View source for Finance:Financial innovation

{{Short description|Creation of new financial instruments, technologies, and institutions}}

'''Financial innovation''' is the act of creating new financial instruments as well as new [[Finance:Financial technology|financial technologies]], [[Finance:Financial institution|institution]]s, and [[Finance:Financial market|markets]]. Recent financial innovations include hedge funds, [[Finance:Private equity|private equity]], [[Finance:Weather derivative|weather derivative]]s, [[Finance:Structured product|retail-structured products]], exchange-traded funds, multi-family offices, and Islamic bonds ([[Finance:Sukuk|Sukuk]]). The shadow banking system has spawned an array of financial innovations including mortgage-backed securities products and collateralized debt obligations (CDOs).<ref name="ftdef"/>

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, investment consulting firms and related services, and [[Finance:Direct bank|direct bank]]s. Product innovation relates to new products such as [[Finance:Derivative|derivatives]], [[Finance:Securitization|securitization]], and [[Finance:Foreign currency mortgage|foreign currency mortgage]]s. Process innovations relate to new ways of doing financial business, including [[Software:Online banking|online banking]] and [[Finance:Telephone banking|telephone banking]].<ref name="ftdef">{{cite web|title=Definition of Financial Innovation|url=http://lexicon.ft.com/Term?term=financial-innovation|website=Financial Times|accessdate=11 February 2018|archive-url=https://web.archive.org/web/20180212005029/http://lexicon.ft.com/Term?term=financial-innovation|archive-date=February 12, 2018|url-status=dead}}</ref>

== Background ==
Economic theory has much to say about what types of [[Finance:Security|securities]] should exist, and why some may not exist (why some markets should be "[[Finance:Incomplete markets|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 [[Finance:Capital asset pricing model|capital asset pricing model]], first developed by Jack L. Treynor and [[Biography:William F. Sharpe|William F. Sharpe]], suggests that investors should fully [[Finance:Diversification|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 [[Finance:Roll's critique|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|expected value]] under the appropriate [[Finance:Risk-neutral measure|risk-neutral measure]].

== Academic literature ==
Tufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.

The extensive literature on [[Social:Principal–agent problem|principal–agent problem]]s, [[Finance:Adverse selection|adverse selection]], and [[Physics:Information asymmetry|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 ''[[Finance:Journal of Economic Theory|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 [[Finance:Financial regulation|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 [[Finance:Index fund|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.

== 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.
* [[Finance:Interest rate swap|Interest rate swap]]s were developed in the early 1980s after interest rates skyrocketed
* [[Finance:Credit default swap|Credit default swap]]s were developed in the early 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the [[Finance:Great Depression|Great Depression]]

=== Mathematical innovation ===
* [[Finance:Option|Options]] markets experienced explosive growth after the Black–Scholes model was developed in 1973
* [[Finance:Collateralized debt obligation|Collateralized debt obligation]]s (CDOs) were heavily influenced by the popularization of the copula technique<ref name="davidx">{{cite journal|author1=David X. Li|title=On Default Correlation: A Copula Function Approach|journal=Journal of Fixed Income |date=2000|volume=9|issue=4|pages=43–54|doi=10.2139/ssrn.187289|url=http://www.ressources-actuarielles.net/EXT/ISFA/1226.nsf/9c8e3fd4d8874d60c1257052003eced6/34e84cb615c8b4eac12575fe006a9759/$FILE/li.defaultcorrelation.pdf|citeseerx=10.1.1.1.8219|s2cid=144055 }}</ref> However, they also played a role in the 2008 financial crisis.
* [[Finance:Flash trading|Flash trading]] came into existence in 2000 at the [[Company:Chicago Board Options Exchange|Chicago Board Options Exchange]] and 2006 in the [[Finance:Stock market|stock market]]. In July 2010, Direct Edge became a [[Finance:U.S. Futures Exchange|U.S. Futures Exchange]]. [[Finance:Nasdaq|Nasdaq]] and Bats Exchange, Inc created their own flash markets in early 2009.

Futures, options, and many other types of [[Finance:Derivative|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 [[Finance:Securitization|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.<ref name="mac">{{cite book|last1=MacKenzie|first1=Donald|title=An Engine, Not a Camera: How Financial Models Shape Markets|date=2008|publisher=MIT Press|location=Boston|isbn=9780262250047|url=https://books.google.com/books?id=M3x5tvAwzrQC}}</ref> See [[Finance:Exotic derivative|Exotic derivative]], [[Finance:Exotic option|Exotic option]].

