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Contemporary Financial Innovation: Orthodoxy and Alternatives

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Contemporary Financial Innovation: Orthodoxy and Alternatives SMU Law Review Volume 51 Issue 3 Article 3 1998 Contemporary Financial Innovation: Orthodoxy and Alternatives Charles R. Pouncy P. Follow this and additional works at: https://scholar.smu.edu/smulr Recommended Citation Charles R. Pouncy, Contemporary Financial Innovation: Orthodoxy and Alternatives, 51 SMU L. REV. 505 (1998) https://scholar.smu.edu/smulr/vol51/iss3/3 This Article is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Review by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu. CONTEMPORARY FINANCIAL INNOVATION: ORTHODOXY AND ALTERNATIVES Charles R.P. Pouncy* TABLE OF CONTENTS I. INTRODUCTION ........................................ 506 II. A DEFINITION OF FINANCIAL INNOVATION ....... 513 A. THE FINANCIAL SECTOR AND FINANCIAL INNOVATION .......................................... 515 B. A CHRONOLOGICAL EXAMINATION OF FINANCIAL INNOVATION .......................................... 519 1. Traditional FinancialInnovation ................... 519 2. Modern FinancialInnovation ...................... 521 3. Contemporary FinancialInnovation ............... 524 a. The Euromarkets .............................. 524 b. Sw aps ......................................... 527 c. Securitization ................. .......... 531 d. Financial Futures and Options ................. 532 C. THE PROCESSES OF TRADITIONAL AND CONTEMPORARY FINANCIAL INNOVATION ............. 535 III. ECONOMIC THEORY .................................. 539 IV. CONTEMPORARY FINANCIAL INNOVATION AS AN ECONOMIC PROCESS ............................. 545 A. NEOCLASSICAL THEORY ............................... 545 1. Neoclassical Economic Scholarship ................ 545 a. R egulation .................................... 548 b. Finance Theory ............................... 551 i. Efficient Capital Market Hypothesis ....... 551 ii. Modern Portfolio Theory .................. 552 iii. The M&M Theorem ....................... 552 iv. Option Pricing Theory .................... 553 c. Technology .................................... 553 2. The Neoclassical Explanation ...................... 554 * Assistant Professor, University of Florida, College of Law. B.A. 1976, Fordham University; J.D. 1979, Cornell Law School; LL.M. 1995, Temple University School of Law. The author thanks Professor Larry Cata Backer, Professor Marilyn Blumberg Cane, Pro- fessor Michelle S. Jacobs, and Professor Pedro A. Malavet for their valuable comments on earlier drafts of this Article. The author also thanks Stephen Tyler and Deborah Rumph for their excellent research assistance. The development of this work was supported by the University of Florida College of Law Summer Research Grant Program. SMU LAW REVIEW [Vol. 51 3. The Neoclassical Explanation Considered .......... 556 B. HETERODOX THEORY ................................. 559 1. Critique of Rationality ............................. 560 2. Technology ........................................ 562 3. Competition Under Uncertainty .................... 563 4. Asymmetric Reward Structure ..................... 564 5. M oney and Credit ................................. 565 C. FINANCIAL INSTABILITY HYPOTHESIS .................. 566 D. THE HETERODOX EXPLANATION ...................... 569 E. HETERODOX RISKS .................................... 571 1. Greater Risk Taking ............................... 571 2. Increased Speculation .............................. 572 3. Monetary Consequences ........................... 573 F. THE HETERODOX EXPLANATION CONSIDERED ........ 574 G. REGULATION OF CONTEMPORARY FINANCIAL INNOVATION-FINANCIAL DERIVATIVES ............... 574 V. LEGAL SCHOLARSHIP AND CONTEMPORARY FINANCIAL INNOVATION ............................. 576 A. THE LIMITS OF ORTHODOXY .......................... 583 B. FINANCIAL INNOVATION ACROSS TIME ................ 584 C. REGULATORY STRUCTURE ............................ 585 D. PERCEPTIONS AND SECTORAL DYNAMICS .............. 588 VI. CONCLUSION ........................................... 589 I. INTRODUCTION T HE second half of the twentieth century has been a period of far- reaching change in the processes and instrumentalities of finance. In the last twenty years, the rate of change has accelerated, result- ing in a thorough redrafting of the landscape of the financial markets.' 