Financial Innovation (a survey study)

1
Financial Innovation(a survey study)

• Author Peter Tufano

2
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
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

Refer to Page 3
4
Agenda

• Definition of Innovation
• History of Innovation
• Functions of financial innovations
• Tufanos Taxonomy
• Identities and Returns to innovators
• The Impact of innovations to social welfare
• Future Studies

5
Definition of Innovation

• Example of innovations Derivatives, risk
  transfer products, ETFs, tax-deductible equity
• Innovate to introduce as or as if new
• Innovation Invention (RD)
• 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
6
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
7
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
8
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 Mertons scheme, an asset
  securitization invokes 3 functions pooling the
  promise reducing risk increasing liquidity
  (moving funds)

Refer to Page 10
9
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

10
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
11
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
12
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) RD financing vehicles reduce
  interest conflicts

Refer to Page 12
13
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
14
3. To minimize transaction, search, or marketing
cost

• Merton(1989)
• Equity swap is efficient to multinational
  investors
• McConnell and Schwartz(1992)
• Merrill Lynchs 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 1416
15
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
16
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
17
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
18
6. Stimulated by technological shocks (2/2)

• Tech of pricing mechanism
• BS,Merton ? hedging contracts
• Techs of information and internet support...
• Risk management systems
• On line retirement planning
• Real option

Refer to Page 15,22
19
A case study no one explanation works

• Innovations in 1970s
• Market funds (i.e. index fund, e.g.
  Equally-weighted SP 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
20
Tufanos 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 2426
21
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
22
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
23
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
24
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
25
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
26
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 OHara (1989), Primes and Scores

Refer to Page 31
27
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
28
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
29
How to protect intellectual property?

• Keep secrecy
• Product secrecy is impossible to hold
• Process secrecy is possible
• Patent
• However, US Pattern offices 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