Financial Innovation – Why It Can Be Both a Force for Good and Bad

EXOTIC INNOVATIONS OR WEAPONS OF MASS DESTRUCTION?

Anybody who has followed the severe and protracted financial crises of the last Eight years would be aware of the damaging role played by Exotic Financial Products such as Derivates, Swaps, Credit Default Swaps, and Options.

These instruments that are supposedly in place to hedge against risk instead have become so toxic to the health of the global financial system and the global economy that it was no wonder the legendary American investor, Warren Buffett called them “Financial Weapons of Mass Destruction”.

This is because the financial innovative instruments which were hailed as bringing a measure of stability and hedge against risk when they were first invented instead turned into liabilities because as it turned out, they were not that good at pricing risk and hedging against defaults after all.

WHAT IS FINANCIAL INNOVATION AND WHY IT WAS WELCOMED?

Before proceeding further, it would be in the fitness of things to understand what is meant by Financial Innovation. As management students learn during their MBAs and other courses, financial instruments are usually invented to price, factor in risk, hedge against risks such as counterparty default. In addition, innovations in finance are also due to the very real possibility that financial and physical assets might lose value suddenly due to economic cycles and at the same time, they can also inflate beyond measure leading to wild gyrations in the financial markets.

Thus, derivatives which are so named because they “derive” their value from underlying assets are created in a manner that protects both the buyers and sellers of the assets against excessive volatility and wild price movements.

WHEN IS FINANCIAL INNOVATION BAD?

So, one might very well ask, what is the problem if risk is priced in and credit events such as defaults are hedged against?

The partial answer to this is that innovation is good as long as it is directed and controlled in a stable manner. Once innovation takes on a life of its own, the net result or the end result is that it often leads to a situation where neither its creators nor its users understand what exactly they are all about.

Of course, this does not mean that innovation is per se bad and more so, financial innovation is something that is inherently wrong. Indeed, it is only because of the financial innovations of the last few decades that consumers and especially the retail ones like you and we have been able to have greater control over our savings, portfolios, and assets.

HOW CAN WE USE FINANCIAL INNOVATION FOR GOOD?

Thus, while we are not suggesting that financial innovation should cease, we are certainly advocating financial innovation that benefits society and which does not become overly complicated and complex that very few of the financial experts understand what it is all about. Indeed, there are numerous examples of how financial innovation is undertaken with a view to genuinely improving the condition of the poor rather than solely as a way of making profits alone.

These include the Microcredit Initiative that was pioneered by the Nobel Prize Winning Bangladeshi Banker and Social Entrepreneur, Mohammed Yunus, who with his Grameen Bank succeeded in bringing banking to poor women who were hitherto denied access to structured credit and were at the mercy of unscrupulous money lenders.

Or, banks such as Bandhan in the Eastern Indian State of Bengal which similarly, is spearheading a revolution in banking for the masses. Of course, even in the West, there are numerous instances such as the Commodity Bourses which as a result of Bankers merging the financial profit imperative with that of social responsibility has helped the farmers in hedging against bad harvests, weather changes, and even pure speculation that can result in the volatility of the prices.

PROFITS ARE NOT THE ONLY CRITERIA

Thus, it can be said that like everything else in the world of business and finance, as long as financial innovation has the underlying them of genuinely merging the profitability with that of social change, then it must be welcomed and even supported and encouraged at all costs. However, when financial innovation becomes yet another instance of speculation wherein the sole objective is to make as much money as possible, then it is certainly something that we must be worried about.

THE EMERGING THREATS OF HIGH-SPEED TRADING WITH UBER COMPLEX FINANCIAL INSTRUMENTS

Moreover, with the advent of high speed trading and electronic trading, it is certainly the case that the marriage of advanced technology with that of overly complex financial products is leading us to a dangerous situation where the speed of technological change and the increase in complexity results in a high stakes game of cards where the decisions are not made by humans but machines which though supposedly objective can also veer out of control. Indeed, the fact that at the moment, computers have taken over the roles that traders used to perform in the markets means that there is every chance that one day, there would not be too many of the experts who understand what is going on.

CONCLUSION

To conclude, financial innovation has certainly leads to efficiencies in the markets. However, at times, such innovation has to be tempered with human and humane considerations. Just like the inventions such as Dynamite and the scientific achievements such as splitting the atom led to devastating outcomes, even financial innovation that is not grounded in the realization that greed can sometimes lead to disaster would definitely lead to that as the world learned the hard way over the last decade or so.