Financial Innovation(a survey study)

Author: Peter Tufano

Sylvan C. Coleman professor at HBS

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

• 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

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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

• 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

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 n

ew means of distributing securities,…

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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 proces

s.

• 1836 new security codes from 1980 to 2001 (financial database, done by Tufano)– a normal pattern: when a security is created, later it m

ay be modified slightly by competitors.

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Taxonomy of financial innovations

• Merton, 19921. Moving funds across times

and space

2. Pooling of funds

3. Managing risk

4. Extracting information to support decision making (VIX index)

5. Addressing moral hazard and info. asymmetry

6. Facilitating sale and purchase of goods

• Finnerty, 19921. Reallocating risk

2. Reducing agency cost

3. Increasing liquidity

• BIS, 19861. Transferring risk

2. Enhancing liquidity

3. Supporting credit

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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)

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6 functions of financial innovations

1. To complete the incomplete markets

2. To address agency concerns and info. asymmetries

3. To minimize transaction cost

4. Response to taxes or regulations

5. Response to globalization and risk

6. Stimulated by technological shocks

1. to complete the incomplete markets (1/2)

• Duffie and Rahi (1995) – – Review the relationship between market inco

mpleteness and innovations– They suggest that hedging function of innovati

ons exists.

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1. to complete the incomplete markets (2/2)

– Black (1986)• Exchange-traded contracts• Viability (trading volume) vs. completeness (correlati

on 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

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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(1

995): R&D financing vehicles reduce interest conflicts

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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)

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3. To minimize transaction, search, or marketing cost

• Merton(1989)– Equity swap is efficient to multinational in

vestors

• McConnell and Schwartz(1992)– Merrill Lynch’s LYONs no cost for rolling o

ver 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

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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 taxesRefer to Page 16,17

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 pa

yment contracts

• Masson and Stratton(1938)– Risk from inflation (1830 - 1930) → currency choice bond

s

• Cleverland(1920)– legal tender = {gold, silver, currency}

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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

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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

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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.

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Tufano’s Cases

• Innovations in 1990s– ETFs, TIPs, SPDRs, HOLDERs– Above are “index funds” but provide more attracti

ons • Reducing transaction cost• Tax-deductible (or tax timing advantage)

• Innovations in 2000s– folioFN: Web based Personal funds

• Small denomination• Tax-timing advantage

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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

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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

• 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.

innovationinnovation

Size↑ Size↑

Mathhhew,1994

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Identities and Returns to innovators

• Innovations of diffusion (adoption)– Which organizations adopt innovations and ho

w 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

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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)

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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 warran

ts– Jarrow and O’Hara (1989), Primes and Score

s

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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

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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)

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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?

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