Financial Innovation(a survey study): Financial Innovation (a survey study) Author: Peter Tufano


Outlines: Outlines This paper provide a survey which covers a wide range of fields: General equilibrium analysis Legal and policy Industrial organization Clinical studies of individual innovations Empirical studies of innovations process Refer to Page 3


Outlines: Outlines Discussions: Taxonomy of financial innovations: classification by functionalities is probably the best way Reasons for financial innovations Identity of innovators Private and social implications of these innovations New means of protecting the intellectual property Refer to Page 3


Agenda: Agenda Definition of Innovation History of Innovation Functions of financial innovations Tufano’s Taxonomy Identities and Returns to innovators The Impact of innovations to social welfare Future Studies


Definition of Innovation: Definition of Innovation Example of innovations: Derivatives, risk transfer products, ETFs, tax-deductible equity Innovate: to introduce as or as if new Innovation= Invention (R&D) + diffusion (adoption) Classification by the targets of innovations Products, e.g. derivatives, structured notes Process, e.g. pricing mechanism or platform, setting new means of distributing securities,… Refer to Page 4,5


History of Innovation: History of Innovation 1694 innovative product: Million Adventure (bond plus a lottery ticket, Allen and Gale, 1994) 258 innovative securities on 17 pages (Graham and Dodd ,1934) financial innovation is an on going evolutionary process. 1836 new security codes from 1980 to 2001 (financial database, done by Tufano) a normal pattern: when a security is created, later it may be modified slightly by competitors. Refer to Page 6,7


Taxonomy of financial innovations: Taxonomy of financial innovations Merton, 1992 Moving funds across times and space Pooling of funds Managing risk Extracting information to support decision making (VIX index) Addressing moral hazard and info. asymmetry Facilitating sale and purchase of goods Finnerty, 1992 Reallocating risk Reducing agency cost Increasing liquidity BIS, 1986 Transferring risk Enhancing liquidity Supporting credit Refer to Page 9,10


Taxonomy of financial innovations: Taxonomy of financial innovations The drawbacks of these taxonomy Even a simple innovation is likely to address multiple functions ≡ these functional dimensions lack discriminating ability E.g. using Merton’s scheme, an asset securitization invokes 3 functions: pooling the promise + reducing risk + increasing liquidity (moving funds) Refer to Page 10


6 functions of financial innovations: 6 functions of financial innovations To complete the incomplete markets To address agency concerns and info. asymmetries To minimize transaction cost Response to taxes or regulations Response to globalization and risk Stimulated by technological shocks


1. to complete the incomplete markets (1/2): 1. to complete the incomplete markets (1/2) Duffie and Rahi (1995) – Review the relationship between market incompleteness and innovations They suggest that hedging function of innovations exists. Refer to Page 10


1. to complete the incomplete markets (2/2): 1. to complete the incomplete markets (2/2) Black (1986) Exchange-traded contracts Viability (trading volume) vs. completeness (correlation with some risks) Grinblatt and Longstaff (2000) STRIPS (zero-coupon bonds) Primary Incentive is to complete the market Allen and Gale(1988) In a short sale restricted market It may be optimal for firms to provide multiple classes claims generating values from different investor preferences and needs Refer to Page 11


2. To address agency concerns and information asymmetries (1/2): 2. To address agency concerns and information asymmetries (1/2) Design contract from the principal-agent theory Harris and Raviv(1989) Allen and Gale(1994) (book) Theoretical proposition on more derivative beyond stocks and bonds Haugen and Senbett (1981): embedded options Lerner and Tufano (1993) and Berger and Magliolo(1995): R&D financing vehicles reduce interest conflicts Refer to Page 12


2. To address agency concerns and information asymmetries (2/2): 2. To address agency concerns and information asymmetries (2/2) Ross(1989) Agency problem →borrowing cost increases Agency considerations interact with marketing costs to produce innovations Dewing(1919, 1934) 19 century, using innovations to squeeze information from firms e.g. assemble stock (pg13), covenant term (pg14), income bond (pg14) Refer to Page 13,14


3. To minimize transaction, search, or marketing cost: 3. To minimize transaction, search, or marketing cost Merton(1989) Equity swap is efficient to multinational investors McConnell and Schwartz(1992) Merrill Lynch’s LYONs no cost for rolling over their notes Ross(1989), Madan and Soubra(1991) Techs reduce cost. e.g. ATM, smart card, ACH, e-401k Web e.g. Instinet, Open-IPO, Ebay (pg15) Reduced cost stimulates innovations Refer to Page 14~16


4. response to taxes or regulations: 4. response to taxes or regulations Miller(1986): “The major impulses to successful innovations over the past 20 years have come, I am saddened to have to say, from regulation and taxes.” e.g. zero coupon bonds or Eurodollar Eurobonds → not to trigger immediate capital gains Tufano(1997b),Santngelo andTufano(1997) Equity-linked structures → delay paying capital gain taxes Refer to Page 16,17


