SPECIAL REPORT FINANCIAL INNOVATION February 25th 2012 Playing with fire SRFininnov1.indd 1 14/02/2012 15:09 SPECIAL REPORT FINANCIAL INNOVATION Playing with fire Financial innovation can do a lot of good, says Andrew Palmer. It is its tendency to excess that must be curbed FINANCIAL INNOVATION HAS a dreadful image these days. Paul CONTENTS Volcker, a former chairman of America’s Federal Reserve, who emerged 4 How innovation happens from the 2007-08 nancial crisis with his reputation intact, once said that The ferment of nance none of the nancial inventions of the past 25 years matches up to the ATM. Paul Krugman, a Nobel prize-winning economist-cum-polemicist, 5 Retail investors has written that it is hard to think of any big recent nancial break- The little guy throughs that have aided society. Joseph Stiglitz, another Nobel laureate, 6 Exchange-traded funds argued in a 2010 online debate hosted by The Economist that most inno- From vanilla to rocky road vation in the run-up to the crisis was not directed at enhancing the 9 High-frequency trading ability of the nancial sector to The fast and the furious perform its social functions. 11 Financial infrastructure Most of these critics have Of plumbing and promises market-based innovation in their sights. There is an enormous 12 Small rms amount of innovation going on On the side of the angels in other areas, such as retail pay- 13 Collateral ments, that has the potential to Safety rst change the way people carry and spend money. But the debate and hence this special reportfo- Glossary cuses mainly on wholesale pro- Finance has a genius for obscuring simple ducts and techniques, both be- ideas with technical jargon. Some of the cause they are less obviously terms used in this special report are useful than retail innovations briefly explained here and because they were more Collateralised-debt obligation: a security heavily implicated in the nan- whose payments flow to investors in order cial crisis: think of those evil cred- of their position in the payment hierarchy. it-default swaps (CDSs), collater- Credit-default swap: a type of insurance alised-debt obligations (CDOs) policy that pays out when an issuer and so on. defaults. This debate sometimes re- Exchange-traded fund: a basket of volves around a simple question: securities that tracks an index and is listed ACKNOWLEDGMENTS is nancial innovation good or bad? But quantifying the benets of inno- on an exchange. High-frequency trading: an ultra-fast As well as the people mentioned in vation is almost impossible. And like most things, it depends. Are credit algorithmic trading strategy. this special report the author would cards bad? Or mortgages? Is nance as a whole? It is true that some instru- like to thank the following for their mentsfor example, highly leveraged onesare inherently more danger- Liquidity swap: a transaction to swap help: Francisco Arcilla, Amar Bhidé, illiquid assets for liquid ones. Mike Bodson, Peter Carroll, Dominic ous than others. But even innovations that are directed to unimpeach- ably good ends often bear substantial resemblances to those that are Longevity swap: a transaction to lay off the Casserley, Leo Civitillo, Guy Cough- risk of unexpected changes in life lan, Onur Erzan, Geert Glas, Will now vilied. expectancy. Goetzmann, Chi Hum, Ross Levine, For a demonstration, look at Peterborough. The cathedral city in Emmanuel Naim, Jim Overdahl, Repo: a (typically) short-term funding Robert Pickel, Craig Pirrong, Michael England’s Cambridgeshire is known for its railway station and an under- transaction in which the borrower sells a Poulos, Andrew Reid, Pretty Sagoo, achieving football club nicknamed the Posh. But it is also the site of a security for cash and agrees to buy it back Nick Shellard, Susan Smith, Conrad nancial experiment that its backers hope will have big ramications for at a later date. Voldstad, David Weild, the sta of the way public services are funded. Social-impact bond: an instrument to the Observatory for Responsible Innovation at the École des Mines de Peterborough is where the proceeds of the world’s rst social-im- finance social programmes that links Paris and a number of people who pact bond are being spent. This instrument is not really a bond at all but investors’ returns to the outcome of wished to remain anonymous. behaves more like equity. In September 2010 an organisation called So- those programmes. cial Finance raised £5m ($7.8m) from 17 investors, both individuals and Swap-data repository: an entity designed A list of sources is at to collect data on derivative transactions Economist.com/specialreports charities. The money is being used to pay for a programme to help pre- vent ex-prisoners in Peterborough from