Toward a Supply-Side Theory of Financial Innovation

Abstract

Innovation. The word is evocative of ideas, products and processes which have somehow made the world a better place. In the frothy days leading up to the global financial crisis, many viewed financial innovation as unequivocally falling into this category. Underpinning this view was a pervasive belief in the self-correcting nature of markets and their consequent optimality as mechanisms for allocating society’s resources. This belief, in turn, exerted a profound influence on how we regulated financial markets and institutions. This paper examines the influence of this market fundamentalist thinking on the regulation of OTC derivatives markets in the U.S. during the pivotal period between the enactment of the Commodity Futures Trading Commission Act (1974) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010). More specifically, it traces how the conventional ‘demand-side’ view of financial innovation played an important role in blinding policymakers to a host of pressing regulatory challenges ranging from uninformed contracting; to fraud and other opportunistic behavior, to regulatory arbitrage and the unprecedented build-up of systemic risk. Ultimately, the objective of this paper is to start us down the path toward a more complete theoretical account of the nature, sources and potential private and social welfare implications of financial innovation. In the process, it also aspires to move us incrementally toward a more constructive equilibrium between the important insights of financial theory and how we conceptualize and pursue the objectives of financial regulation.

Keywords: financial innovation, Modigliani and Miller, OTC derivatives, securitization, structured finance, swaps, collateral swaps, synthetic exchange-traded funds, ETFs, Dodd-Frank Act

JEL Classification: A12, B26, D86, G5, G18, G28, G38, K22