Gillian Tett had an excellent article in the FT this weekend on innovation in the derivatives markets: I highly recommend you read it. She gets some great quotes:
“It’s a strange business,” admits one senior banker. “First you make money by creating products no one understands, then you make money by cleaning the mess up.”
Her insights are powerful, too. For instance,why is it that most of the innovation in derivatives took place on the interest-rate side in the early 1990s, but on the credit side more recently? After all, both were ways of trying to squeeze out extra yield in a falling-interest-rate environment. The answer is what Tett calls "the innovation cycle":
Swaps had started life as a high-margin business, but by the early 1990s they had been copied so widely that they had turned into a mass-market product. Almost as soon as the derivatives scandals had died down, bankers started the hunt for the next big thing.
And what’s the driving force behind the innvoation cycle? The lack of patent protection.
There is a bitter irony that stalks the modern investment banking world: while many financial institutions exude vast power, they are highly vulnerable because it is so hard to patent their ideas. Thus, whenever a new product is invented, it tends to be copied quickly. That means that although new instruments – such as interest-rate swaps – typically start out as high-margin, bespoke products, they soon become low-margin, ubiquitous products. The only way that a bank can beat its competitors – other than having more capital or financial muscle – is to be much more creative.
Finance in general, in other words, and the derivatives market in particular, is that rarest of industries: one which is (a) based on intellectual property and (b) which has no real patent or copyright protection. And despite that, it thrives.
I do wonder how this happened. Given the ease with which companies in all other industries seem to be able to churn out thousands of patents a year, why has that never happened in finance? Is it just an accident of history, one which happens to have turned out quite well?