=== Avoiding taxes and regulation ===
Miller (1986) placed great emphasis on the role of taxes and government regulation in stimulating financial innovation.<ref>{{Cite journal
| doi = 10.2307/2330693| volume = 21| issue = 4| pages = 459–471 | last = Miller| first = Merton H.| title = Financial Innovation: The Last Twenty Years and the Next| journal = The Journal of Financial and Quantitative Analysis| year = 1986| jstor = 2330693| s2cid = 154745008}}</ref> 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 [[Finance:Total return swap|total return swap]]s to convert dividends into capital gains, which are taxed at a lower rate.<ref>{{cite web | url=http://www.internationaltaxreview.com/?Page=10&PUBID=35&ISS=24454&SID=700023&SM=&SearchStr=passive%20investment%20income | title=Home &#124; International Tax Review }}</ref>

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 [[Organization:Chicago Board of Trade|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 [[Finance:Eurodollar|eurodollar]]s 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 [[Finance:Automated teller machine|ATM]] was a greater financial innovation than [[Finance:Asset-backed security|asset-backed securitization]].<ref name="volker1">[http://uk.reuters.com/article/marketsNewsUS/idUKN2029103720090220 "Crisis may be worse than Depression, Volcker says"], ''Reuters'', February 20, 2009</ref> Other types of financial innovation affecting the payments system include [[Finance:Credit card|credit]] and [[Debit card|debit card]]s and online payment systems like [[Company:PayPal|PayPal]].

These types of innovations are notable because they reduce [[Finance:Transaction cost|transaction cost]]s. Households need to keep lower cash balances—if the economy exhibits [[Finance:Cash-in-advance constraint|cash-in-advance constraint]]s 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.<ref>{{Cite journal
| doi = 10.3982/ECTA7451
| volume = 77
| issue = 2
| pages = 363–402
| last = Alvarez
| first = Fernando
|author2=Francesco Lippi
| title = Financial Innovation and the Transactions Demand for Cash
| journal = Econometrica
| year = 2009
| s2cid = 17298975
| url = http://www.eief.it/files/2012/09/wp-07-financial-innovation-and-the-transactions-demand-for-cash.pdf
}}</ref>

These types of innovations may also affect [[Finance:Monetary policy|monetary policy]] by reducing real household balances. Especially with the increased popularity of [[Software:Online banking|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 [[Social:E-commerce|e-commerce]] and central banking, Goodhart (2000) and [[Biography:Michael Woodford (economist)|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,<ref>{{Cite journal
| doi = 10.1111/1468-2362.00048
| volume = 3
| issue = 2
| pages = 189–209
| last = Goodhart
| first = Charles A. E.
| title = Can Central Banking Survive the IT Revolution?
| journal = International Finance
| year = 2000 }}</ref><ref>{{Cite journal| doi = 10.1111/1468-2362.00050
| volume = 3| issue = 2
| pages = 229–260
| title = Monetary Policy in a World Without Money
| journal = International Finance
| year = 2000 | url = http://www.nber.org/papers/w7853.pdf}}</ref> while Friedman (2000) is less sanguine.<ref>{{cite journal|author1=Benjamin M. Friedman|title=Decoupling at the Margin: The Threat to Monetary Policy from the Electronic Revolution in Banking|journal=International Finance|date=July 2000|volume=3|issue=2|pages=261–272|doi=10.1111/1468-2362.00051|url=http://static.stevereads.com/papers_to_read/decoupling_at_the_margin_the_threat_to_monetary_policy_from_the_electronic_revolution_in_banking.pdf}}</ref>

A 2016 [[Company:PwC|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".<ref name="pwc2016">{{cite book|title=Financial Services Technology 2020 and Beyond: Embracing Disruption|date=2016|publisher=PwC|url=https://www.pwc.com/gx/en/financial-services/assets/pdf/technology2020-and-beyond.pdf}}</ref>