1. See Henry T.C. Hu, New FinancialProducts, the Modern Process of FinancialIn- novation, and the Puzzle of Shareholder Welfare, 69 TEX. L. REv. 1273 (1991) (The 1980s have spawned a plethora of new financial products as well as a distinctive new process of financial innovation rooted in the institutionalization of change and the application of ad- vanced finance theory.); Henry T.C. Hu, Swaps, the Modern Process of FinancialInnova- tion and the Vulnerability of a Regulatory Paradigm, 138 U. PA. L. REV. 333, 334 (1989) [hereinafter Swaps] ("The past decade has been a golden age for innovation in corporate and international finance."); Edward D. Kleinbard, Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System, 69 TEX. L. REV. 1319, 1353 (1991) ("I would respond that this philosophy [incrementalism] fails to address the ever-accelerating pace of financial innovation and its overall benefits to the United States economy."); Todd E. Petzel, Derivatives: Market and Regulatory Dynamics, 21 J. CORP. L. 95 (1995) ("The derivatives industry has experienced unparalleled growth during the last twenty-five years."); Peter Tufano, Securities Innovations: A Historical and Functional Perspective, J. APPLIED CORP. FIN., Winter 1995, at 90 ("The past two decades have produced a remarka- ble number and variety of seemingly new securities."). 19981 FINANCIAL INNOVATION As a result of this explosion in financial innovation,2 new products,3 serv- ices 4 and processes, 5 have been developed, refined and diffused through- out the sector. Financial innovation has generated products that permit 6 formerly unmanageable business risks to be traded or bargained away. Advances in "financial science ' 7 are now employed to create "derivative realities."8 These environments are created with financial innovations and limit the extent to which the exchange rate, interest rate, and infla- tion risk adversely impact the proverbial bottom line. The terms "finan- cial engineering,"9 "nuclear finance," 10 or "particle finance,"'" to use 2. Financial innovation is the process by which new methods are created to provide the fundamental services furnished by the financial sector. See infra text accompanying notes 40-64. 3. See, e.g., Greg Ip & Aaron Lucchetti, Dow Contracts May Appeal to Individuals, WALL ST. J., June 6, 1997, at Cl (discussing the initiation of a new futures contract based on the Dow Jones industrials index). 4. For example, portfolio insurance is a service that attempts to attain a target rate of return on a portfolio of assets, such as equity securities, by hedging the portfolio with various risk mediating financial instruments. As the generation of the appropriate strate- gies frequently required development and use of sophisticated mathematical models, port- folio insurance became a service provided to portfolio managers by investment bankers and specialist portfolio insurance providers. See JOHN F. MARSHALL & VIPUL K. BANSAL, FINANCIAL ENGINEERING 637-38 (1992). 5. See infra text accompanying notes 62-65 and 429-33 for a discussion of index arbitrage. 6. See Henry T.C. Hu, Hedging Expectations: "Derivative Reality" and the Law and Finance of the Corporate Objective, 73 TEX. L. REV. 985 (1995) [hereinafter Derivative Reality]. "Derivatives [a product of financial innovation] allow corporations to insulate themselves from, amplify, or otherwise modulate the impact of changes in interest and exchange rates and commodity, equity, and real estate prices." Id. at 986. 7. Professor Hu characterizes the body of information representing modern finance theory as "financial science." See id. at 989-90. Professor Hu also uses scientific analogies in describing what he views as the competing visions of the world after the introduction of the sophisticated products of contemporary financial innovation, a world run amok as a result of "Jurassic Park" science, or a world of increased order and stability. See id. 8. "If clever and careful enough, a corporation can avoid the chaos of the real world. A corporation can enter a private 'derivative reality,' a synthetic world purged of risks it deems undesirable." Id. at 986. 9. "Financial engineering involves the design, the development, and the implementa- tion of innovative financial instruments and processes, and the formulation of creative so- lutions to problems in finance." John D. Finnerty, Financial Engineering in Corporate Finance: An Overview, in THE HANDBOOK OF FINANCIAL ENGINEERING 69 (Clifford W. Smith, Jr. & Charles W. Smithson eds., 1990). The term, "financial engineer," came into popular usage in London in the mid-1980s to describe the teams of professionals employed in designing financial solutions to corporate risk management problems. See MARSHALL & BANSAL, supra note 4, at 6. Although financial engineers may be "deal makers," "idea generators" or "loophole exploiters," they are all proficient in financial theory and the applied mathematics necessary to craft their products. The conceptual tools of financial engineering are valuation theory, portfolio theory, hedging theory, accounting, and taxa- tion. Their physical tools are
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