How and why we (mis)understand financial innovation

Financial innovation is a ubiquitous concept in today’s discourse on finance and its regulation. Private firms relentlessly market their ‘innovative’ financial products, policymakers profess their commitment to ‘facilitating’ financial innovation, and academics brandish the term as a prized intellectual weapon in arguing for or against various regulatory developments. Yet, we still do not have a clear sense of what exactly ‘financial innovation’ is, whether it means the same thing in different contexts, or why such an elusive phrase wields so much power in the public debate on all things finance. Without understanding what financial innovation is, how can we possibly manage it?

In a forthcoming essay, ‘Financial Innovation: Three Fallacies in the Debate’, I puzzle over, and attempt to explain, our persistent collective inability to make sense of financial innovation as a systemic phenomenon. As a starting point in this deliberative process, I identify three fundamentally false background assumptions—or fallacies—which quietly confuse and misdirect the ongoing public debate on the dynamics and effects of financial innovation.

The first fallacy is an implicit default assumption in much of contemporary financial law and regulation that financial transactions—and, by implication, financial innovation—take place in primary markets, where the counterparties engage in capital-raising for some productive purpose that is exogenous to the financial market. It is difficult to overestimate the importance of this contextual framing, especially since the financial system derives its legitimacy from our collective recognition of its indispensable role in serving the needs of the real (or non-financial) economy. It is not coincidental that so many textbook explanations of financial transactions use examples involving at least one non-financial actor as a principal counterparty: a widget-producing company taking out a bank loan or issuing securities, a farmer or an airline hedging their idiosyncratic physical commodity risks in futures markets, or next-door neighbors Alice and Bob making purchases and money transfers. Repeatedly and inconspicuously highlighting this generalized primary-market logic helps to form an ambient mental construct of the financial market fully attached to, interacting with, and faithfully supporting the real economy and its ordinary inhabitants. It generates a master narrative of the constantly innovating financial market as a presumptively socially beneficial mechanism, an essential enabler of economic growth.

This default contextual assumption, however, is increasingly divorced from reality. Today, by far the greatest volume of financial claims change hands not in primary but in secondary markets that exhibit fundamentally different dynamics. What drives the behavior of modern financial markets is the quest for a greater, more efficient trading of financial instruments among investors, arbitrageurs, dealers, brokers, portfolio managers, and other financial players. Using specific examples, the essay shows that, contrary to the standard narrative, secondary-market trading often determines the terms and volumes of primary issuances of financial claims. That also explains why today’s secondary markets act as the principal sites of both relentless transactional ‘innovation’ and chronic over-generation of systemic risk.

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 can and should be assessed primarily, if not solely, in the context of individual market transactions. If a new financial product or service promises to generate cost savings or other quantifiable efficiencies for individual lenders, borrowers, traders, hedgers, and other transacting counterparties, it is presumed to constitute a bona fide financial innovation. The macro-level benefits and costs of that product or service are generally presumed to follow from these micro-level benefits and costs.

As the essay argues, treating financial innovation as a micro-transactional phenomenon has far-reaching public policy and regulatory implications. It creates an invisible fence around private financial actors’ never-ending quest for more and faster trading, quietly diffusing any attempts to question the social value of innovation in service of that narrow goal. Instead of asking pointed questions about a particular financial technology’s contribution to society’s well-being, policy analysis often gets mired in the technical features of individual innovations. In effect, placing micro-transactional efficiencies at the core of the concept of financial innovation helps to insulate individual innovations from meaningful regulatory scrutiny.   

Finally, the third fallacy analyzed in the essay is a widely shared presumption that financial innovation is a ‘natural’ product of private action in response to private market incentives. Market competition and competition-driven innovation are seen as two sides of the same shiny coin of human progress. The government in this view is not an agent of financial innovation because it lacks private profit motivation and private market knowledge. Its ‘appropriate’ role is accordingly limited to supporting and gently guiding private financial innovation, without ‘stifling’ it through restrictive regulation.  

This erroneous presumption ignores the fact that public entities have long performed critical functions pioneering and supporting markets in innovative financial instruments. Governments generally innovate in response to significant structural problems in financial markets, which cannot be solved through private action alone. This typically happens where private firms cannot overcome collective action problems or bear prohibitively high investment risks, especially if the benefits of such investments are not easily privately captured. From this perspective, public actors’ superior risk-bearing capacity, long investment time horizons, and a naturally macro-level perspective make them uniquely effective agents of transformative change with broadly shared benefits. Persistent failure to recognize this potential is one of the key obstacles to such transformative change.

The essay’s overarching point is that 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, in turn, has dangerous implications for the efficacy and consistency of financial regulation and financial innovation policy. Among other things, the three identified fallacies result in ill-fitting legal or regulatory solutions to specific problems in the financial sector and are often used to justify socially suboptimal deregulatory policies. As the current debates on stablecoins, central bank digital currencies, and other financial technologies illustrate, these unquestioned assumptions can preemptively limit the range of viable options for managing structural shifts and nurturing publicly beneficial innovation in the rapidly changing world of finance. To avoid potentially costly mistakes, we must confront and correct the many hidden errors in our collective thinking on financial innovation.

Saule T Omarova is Beth and Marc Goldberg Professor of Law at Cornell University and Sidley Austin - Robert D. McLean Visiting Professor of Law at Yale University.

The full draft of the essay is available here. It is scheduled for publication in a forthcoming volume, Hidden Fallacies in Corporate Law and Financial Regulation: Reframing the Mainstream Narratives, co-edited by Saule T Omarova, Alexandra Andhov, and Claire A Hill.