30th, November, 2013
Financial Innovation has changed the world after their birth during early 1990’s with innovative instruments like swaps, zero coupon bonds, portfolio insurance and synthetic cash etc were the first innovative products to initiate the innovative activity. Economists cites many reasons and events that led to beginning of financial innovation.
The first ever innovation is said to begin during 1970 with advent of collapse of Breton Woods(Fixed Exchange Rate) under which the US Government abondoned the tie of gold with dollar. As a result, wide fluctuations in international transactions were witnessed and this gave birth to exchange traded foreign exchange futures contract on Chicago Mercantile Exchange, which was followed by Exchange Traded Options on Chicago Board of Trade. Although, computer technology going cheap in late 1960’s is said to be the reason for sudden burst of financial innovation after 1970’s but many economist do not consider it(computer) as the reason for financial innovation as the financial futures and exchange traded options did not require any computer technology to trade on.
However, author finds that the core reason for the burst of innovation in 1970’s was the delay in long term growth part of financial improvement that started way back in 1920’s. The prolonged depression of 1929 undermined any demand pull inflation and so do the government regulation which suppressed supply side needs of innovation. The increased government regulation was a reaction to the evils caused by exchange traded products and thus post the regulation period more liquid and common stock were major investment by 1920’s. Post the era of 1929 depression, financial innovation did not came to halt, rather the major contributions were only from government sponsored institutions with arrival of new treasury securities like Series ‘E’ Bonds and then the Treasury Bills. With advent of 1940’s the financial regulation by government proved to stimulate the process of innovation. The most well known and striking example of innovation driven financial instrument was Swaps in which one party exchange its fixed rate debt obligations for floating rate obligations of other party or in currency swap a yen denominated payment were swapped for US Dollar Denominations with other party. The similar, regulation induced or tax induced innovations were Zero Coupon Bonds, Instruments in Euro-Dollar Market and Eurobond Market to name a few.
The financial innovation has not always been appraised in history as well, since we have complaints about harmful social effects of financial innovations. The crtitics of financial innovation propose that new instruments by lowering transaction costs have led to too much short term trading which leads to wastage of resources and unduly shortened planned time horizons for investments by both firms and individuals. Another set of critic of financial innovation blames not the middlemen but the financial instrument itself. The crictics blames Index Futures and options for bringing ever increasing stock market volatility. The author also cites the example of stock market crash of 1987 to illustrate the devastating effect of financial innovation like Index Futures, on performance of stock market.
Thinking of what to expect in next 20 years, author concludes that changes will still take place in financial arena. The new instruments will spread to the developed financial markets and also most possibly to the liberalized economies of Eastern Europe and futures and options contracts will be written on an ever widening set of underlying commodities and securities but the pace and process of stock market development to these changes will be normal and slow rather than ‘’punctuated equilibrium’’ of the recent past.
Works Cited
Miller, M. Financila Innovation:Achievement and Prospects. In M. Miller, Risk Management (pp. 337-345). Chicago: University of Chicago.
