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How Financial Innovations

improve economic performanceCompleting markets: expandingopportunities foro risk-sharing

o risk-poolingo hedgingo intertemporal or spatial transfers of resources

lowering transactions costs or increasingliquidity

reducing agency costs caused byo asymmetric information between trading

parties

o principals incomplete monitoring of agents

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Financial SystemFunctions

Payments system for the exchange ofgoods.

Mechanism for the pooling of funds for

large-scale indivisible enterprises.Transfer of economic resources throughtime and across geographic regions andindustries.

Management of uncertainty and controlrisk.

Provision of price information to

coordinate decentralized decision-making.

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FunctionsPayments system

Decreasing the cost of processingpayments for transactions

E.g. SWIFT, CHIPSIncreasing the speed

Decreasing the possibility of fraud

Examples: Credit cards, debit cards

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Mechanism for the pooling of fundsto create large-scale indivisible

enterprises.Creating a mechanism for poolingcapital in a low-cost way and/orminimizing related agency problems.

Example: Limited LiabilityCompanies, hedge funds, mutualfunds, private equity funds

Financial SystemFunctions

Pooling of funds

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FunctionsResources transfer through

time and space

Investors need ways of transferring

savings from the present (when they arenot needed) to the future (when they willbe needed).

They might also need to transfer

resources through space.The same applies to borrowers as well.

Examples: All securities, e.g. Bonds,Currency Swaps.

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FunctionsRisk Management

Reducing the risk by selling thesource of it.

In general, adjusting a portfolio bymoving from risky assets to a risklessasset to reduce risk is called hedging;this can be done either in the post cash

market or in a futures or forward market.Examples: Securitization (ABS,GNMAs)

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Financial SystemFunctions

Risk ManagementEven if aggregate risk is notreduced, the risk of an individual

investors position can be reducedby diversification

Examples: Mutual funds, Indexfunds

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Functions

Risk Management

Reducing the risk by buying insurance againstlosses.Selling part of the return distribution; the fee

or premium paid for insurance substitutes asure loss for the possibility of a larger loss. Ingeneral, the owner of any asset can eliminatethe downside risk of loss and retain the upsidebenefit of ownership by the purchase of a put

option.Examples: Options, Range floaters(A RangeFloater is a deposit or Note that accruesinterest daily when the underlying referencepoint is within a predefined range and accrueszero when outside that range)

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Information fordecentralized decision-

makingDecision makers need information

about demand and supply and pricesin their own and in other sectors ofthe economy. This might involve thecollection of data from many

individuals.

Examples: Futures markets, stockmarkets

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nnova ons anInformation

Portfolio Insurance was developed as ameans of synthetically creating a put,so that there would be a lower bound on

the value of a portfolio.Unfortunately, the lack of an actualmarket where such puts were tradedmeant that information was not

aggregated and provided to marketparticipants.

The Oct. 1987 liquidity crunch and

market meltdown was due partly to this.

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Functions Managingagency costs

Investors and Issuers may be unwilling totrade because of concerns as to whetherthe other party to the trade is informed or

not.The benefits to trade might decrease ifthe relationship is long-lived and there arenegative incentives for the participants in

the trade.

Examples: Puttable stock, convertibledebt

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The Impact of Government

on Financial Markets

The primary role of government is

to promote competition, ensuremarket integrity (including macrocredit risk protections), and

manage public good typeexternalities.

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functions that affectfinancial markets

As a market participant following thesame rules for action as other private-sector transactors, such as with open

market operations.As an industry competitor or benefactorof innovation, by supportingdevelopment or directly creating new

financial products such as index-linkedbonds or new institutions such as theGovernment National MortgageAssociation.

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How governments affectfinancial markets

As a legislator, by setting/ enforcing rulesand restrictions on market participants,financial products, and markets such as

margins, circuit breakers, and patents onproducts.This can encourage financial innovation bysetting and enforcing rules for property rightsto innovation.

As a negotiator, by representing itsdomestic constituents in dealings withother sovereigns that involve financialmarkets.

This can encourage innovations intended to

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How governments affect

financial marketsAs an unwitting intervenor, bychanging general corporate

regulators, taxes, and other laws orpolicies that frequently havesignificant unanticipated andunintended consequences for the

financial services industry.This can spur innovation to try andget around the intended effects ofgovernment legislation

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How governments affectfinancial markets

These activities can have potential coststhat can be classified as follows:

direct costs to participants, such as fees forusing the markets or costs of filings

distortions of market prices and resourceallocations

transfers of wealth among private partyparticipants in the financial markets.

transfers of wealth from taxpayers toparticipants in the financial markets

Financial Innovations are sometimesgeared to avoidance of these regulatorycosts.

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The dynamic of financial

innovationAggregate Trading Volume expandssecularly

Trading is increasingly dominated byinstitutions

Further expansion in round-the-clocktrading permits more effective

implementation of hedging strategies.Financial services firms will increasinglyfocus on providing individually tailoredsolutions to their clients investment

and financing problems.

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The dynamic of financial

innovationSophisticated hedging and riskmanagement will become an integratedpart of the corporate capital budgetingand financial management process.

Retail customers (households) willcontinue to move away from direct,individual financial market participationsuch as trading in individual stocks orbonds and move to aggregate bundlesof securities, such as mutual funds,basket-type and index securities andcustom-designed securities designed by

intermediaries.

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ImplicationsLiquidity will deepen in the basket/index

securities, while individual stocks willbecome less liquid.

There will be less need for thetraditional regulatory protections and

other subsidies of the costs of retailinvestors trading in stocks and bonds.

The emphasis on disclosure andregulations will tend to shift up the

security-aggregation chain to theinterface between investors andinvestment companies, asset allocators,and insurance and pension products.