Financial Innovation: Three Fallacies in the Debate

Abstract

This essay identifies and examines a set of three fundamentally false background assumptions — or fallacies — that invisibly shape and quietly distort the ongoing debate on pros and cons of financial innovation.

The first fallacy is the implicit default assumption in much of the U.S. financial law and regulation that financial transactions take place in primary markets, where the counterparties engage in capital-raising for some productive purpose exogenous to the financial market — despite the fact that by far the greatest volume of financial activity currently takes place in secondary, rather than primary, markets. The second fallacy shaping the current discourse on financial innovation is an unspoken assumption that the novelty and beneficial impact of financial products or services are to be assessed in the context of individual market transactions, with the pertinent macro-level benefits and costs of that product or service supposedly following in a linear fashion from these core micro-level dynamics. The third fallacy, closely related to the first two, is a widely shared presumption that financial innovation is a ‘natural’ product of private action in response to private market incentives, which obscures the public sector's role as an important agent of publicly beneficial financial innovation.

As the essay argues, defining and evaluating financial innovation by reference to this skewed contextual baseline — as a purely private, micro-transactional, primary-market phenomenon — yields a systematically misleading narrative of modern finance and the challenges it presents. That has dangerous implications for the efficacy and consistency of U.S. financial regulation and financial innovation policy. To successfully harness the power of innovation in modern finance, we must first confront the errors and gaps in our collective thinking about what it means and why we value it.

Keywords: financial innovation, fintech, crypto, financial regulation, secondary market, primary market, market efficiency, stablecoin, CBDC, structural reform, derivatives, MBS