Those were the days my friend. We thought they'd never end.
-- Mary Hopkins
What process creates important, lasting, financial innovation? It’s a glacial process. There is an important difference between financial innovation and the kind of flagship innovation that characterizes IT - for example Facebook or the iPhone. These IT inventions spring from revelation – eureka moments.
Financial innovations, in contrast, evolve slowly. The process of financial innovation is also vulnerable to interruption, often from ill-founded financial regulators’ market intervention. Another difference between IT and finance is the impossibility of protecting financial innovation from the competition. Every financial innovation will also be extensively copied and released by others after cosmetic changes. A real financial innovator must back her move with everything she’s got to beat imitators to the punch.
This article begins a longer discussion of the distinct nature of financial innovation. The discussion draws conclusions for long-run performance of the incumbent financial institutions, those that were sources of innovation over the past half-century.
Phony innovation is easy to identify. It is greeted with little complaint from the competition. Phony innovation threatens no one because it doesn’t replace the established, inefficient way of doing things. A real creation is a beast. It must be destructive of the old way of things. Competitors will hit the roof, and financial regulators will tut-tut.
The financial news leaves the impression that financial innovation is a daily event. The catch-phrase: FinTech. But to date, FinTech produces mostly reams of white papers. I find it shocking what drivel can attract tens of millions from investors, if the omnipresent innovation-descriptive white paper includes FinTech in its title.
My personal favorite is the DAO, or Distributed Autonomous Organization. The DAO phenomenon is the most prominent manifestation of the obsession of financial geeks with the purported benefits of the irreversible nature of computer programming code. The DAO, in theory a human-free investment vehicle self-managed by its code, proved catastrophic for its investors and the cryptocurrency in which it resided, Ethereum.
The DAO displayed, to those not drinking the Kool-Aid of cryptocurrencies, that code is never independent from its authors, that investors should steer clear of investments with no clear human governance, and that blockchain has several years to go before it can be placed into use by mainstream finance. Despite the DAO disaster, the price of Ethereum, whose leaders foolishly permitted DAO into their source code, continues to skyrocket. The greater fool theory of investment lives on.
To innovate in financial markets without seeing a clear unmet need is to get the cart before the horse. The appropriate litmus test for financial innovation is learned from an understanding of the essence of finance. Finance is fundamentally unimportant – financial intermediation is a cost to be eliminated wherever possible. Financial markets and institutions exist solely to minimize the cost of providing resources to something useful – production of goods and services to meet human wants and needs. If a financial innovation does not identify some more expensive financial activity that it will destroy, it cannot succeed. And most FinTech “innovations” conspicuously ignore this central issue.
Financial innovation is scarce.
The reality of financial innovation is different from financial PR. Important financial innovation is rare and quite difficult to achieve. It stems from one of three sources:
- A significant change in the financial environment. (A sudden increase in demand for unprovided financial services.)
- A significant discovery by financial scholars. (A discovery of massive waste in the financial sector, such as the waste uncovered by the Capital Asset Pricing Model.)
- A significant technological development with application to financial activities. (Most conspicuously, electronic trading in its many forms.)
The financial innovations of the last fifty years can be collected into three groups related to these three sources of demand for financial innovation:
- Innovation responding to the catastrophic early 1970s; a sudden and permanent increase in price volatility of financial assets other than common shares.
- Innovation responding to the Capital Asset Pricing model: financial market index-based financial instruments.
- Innovation responding to the electronic revolution, such as program trading and high frequency trading.
These innovations are a process, each one a forest with trees that are glorified by the press and financial publicists, specific products that remain half-baked, works in progress. Various barriers, created by the crisis and various government regulators, have stunted the growth of financial innovation in the past fifteen years or so. As a result, financial technology has stalled - far from the end of the development of the three financial innovation processes above.
Results of early 70s price volatility.
One wellspring from which modern finance flows is the 70s-era sudden explosion of price volatility. From this volatility came the rise of trading within financial institutions at the expense of more stable (boring, really) activities like lend-and-hold, deposit-financed, banking.
The stress this sudden price volatility placed on non-financial businesses that produce real goods and services made creative financial institutions like exchanges and banks suddenly a newly vital source of risk transfer. This gargantuan task began positively with the original growth and development of financial futures and over-the-counter (OTC) derivatives. But this growth has been stunted, mostly due to the protection the banks that were early movers received, as the Bank of England (BOE) provided shelter for anticompetitive oligopoly pricing in the cash deposit and foreign exchange markets and the markets for their associated derivatives.
American regulators’ disastrous failure to adapt to this new risky environment provided an opening for the London market, which jumped at the opportunity. In retrospect, British banks have proven unable to capitalize on the opportunity American regulatory failure created. The City’s banks have gradually been absorbed or replaced by American banks.
For their part, American banks have found British regulation by opaque Chatham House Rules to their liking. But the oligopolies formed under BOE protection have served to discourage further development of still-immature hedging instruments such as interest rate swaps.
Innovation due to the Capital Asset Pricing Model and the electronic trading revolution.
In following articles, the innovation from these other two sources will be developed. As with the hedging instruments discussed above, these instruments have been cursed by government protection of existing market participants at the expense of future innovation.
This is an inevitable process, as old as the rise and fall of the Roman Empire. Financial innovation is stalled today. It awaits the decline and fall of the dealer banks such as Bank of America (BOA), Citigroup (C), Goldman Sachs (GS), and JPMorgan Chase (JPM), in the case of BOE-protected derivatives markets, on one hand. In the case of market index trading and electronic trading, on the other hand, further innovation awaits the decline and fall of the old-line exchanges, the New York Stock Exchange [a subsidiary of Intercontinental Exchange Inc. (ICE)], Nasdaq Group (NDAQ), and CBOE Holdings (CBOE), as their SEC protection crumples away.
The end of the Roman Empire took a millennium. The end of these financial empires will be measured in years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.