reoending. Reconviction rates and make the information available to An audio interview with regulators. the author is at among the prisoners recruited to the scheme will be measured against a VIX: a measure of the expected volatility Economist.com/audiovideo/ national database of prisoners with a similar prole, and investors will of the S&P 500, known as the “fear index”. specialreports get payouts from the Ministry of Justice if the Peterborough cohort does 1 The Economist February 25th 2012 1 SPECIAL REPORT FINANCIAL INNOVATION 2 better than the rest. If all goes well, the rst payouts will be made in 2013. The scheme is getting lots of attention, and not just in Brit- ain. A mixture of social and nancial returns is central to a bur- geoning asset class known as impact investing. Linking payouts to outcomes is attractive to governments keen to hus- band scarce resources. And if service providers like the people running the Peterborough prisoner-rehabilitation scheme can get a lump sum up front, they can plan ahead without bearing any nancial risk. There is talk of introducing social-impact bonds in Australia, Canada and the United States. Here, surely, is a nancial innovation that even the indus- try’s critics would agree is worth trying. Yet in fundamental ways an ostensibly good instrument like a social-impact bond is not so dierent from its despised cousins. First, at its root the social- impact bond is about creating a set of cashows to suit the needs of the sponsor, the provider and the investor. True, the investors in the Peterborough scheme may be more willing than the aver- age individual or pension fund to sacrice nancial returns for social benets. But as Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken In- stitute, a think-tank, argue in their useful book, Financing the Future, the thread that runs through much wholesale nancial innovation is the creation of new capital structures that align the interests of lots of dierent parties. Second, the social-impact bond is based on the concept of be all that much. risk transfer, in this case from the government to nancial inves- Whether protecting a retirement pot or signalling problems tors who will get paid only if the scheme is successful. Risk trans- with a government’s debt burden, nance can be socially use- fer is also one of the big ideas behind securitisation, the bundling ful (to use a phrase popularised by Adair Turner, the outgoing of the cashows from mortgages and other types of debt on chairman of Britain’s Financial Services Authority) without be- lenders’ books into a single security that can be sold to capital- ing obviously social. Lord Turner himself acknowledged that in markets investors. The credit-default swap is an even simpler a speech he gave in London in 2009: It is in the nature of markets risk-transfer instrument: you pay someone else an insurance that there are some things which are indirectly socially useful premium to take on the risk that a borrower will default. but which in the short term will look to the external world like Third, even at this early stage the social-impact bond is pure speculation. grappling with the diculties of measurement and standardisa- Many people point to interest-rate swaps, which are used to tion. An obvious example is the need to create dened sets of bet on and hedge against future changes in interest rates, as an ex- measurements in order to work out what triggers a payoutin ample of a huge, well-functioning and useful innovation of the this case, the comparison between the Peterborough prisoners modern nancial era. But there are more contentious examples, and a control group of other prisoners in a national database. too. Even the mention of sovereign credit-default swaps, which Across nance, standardisationaround contracts, reporting, oer insurance against a government default, makes many Euro- performance measures and the likeis what enables buyers and peans choke. There are some specic problems with these in- sellers to come together quickly and new markets to take o. struments, particularly when banks sell protection on their own governments: that means a bank will be hit by losses on its hold- Neither angels nor demons ings of domestic government bonds at the same time as it has to For all the similarities, there are two big dierences be- pay out on its CDS contracts. But in general a sovereign CDS has a tween the social-impact bond and other, less lauded nancial in- useful signalling function in an area tilted heavily in favour of struments. The rst is that the new tool has been designed explic- governments (which do not generally have to post collateral and itly for a social purpose. But ask a pensioner how much money can bully domestic buyers into investing).