A New Theory of Financial Innovation: The Ticker

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By Mark Whitehouse

Financial innovators on Wall Street, take notice: The justification for much of what you do may be crumbling.

The dominant paradigm in financial economics has long given the creators of new derivatives and other exotic products comfort that, whatever their immediate motivations, they are ultimately contributing to the greater good. Anything that allows people to diversify their investments and share risks, the logic goes, will inevitably make the global economy more stable.

Lately, though, the central role that credit-default swaps, collateralized debt obligations and other innovations played in the financial disasters of 2007 and 2008 has inspired some economists to question the accepted wisdom. In the vanguard is a 29-year-old assistant professor at Harvard named Alp Simsek, who is combining macroeconomics and finance in a way that few did before the crisis. Bloomberg View caught up with Simsek this week for a brief interview.

BV: You've chosen a topic that could make you unpopular in the financial industry. What motivated you to do this?

AS: It was a coincidence. As a graduate student, I was interested in economic growth -- why some countries are poorer than others. But as I was thinking of what I wanted to do for my thesis, the financial crisis hit. It was clear to me that the crisis originated in these new assets. According to the traditional view in economics, new assets are supposed to bring stability. I saw that the dominant paradigm was possibly wrong, and that’s very interesting for a graduate student.

I wasn't worried at all about what the financial industry would say. I have no interest in working in the financial industry.

BV: So what have you figured out so far? Is financial innovation always good?

AS: What I've found is that financial innovation has at least one dark side that we hadn’t identified before. We thought that new financial assets would reduce individuals' or institutions' risk. But once you account for the speculation the new products facilitate, they might actually increase the risks.

Consider two economists sitting on a couch. Each has a very strong belief: One thinks the couch is made of cotton, the other thinks polyester. They make a $2000 bet based on their beliefs. This is pure speculation, not risk transfer. In fact, their risks have increased because each now bears some risk of losing $2000. They are taking these added risks because they both think their wealth will go up. But obviously they cannot both be correct -- it is either cotton or polyester.

Thus, betting on the couch increases everyone's risks without increasing total wealth. In fact, betting actually decreases the relevant total wealth in this example. People are willing to pay for insurance to get rid of risks. Thus, the fact that they are taking more risks here means that they are effectively giving up some wealth.

To visualize this wealth destruction, consider a slight variant of the example. Let's say the couch is worth $800. According to traditional theory, it would be optimal for the economists to tear the couch apart to find out who is right. Each fully expects to make $2000, whereas the cost of replacing the couch, if split between them, is only $400 apiece. In other words, economic theory would give the green light to the destruction of the couch. There is something deeply wrong about this.

New products can also increase risk by enabling investors to purify their bets. Suppose people want to bet on the Swiss economy, but can only do so via the Swiss franc. They’re not going to bet too much because they're taking on all kinds of risks they don't want. Something unrelated to the Swiss economy, such as the European Central Bank's policies, could affect the franc's exchange rate.

Now suppose we introduce an innovation, such as a derivative on the euro, that allows them to eliminate some of the added risks. The investors can bet more, boosting their expected returns but also exposing themselves to more risk. If things go against their bet on the Swiss economy, they’re going to take a bigger hit.

Of course, it’s important to recognize that in economic theory there are always multiple dimensions to an issue. The effect of financial innovations on risk is only one aspect of what they do to the economy. They may also provide valuable information, helping make prices more accurate and so on.

BV: How can we tell the difference between good and bad innovation?

AS: It's difficult, but not impossible. You can look at the people who are trading and look at their portfolios. The first sign of a good innovation would be risk sharing. Are they actually getting rid of any risks they don't want to have?

Who invests in credit-default swaps? The instrument enables people who own bonds to hedge the risk of default. If the people using the instrument don't own any bonds, that suggests the swaps are being used for speculative purposes.

Of course, if the speculators using the swaps have valuable information, and their trading allows that information to be reflected in the price of the swaps, they could still be doing a socially valuable thing.

BV: What are the policy implications?

AS: I'm very far from making recommendations. But one idea might be to restrict trade in some way when new assets are first introduced into markets. People are not stupid, they learn. If they observe how a new asset performs over time, they will be less likely to be unduly optimistic and create big risks. Start slow. Once people figure out how to use the innovation and what the returns should be, then relax the restrictions.

Requiring that assets be traded on exchanges or through central counterparties might also help. Traders like over-the-counter markets because they're flexible -- they allow them to tailor new products to their specific needs. This is precisely the kind of flexibility that tends to increase the risks in the market.

We can’t rely on financial institutions to police themselves. They have a big incentive to generate innovations: If they can get people to bet on something, they can collect the fees. It's like running a casino. The financial institutions don’t care if you're trading for risk-sharing or speculative purposes.

(Mark Whitehouse is a member of the Bloomberg View editorial board.)

-0- Jan/10/2012 15:01 GMT