When speculation squashes innovation

October 28, 2011

Paul Volcker famously joked in the wake of the 2008 credit crisis that the most important financial innovation of the last few decades had come not from Wall Street’s fancy footwork but rather the engineering acumen that created the ATM. A paper published by the National Bureau for Economic Research lends some academic credence to Volcker’s view. In particular, the research of Alp Simsek, a Harvard economist, finds the very uncertainty that esoteric new securities introduce into financial markets eats away at benefits arising from greater credit availability:

Financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing. My main result shows that financial innovation also always increases the speculative variance. This is true even if traders completely agree about the payoffs of new assets. The intuition behind this result is the hedge-more/bet-more effect: Traders use new assets to hedge their bets on existing assets, which in turn enables them to place larger bets and take on greater risks. This effect suggests that financial innovation is more likely to be destabilizing in more complete financial markets and when it concerns derivative assets.

The author argues that rules prohibiting too many new types of securities from being introduced at once – so that traders don’t go too crazy too quickly – isn’t enough. As the crisis showed, when push comes to shove, hard-and-fast rules deliver better results than efforts at industry self-discipline.

Staggering the introduction of new assets is likely to be ineffective because it reduces traders’ speculation simultaneously with their learning. A more viable alternative appears to be temporary position limits on new assets, which can be implemented with temporary capital requirements.



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