== 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.<ref>{{cite journal |last1=Lerner |first1=J. |last2=Tufano |first2=P. |year=2011 |title=The Consequences of Financial Innovation: A Counterfactual Research Agenda |journal=Annual Review of Financial Economics |volume=3 |pages=41–85 |doi=10.1146/annurev.financial.050808.114326 |ssrn=1759852 |doi-access=free }}</ref>

== Criticism ==
Some economists argue that financial innovation has little to no [[Finance:Productivity|productivity]] benefit: Paul Volcker stated that "there is little correlation between sophistication of a banking system and productivity growth",<ref name="volker1"/> that there is no "neutral evidence that financial innovation has led to economic growth",<ref>Patrick Hosking and Suzy Jagger,[http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6949387.ece "'Wake up, gentlemen', world's top bankers warned by former Fed chairman Volcker"], ''The Times of London'', December 9, 2009</ref> and that financial innovation was a cause of the financial crisis of 2007–2010,<ref>Tim Iacono, [http://seekingalpha.com/article/177300-paul-volcker-atm-was-the-peak-of-financial-innovation "Paul Volcker: ATM Was the Peak of Financial Innovation"], ''Seeking Alpha'' December 9, 2009.</ref> while [[Biography:Paul Krugman|Paul Krugman]] states that "the rapid growth in finance since 1980 has largely been a matter of [[Social:Rent-seeking|rent-seeking]], rather than true productivity".<ref>Paul Krugman, [https://krugman.blogs.nytimes.com/2009/12/09/darling-i-love-you/ Darling, "I love you"], The Conscience of a Liberal, ''{{wipe|The New York Times}},'' December 9, 2009</ref>

== See also ==
* [[Finance:Financial technology|Financial technology]]

== Notes ==
{{reflist|colwidth=30em}}

== Bibliography ==
* {{Cite journal
| doi = 10.1093/rfs/1.3.229
| volume = 1
| issue = 3
| pages = 229–263
| last = Allen
| first = Franklin
|author2=Douglas Gale
| title = Optimal Security Design
| journal = The Review of Financial Studies
| year = 1988
}}
* {{Cite journal
| doi = 10.1006/jeth.1995.1001
| volume = 65
| issue = 1
| pages = 1–42
| last = Duffie
| first = Darrell
|author2=Rohit Rahi
| title = Financial Market Innovation and Security Design: An Introduction
| journal = Journal of Economic Theory
| year = 1995
}}
* {{Cite book
| edition = First
| publisher = Wiley
| isbn = 978-0-471-11215-0
| last = Melamed
| first = Leo
| title = Leo Melamed: Escape to the Futures
| year = 1996
}}
* {{Cite journal
| doi = 10.1016/0304-405X(84)90023-0
| volume = 13
| issue = 2
| pages = 187–221
| last = Myers
| first = Stewart C.
|author2=Nicholas S. Majluf
| title = Corporate financing and investment decisions when firms have information that investors do not have
| journal = Journal of Financial Economics
| year = 1984
| hdl = 1721.1/2068
| hdl-access = free
}}
* {{Cite report
| last = Shiller
| first = Robert J.
| title = Derivatives Markets for Home Prices
| year = 2008
| publisher = [[Organization:Cowles Foundation|Cowles Foundation]]
| type = Discussion Paper
| id = CFDP 1648
| url = https://cowles.yale.edu/sites/default/files/files/pub/d16/d1648.pdf
}}
* {{Cite journal
| doi = 10.1093/rfs/10.4.939
| volume = 10
| issue = 4
| pages = 939–967
| last = Persons
| first = John C.
|author2=Vincent A. Warther
| title = Boom and Bust Patterns in the Adoption of Financial Innovations
| journal = The Review of Financial Studies
| year = 1997
}}
* {{Cite journal
| doi = 10.2307/2328769
| volume = 44
| issue = 3
| pages = 541–556
| last = Ross
| first = Stephen A.
| title = Institutional Markets, Financial Marketing, and Financial Innovation
| journal = The Journal of Finance
| year = 1989
| jstor = 2328769
}}
* {{Cite book
| publisher = Elsevier
| isbn = 978-0-0804-9507-1
| volume = 1A
| pages = 307–335
| last = Tufano
| first = Peter
| title = The Handbook of the Economics of Finance
| chapter = Chapter 6 Financial innovation
| year = 2003
}}

[[Category:Securities (finance)]]
[[Category:Financial economics]]

{{Sourceattribution|Financial innovation}}