5. response to globalization and risk: 5. response to globalization and risk Globalization →exchange rate, interest rate, political risk →Interamerican Development Bank →innovations embed currency convertibility Mason, Merton, Perold and Tufano(1995) Risk from deregulation of gas → volumetric production payment contracts Masson and Stratton(1938) Risk from inflation (1830 - 1930) → currency choice bonds Cleverland(1920) legal tender = {gold, silver, currency} Refer to Page 20,21


6. Stimulated by technological shocks (1/2): 6. Stimulated by technological shocks (1/2) A “supply-side” explanation for the timing of innovations. e.g. folioFN, OpenIPO White(2000): technological view of financial innovations Refer to Page 15,22


6. Stimulated by technological shocks (2/2): 6. Stimulated by technological shocks (2/2) Tech of pricing mechanism B&S，Merton → hedging contracts Techs of information and internet support... Risk management systems On line retirement planning Real option Refer to Page 15,22


A case study: no “one” explanation works: A case study: no “one” explanation works Innovations in 1970s “Market” funds (i.e. index fund, e.g. Equally-weighted S&P 500 fund, Value-weighted fund) Complete market + reduce traction cost+ stimulated by tech ←no single one explanation can explain the development of index fund. Refer to Page 23


Tufano’s Cases: Tufano’s Cases Innovations in 1990s ETFs, TIPs, SPDRs, HOLDERs Above are “index funds” but provide more attractions Reducing transaction cost Tax-deductible (or tax timing advantage) Innovations in 2000s folioFN: Web based Personal funds Small denomination Tax-timing advantage Refer to Page 24~26


Identities and Returns to innovators: Identities and Returns to innovators Ross(1988) Investment banks max profit by bundling securities Boot and Thakor(1997)-pg27 Lower innovations in a “universal banking system” Greater competition leads to increased innovation Silber(1983) - pg28 Constrained (small, weak) firms would be more likely to innovate because they benefit more from innovations This can not be observed in empirical studies Refer to Page 27,28


Identities and Returns to innovators: Identities and Returns to innovators Tufano(1989) Underwriting spreads of the 1st innovator were not higher Carrow(1999) As rivals increase, the spreads decrease Underwriting spreads of the 1st should be higher Other benefits Profit from enhanced reputation by innovation Increasing the quality of staffs (personal involvement, career progression…) Refer to Page 27


Identities and Returns to innovators: Identities and Returns to innovators Empirical Thesis Tufano(1989) Larger investment banks → more innovations Matthews(1994)(book) Self-reinforcing cycle Small institution has higher willing (larger gradient for its utilization). However, small institution has smaller feasible region for innovative products to span. Refer to Page 29


Identities and Returns to innovators: Identities and Returns to innovators Innovations of diffusion (adoption) Which organizations adopt innovations and how quickly they do so? Hannan and McDowell (1987), ATM Saloner and Shepherd (1995), ATM Akhavein, Frame and White(2001), Credit scoring Lerner (2002), patterns Molyneux and Shamroukh(1996), Obay (2000), off-balance Molyneux and Shamroukh(1999), junk bond Larger firms have innovated more rapidly Refer to Page 30


Identities and Returns to innovators: Identities and Returns to innovators Although innovations usually bring benefits to issuers (Geanuracos and Millar, 1991), investors may endured slightly increasing benefit while bearing much higher risk (Tufano, 1996) Refer to Page 30,31


Identities and Returns to innovators: Identities and Returns to innovators wealth impact of innovations: some Innovations were used to take advantages of investors: Nanda (1996), poison put in CB Rogalski and Seward (1991), currency warrants Jarrow and O’Hara (1989), Primes and Scores Refer to Page 31


The Impact of innovations to social welfare: The Impact of innovations to social welfare Positive opinions Merton (1992) Shilling (1989) Sirmans and Benjamin(1990) Jameson, Dewan and Sirmans (1992) Negative opinions Terence (1995) Peter (2000) Innovations increase volatility Refer to Page 32,33


We cannot directly measure whole social welfare, thus…: We cannot directly measure whole social welfare, thus… Innovations in mortgage loan lead to lower mortgage rate charged to borrowers Innovation leads to complexity that in turn leads to bad business decisions and social costs (e.g. misuse of derivatives) Specific innovations contribute to high market volatility The completeness of the market may make all agents worse off! See Elul (1995) Refer to Page 34


How to protect intellectual property?: How to protect intellectual property? Keep secrecy Product secrecy is impossible to hold Process secrecy is possible Patent However, US Pattern office’s point of view : Financial innovation is “business process” which is hard to patent opportunity 1998, Signature Financial sued State Street Bank on Federal Circuit Court Will patenting encourage or discourage innovations? Refer to Page 36