considered a major institutional breakthrough and the model for modern corporations (large-scale business enterprises in particular). It is important to note that most of the largest and most influential companies of the modern-day world are publicly-traded multinational corporations, including Forbes Global 2000 companies. Like present-day publicly-listed multinational companies, in many ways, the post-1657 English/British East India Company's operational structure was a historical derivative of the earlier VOC model.[30][38]
- The establishment of the Amsterdam Stock Exchange (or Beurs van Hendrick de Keyser in Dutch), the world's first official stock exchange,[c] in 1611, along with the birth of the first fully functioning capital market in the early 1600s.[40] While the Italian city-states produced the first transferable government bonds, they didn't develop the other ingredient necessary to produce the fully fledged capital market in its modern sense: a formal stock market.[41][38][42] The Dutch were the firsts to use a fully fledged capital market (including the bond market and stock market) to finance public companies (such as the VOC and WIC). This was a precedent for the global securities market in its modern form. In the early 1600s the VOC established an exchange in Amsterdam where VOC stock and bonds could be traded in a secondary market. The establishment of the Amsterdam Stock Exchange (Beurs van Hendrick de Keyser) by the VOC, has long been recognized as the origin of modern-day stock exchanges[43][44] that specialize in creating and sustaining secondary markets in the securities issued by corporations. The process of buying and selling shares (of stock) in the VOC became the basis of the first formal stock market.[45][46] The Dutch pioneered stock futures, stock options, short selling, bear raids, debt-equity swaps, and other speculative instruments. Amsterdam businessman Joseph de la Vega's Confusion of Confusions (1688) was the earliest book about stock trading.[47]
- The establishment of the Bank of Amsterdam (Amsterdamsche Wisselbank), often considered to be the first historical model of the central bank,[48][49][50] in 1609. The birth of the Amsterdamsche Wisselbank led to the introduction of the concept of bank money. Along with a number of subsidiary local banks, it performed many functions of a central banking system.[51][52][53][54][55] It occupied a central position in the financial world of its day, providing an effective, efficient and trusted system for national and international payments, and introduced the first ever international reserve currency, the bank guilder.[56] Lucien Gillard calls it the European guilder (le florin européen),[57] and Adam Smith devotes many pages to explaining how the bank guilder works (Smith 1776: 446–455). The model of the Wisselbank as a state bank was adapted throughout Europe, including the Bank of Sweden (1668) and the Bank of England (1694).
- The formation of the first recorded professionally managed collective investment schemes (or investment funds), such as mutual funds,[58][59] in 1774. Amsterdam-based businessman Abraham van Ketwich (also known as Adriaan van Ketwich) is often credited as the originator of the world's first mutual fund. In response to the financial crisis of 1772–1773, Van Ketwich formed a trust named "Eendragt Maakt Magt" ("Unity Creates Strength"). His aim was to provide small investors with an opportunity to diversify.[60][61] Today the global funds industry is a multi-trillion-dollar business.
In many respects, the Dutch Republic's pioneering institutional innovations greatly helped revolutionize and shape the foundations of the economic and financial system of the modern-day world, and significantly influenced many English-speaking countries, especially the United Kingdom and United States.
| This article uses material from the Wikipedia article Metasyntactic variable, which is released under the Creative Commons Attribution-ShareAlike 3.0 Unported License. |