MANAGING OF INNOVATION

Managing innovation in a financial services context is challenging, and in many ways different, from a product environment. Only a superior innovation capability can create a sustainable advantage. It is virtually impossible to create sustainable competitive advantage with a single innovation. Most innovations in financial services can and will be copied by competitors. "If you think about how financial services have been driven during the last 15 years, it has really been driven by the advancements in technology, and some would say that the technology has advanced much faster than consumers or corporations have been able to adopt the processes that the technology has allowed."Financial services companies need to manage the matrix of market and product and platform. Hagegard says, "Innovation's purpose is market facing.It's about serving customers, but it impacts multiple products serving multiple markets that reside on different platforms. Further, organizations involved in financial services need to combine the aspects of products, service delivery, and production process in the innovation process, which increases complexity." The innovation process is inherently cross-functional which creates organizational complexity. There are often organizational barriers between both business and IT organizations and between business

organizations. "Innovation and product development is expected of line management rather than a separate R&D department, creating further cross-functional issues and placing great strain on line management," "We believe that effective innovation starts with a clear view on the role of the company in the innovation game," says Hagegard, and he gives several examples of different innovation approaches. Some are more market-driven and some are more R&D driven; some are passive while others are aggressive. See Figure 2 for detailed descriptions of some examples. "The Internet really turned everyone in financial services upside down. It brought information to our fingertips, much, much more than the PC ever did. It drove customers closer to financial services institutions. It made feedback much easier, made switching cost less."

FINANCIAL INSTRUMENT INNOVATIONS

Financial instruments have come a long way since the advent of listed stocks that allowed trading on exchanges, aiding in the development of formal marketplaces and liquidity. Some of the innovations

that sought to address the requirement of capturing market needs include: Mutual funds, which extended professionally managed, diversified asset portfolio benefits to a wider investor population, while helping households acquire financial assets. Hedge funds to address the needs of investors with high net worth and a far higher appetite for risk. Exchange traded funds (ETF) to provide attractive investment opportunities at far lower costs by focusi ng on passive investing that mimics select indices. Meanwhile, instruments emerged to provide risk management benefits. They include: Commodity and interest rate futures, which allow businesses to hedge their exposure to adverse commodity price/interest rate movements. Inflation indexed bonds, which allow better management of the risks incurred by the adverse impact of a rise in inflation. Catastrophe bonds, which insure against the impact of natural calamities.

 Credit default swap (CDS) or credit derivatives, which allow institutions to hedge the credit risks of loans they originate. Another significant area of innovation is securitization to allow firms to convert streams of loan receivables into tradable securities that are sold to investors with a high tolerance for risk; these instruments enable institutions to extend more credit and meet liquidity demands. WHY DOES FINANCIAL INNOVATION OCCUR? Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incomplete") but little to say about why new types of securities should come into existence. One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth (absent taxes, etc.). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.

Furthermore, there should be little demand for specific types of securities. The capital asset pricing model, first developed by Treynorand Sharpe, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those RISKS in their portfolio). If the world existed as the Arrow-Debreu model posits, then there would be no need for financial innovation. The Arrow-Debreu model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.

UNIQUENESS OF INSTRUMENT INNOVATIONS Innovations in financial instruments differ vastly from innovations in other industries, whose benefits and potential downsides are clear. Unlike a drug whose ill effects may be limited to only those who consumed it, the adverse impact of financial instruments affects the entire economy, not just the parties involved in specific transactions. This is a result of the interconnectedness of financial systems with the general economy which transmits the benefits and negative impacts of innovations somewhat equally. In fact, securities firms are both creators and followers of innovation. They both experiment with and adopt new instruments from competitors to create investment standards that build markets and house revenue streams.2 Robert Merton calls this phenomenon the innovation spiral,3 in which institutions devise new instruments to meet their emerging needs that they then standardize and promulgate into the markets, spreading their breadth and depth. These instruments continuously mutate, extending the cycle of standardization and adoption. Interestingly, the never-ending hunt for investment returns and competition motivates players to evolve key instruments. ETF, an innovation that sought to provide diversification benefits a la market indices to small investors at far lower costs, is one example. Todays ETFs invest in a wide array of assets, from commodities through equities.

HISTORY OF FINANCIAL INNOVATIONS YEAR 1600s INNOVATION Stock Exchange Publicly Listed Stocks Central Bank Japanese Rice Futures Market Call Options Mutual Funds Inflation-linked Bonds Futures Exchange, Chicago Hedge Funds Securitization Black-Scholes Option Pricing Model Interest Rate Futures Fannie Mae Exchange Traded Funds Credit Default Swaps Electronic Trading Catastrophe Bonds Algorithmic Trading High Frequency Trading Continuous Linked Settlement

1700s

1900s

2000s

Alternative Trading Systems, Multilateral Trading Facilities Target2-Securities

HISTORICAL EXAMPLES OF FINANCIAL INNOVATION
Examples of spanning the market Some types of financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.

The development of interest rate swaps in the early 1980s after interest rates skyrocketed. The development of credit default swaps in the early 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression.

Examples of mathematical innovation

The market in options exploded after the development of the BlackScholes model in 1973. The development of the CDO was heavily influenced by the popularization of the copula technique (Li 2000).

