- The Language of Finance
- What Is Financial Innovation?
- The First Financial Innovations: From Capital to Credit
- Financial Innovations in the Age of Discovery
- The Rise of Financial Capitalism
- Landmarks in Financial Innovation
- Did Financial Innovation Cause the Crisis?
- Using Finance to Manage Risk and Democratize Access to Capital
Landmarks in Financial Innovation
Multiple factors must be in place for new financial structures to work, including transparency, standardization, a system of exchange, and price discovery. These are necessary ingredients for overcoming information asymmetries and helping all parties to price and manage risk. Just as physical infrastructure is required for transportation and communications, an adequate information infrastructure must be in place for financial innovations to take hold and succeed.16
Uniform Commodity and Security Standards
Transaction costs are reduced and markets are made more reliable when uniform commodity and security standards are defined. The ability to measure, monitor, and manage data about any security underlies the ability to price or trade it. Standardization is key to ensuring that accurate valuation can occur. The underlying asset must be specified, whether it is a bushel of corn or an interest rate. Benchmarking, auditing, and information management allow transparent transactions to take place. Standardization delineates the type of settlement (cash or physical), the number of units of the underlying asset per contract, the currency or unit of exchange, the grade (type of commodity or grade of security), and the timing of the trade (delivery, trading date, and maturation). The process of standardization is carried out by establishing broadly accepted principles for determining accounting values, while still allowing some degree of methodological flexibility. Competing interests must be overcome to harmonize measurements so that accurate valuations can be made.
Legal Instruments Providing Evidence of Ownership
Property rights constitute one of the fundamental building blocks that make financial innovations and markets possible. Ownership grows as cash flows from operations, trading, and commerce. The registration and protection of property rights—whether involving a parcel of land or intellectual property—is necessary for the mobilization of all forms of capital for productive use. The ability to establish proprietary interests in economic activity underlies what Hernando de Soto has appropriately called "the mystery of capital."17 Claims that can leverage other means of finance toward creative goals of economic activity must be established and protected. Tangible ownership stakes provide the physical means and incentives for individuals to take transformative action.
Exchanges grew out of the need to provide channels for the flow of savings to investment. The prospects of long-term capital gains for investors emerged systematically as firms that had growing demands for capital reinvested earnings to attract investors seeking higher returns. The earliest exchanges grew out of the need to finance trades and fairs through bills of exchange, drafts, notes, and instruments. From exchanges for bills and notes, the movement toward more complex securities came swiftly as the structural needs for external financing grew to accommodate new markets, technologies, and challenges. Exchange-traded financial innovations are standardized and can be margined and financed.
Futures, Options, and Forward Markets
Futures are standardized contracts committing parties to buy or sell goods at a specific quality and price for delivery at a specific point in the future. Traders on a mercantile exchange can use them to swap pork belly futures, or airlines can use them to hedge oil prices. They have been at work for centuries—in fact, they surface as Aristotle relates the story of Thales of Miletus in the sixth century B.C.18 Thales overcame his legendary poverty by developing forecasting and estimation skills relative to weather and geography: He predicted a bumper crop of olives and raised money to deposit for olive presses, which he then claimed and traded at profit.
Futures exchanges act as clearinghouses between buyers and sellers, guaranteeing their contracts. They monitor the credit of buyers and sellers, process new information about supply and demand, and generally provide stability in an unstable environment by ensuring future prices and availability.
Futures are standardized and exchange-traded, while forwards and options are customized for a counterparty and therefore not frequently traded on exchanges. (The "forward market" is a general term used to refer to the informal market in which these contracts are entered and exited.) Informal spot markets form when economic actors make only limited contractual obligations to the future by negotiating a cash price for a good, service, or commodity on the spot at current market prices. Later, the ability to commit to forward prices occurs.
In all cases of the evolution of these markets, standardization of the underlying good or asset is required to measure price variability, arrive at competitive prices, ensure that viable cash markets exist, and determine patterns of forward contracting. Patterns of contract design emerge that are consistent with legal and tax restrictions, enabling trade.
Over-the-Counter (OTC) Markets
The need for customized solutions to control financial risk gave rise to OTC markets. If a standardized exchange-based option is inadequate, a corporation can write a more tailored contract that is designed and priced to provide greater stability. For example, a corporation needing to plan production might need to hedge a stream of foreign currency revenue for a longer period than what is available via an exchange-traded instrument. In a bilateral over-the-counter contract (such as a corporate bond), two parties agree on how a particular trade or transaction is to be settled in the future. While exchange-traded instruments are standardized contracts, OTC options are tailored to particular risks. Price discovery on exchange-traded options is important for determining prices of OTC options. Banks, investment banks, insurance companies, large corporations, and other parties participate in OTC markets. Forwards and swaps are prime examples of OTC contracts; without futures, insurance and risk management for these more customized instruments can be extreme.