Tuesday, 26 May 2009

Preparing for the downside of financial innovation

A cornerstone from modern financial theory which has driven the thirst for innovation in financial engineering is the notion of deriving a profit through arbitrage. In the strongest version of arbitrage - the so called "free lunch" view - there is the belief that one may be able, by clever observations and discovery of mis-calculations in market behavior and pricing, to receive a positive return from the "risk-less" use of capital by seizing upon such inefficiencies and waiting for markets to realize their mistakes and return to rational pricing. [Often the waiting period is a lot longer than anticipated at the time of putting on an arbitrage trade but that's another matter.]

Even in a less extreme form, if we substitute the words "minimal risk" for "risk-less" use of capital in the above, the returns achievable from certain kinds of arbitrage-like financial transactions have been powerful inducements for investment banks and other financial intermediaries to explore new areas of financial technology.

But do such opportunities for a free lunch or at least a very inexpensive one really exist? Furthermore, in what sense is innovation in finance a value added activity? With the activities of the financial sector contributing such a large proportion of national income this question takes on considerable significance as another associated question arises as well.

Did the underestimation of the inherent risks in complex financial products and financial innovation lead to greater risk taking by the financial services industry which culminated in the great meltdown seen in the fall of 2008?

This appears to be the underlying assumption of a thoughtful article by Rortybomb.
we should think of our financial sector as something that can’t create a lot of value without taking on more risk. So whenever I hear someone pitch an idea for a way to “innovate” the financial market, I ask him “what makes you think that you are smarter than the entirety of the financial market? Are you smarter than everyone at DE Shaw?” It is possible, of course. But I approach it as if someone has told me they found a certain way to beat the casino at cards without cheating; one needs to make sure that better returns are just the result of hiding away the risk from where people can see it.
A case could be made that the value added component from any innovation in finance or technology is very simply the novelty itself. In a culture of aspiration that needs to be stimulated with new memes and motivations - to kindle the animal spirits - there is a positive virtue in allowing innovators to innovate. If one places a value on the aspirational element of our global economy, the benefits of a cultural sense of direction and progress are of inestimable value. But how do we reconcile that benefit with the undoubted costs that the economy and culture are having to suffer as the result of the private gain/public pain asymmetry which seems also to be a foundation stone of that same culture of collective aspiration?

Might there be some pricing mechanism for determining the external or hidden system risk costs which will often accompany innovative financial transactions and which should then be levied as a tax payable to a global depository at the time such transactions are entered into?

The levying of a derivatives insurance tax in all instances where there exists a counter-party risk of sufficient magnitude above a threshold amount would then provide an insurance fund or safety net to cover the systemic accidents when they arise.

Rather than having to rely on the public sector to continually bail out those guilty of inevitable mis-calculations, the external costs - just like the costs levied to cover eco-system damage by polluters - could become the security blanket required to protect the collective purse from the flipside of the benefits of innovative finance.

This I believe is the view being advocated by Andrew Lo from MIT in the following which appeared recently in the Financial Times.

There is a very appealing and equitable logic to Lo's suggestions and I have previously discussed the alarming consequences of failing to properly factor in the true external costs of the credit creation process which has lead to its persistent under-pricing. One can but hope - in the context of our culture of aspiration - that Lo, or one of his followers, is able to successfully provide a more detailed implementation framework and pricing basis for calculating the true costs, surface and external, for the use of innovative financial products and credit agreements in general.

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