Flash trading exists since 2000 at the Chicago Board Options Exchange and 2006 in the stock market. In July 2010, Direct Edgebecame a U.S. Futures Exchange. Nasdaq and Bats Exchange, Inc created their own flash market in early 2009. Futures, options, and many other types of derivatives have been around for centuries: the Japanese rice futures market started trading around 1730. However, recent decades have seen an explosion use of derivatives and mathematicallycomplicated securitizationtechniques. MacKenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new asset

Examples of innovation to avoid taxes and regulation Miller (1986) places great emphasis on the role of taxes and government regulation in stimulating financial innovation. Modigliani and Miller (1958) explicitly considered taxes as a reason to prefer one type of security over another, despite that corporations and investors should be indifferent to capital structure in a fractionless world.

The development of checking accounts at U.S. banks was in order to avoid punitive taxes on state bank notes that were part of theNational Banking Act. Some investors use total return swaps to convert dividends into capital gains, which are taxed at a lower rate.[1] Many times, regulators have explicitly discouraged or outlawed trading in certain types of financial securities. In the United States, gambling is mostly illegal, and it can be difficult to tell whether financial contracts are illegal gambling instruments or legitimate tools for investment and risk-sharing. The Commodity Futures Trading Commission is in charge of making this determination. The difficulty that the Chicago Board of Trade faced in attempting to trade futures on stocks and stock indexes is described in Melamed (1996). In the United States, Regulation Q drove several types of financial innovation to get around its interest rate ceilings, includingeurodollars and NOW accounts

THE ROLE OF TECHNOLOGY IN FINANCIAL INNOVATION

Some types of financial innovation are driven by improvements in computer and telecommunication technology. For example, Paul Volcker suggested that

for most people, the creation of the ATM was a greater financial innovation than asset-backed securitization.[2]Other types of financial innovation affecting the payments system include credit and debit cards and online payment systems likePayPal. These types of innovations are notable because they reduce transaction costs. Households need to keep lower cash balancesif the economy exhibits cash-inadvance constraints then these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi (2009), using data on Italian households' use of debit cards, find that ownership of an ATM card results in benefits worth 17 annually. These types of innovations may also have an impact on monetary policy by reducing real household balances. Especially with the increased popularity of online banking, households are able to keep greater percentages of their wealth in non-cash instruments. In a special edition of 'International Finance' devoted to the interaction of electronic commerce and central banking, Goodhart (2000) andWoodford (2000) express confidence in the ability of a central bank to maintain its policy goals by affecting the short-term interest rate even if electronic money has eliminated the demand for central bank liabilities, while Friedman (2000) is less sanguine.

INNOVATIONS ROLE IN FINANCIAL MARKET CRISES Amid the ongoing financial crisis, financial instrument innovation of the early 21st century is being closely examined for the severe adverse economic consequences that ensued. Given their ubiquity, financial instruments are typically found at the center of economic crises. Innovations per se are neither evil nor good. They can evolve and be applied to meet specific objectives. The objectives are influenced by a host of external and internal factors. As The Economist recently put it, When bubbles froth, innovations are used inappropriately to take on exposures that should not have been, to manufacture risk rather than transfer it, to add complexity.10 This is also summarized11 by Steve Kohlhagen, an advisory board member at the Stanford Institute for Economic Policy Research (SIEPR), who said that blaming financial innovation for crises is like blaming the Wright brothers for 9/11. The systemic significance of innovations arises when the markets for these instruments grow wider and deeper and pose unintended consequences. 12 ETFs rapid growth is a case in point A Kauffman Foundation report13 warns of potential systemic risks that can arise due to the growing influence of ETF investments, which are increasing correlations among index constituents. The benign or malignant consequences of financial innovations are determined by three sources the environment, innovation itself and the area of application.14 Environmental forces that shape markets

and drive innovation typically change over time and influence outcomes. Innovations attempted in an unhealthy environment that provides the wrong incentives are likely to produce negative outcomes. On the contrary, a healthy environment that fosters a longterm view that encourages firms to appropriately assess attendant risks can lead to positive outcomes.15 In the run-up to the recent crisis, the environment was beset by a host of adverse factors, including the following: Prolonged deregulation paved the way for shadow banking to flourish. Institutions took part in opaque OTC derivatives, coupled with high leverage Central banks remained solely focused on inflation targeting, even as asset prices bubbled. Environmental factors such as overt tax incentives for debt, a prolonged rise in property values and easy availability of mortgages even for subprime borrowers, incented individuals to expose their household balance sheets to excessive debt. At the institutional level, back offices that process trades remained largely antiquated, 16 even as the front offices made headway to meet increasing market demand.

MAKING INNOVATION SAFER

Innovations are necessary for the evolution of financial markets. The ability to innovate has never been a challenge for most financial firms. As is evident from the recent crisis, the biggest challenge for regulators, industry groups and financial services firms is to develop ways and means to minimize the ill effects of instrument innovation (as referenced above). The crisis presents an opportunity to reinvent the system. As Andrew Lo of the Massachusetts Institute of Technology suggests,21 the financial industry needs to establish an independent body modeled on the lines of the National Transportation Safety Board (NTSB), which has the impeccable track record of continuously increasing the safety of commercial aviation. Robert Shiller, an economist and Professor of Economics at Yale, advocates the idea that the government has to assume sponsorship of innovation, just as is it does with scientific innovation.22 Industry groups also have a useful role to play. They can work toward evolving best practices around innovation processes and ensure their dissemination among participating institutions. These groups can also join hands with regulators in applying innovations to monitor unfolding negative outcomes.