What Is Financial Innovation?

Financial innovation is the creation of new financial instruments, technologies, institutions and markets. As in other technologies, innovation in finance includes research and development functions as well as the demonstration, diffusion and adoption of these new products or services. In finance, particularly, innovation involves adapting and improvising on existing products and concepts. Advances emerge initially as either products (such as derivatives, high yield corporate bonds and mortgage backed securities) or processes (such as pricing mechanisms, trading platforms and means and methods for distributing securities). By moving funds or enabling investors to pool funds, these tools increase liquidity to facilitate the sale and purchase of goods or the management of risks in markets and enterprises. Exchange traded derivatives, credit derivatives, equity swaps, weather derivatives, new insurance contracts and new investment management products such as exchange traded funds can all be classified as innovations. But the field also encompasses developments that make the allocation of capital more efficient and operational methods that reduce transaction costs, whether in primary markets where equity and debt originate or in the secondary market where those products are traded. The process of financial innovation, as Nobel laureate Robert Merton has explained, is similar to high speed rail technology: The velocity the train can achieve depends on the state of the roadbed and the physical infrastructure along which the train travels. Similarly, White House National Economic Committee Chairman Larry Summers observed, Global capital markets pose the same kinds of problems that jet planes do. They are faster, more comfortable and they get you where you are going better. But the crashes are much more spectacular. In finance, we have rapidly developed the ability to absorb and process information about risk management, to create products and services that seize on new technologies, to restructure companies and industries and to build completely new markets. But the regulatory and market infrastructure to monitor the trading and pricing of risk has not always kept pace with the lightning fast speed of information transmission, product trading and pricing that streams through todays market. From that point emerges many problems we will explore in the process of innovation.

   Our discussion of financial innovations focuses on the following:

• New products and services (such as bank deposits, warrants, futures, options, high yield securities, venture capital and securitization)
• New processes and operations (such as net present value, Black Scholes estimation and asset pricing)
• New organizational forms (such as types of banks, exchanges, special purpose vehicles, limited liability corporations, private equity and leveraged buyout firms)

Innovations have given rise to new financial intermediaries (such as venture capitalists and private equity firms), new types of instruments (collateralized loan obligations and credit derivatives, for example), and new services or techniques (such as e-trading). At their best, these creations can overcome a variety of risks in a global economy. The traditional function of finance is to transfer money from areas of surplus to areas with a demand and need for it. Financial innovation accomplishes this, becoming the central input for virtually all productive activity. Better finance encourages more saving and investment while improving productivity and investment decisions. Finance is simply an intermediary that catalyzes other aspects of capital inputs to production. Its multiplying power derives from financial technologies that mobilize all the dimensions of capital: real capital (inputs of natural resources, land, buildings, machinery and equipment, cash, and the like), human capital (knowledge, intellect, skills, talents, and all qualities of human resources) and social capital (the social networks of people, institutions, and traditions).

Each section of this book addresses common questions about the means, methods and processes of financial innovation:

• What triggers financial innovation, and why?
• What challenge is the innovation trying to address?
• Which form (product, service, organizational form) does a financial innovation take?
• What changes are created in the market as a result?

Invariably, some historical shift that generates an increased demand for capital sparks financial innovation. Some structural break occurs, requiring new vehicles that can move the markets forward. Centuries ago, population growth and increased trade provided those triggers as the need arose for a system that would enable merchants to store commodities for future use. In the ancient societies of Mesopotamia, Egypt, and Rome, new advances emerged to finance the future production of precious goods such as olive oil, wine and date sugar. In eighteenth century Japan, warehouse owners sold receipts against stored rice, which eventually became a commercial currency that could be traded, standardized and exchanged more broadly as future contracts. By the nineteenth century, this kind of trading in wheat, corn, and livestock was formalized as commodities markets were established in the United States and Europe. Tracing these developments reveals the historical dynamics at work in the evolution of finance.