and innovation.3 This literature attempts to establish conditions under which innovation would occur in equilibrium.In summarizing a wide range of the literature they conclude: At this early stage,while there are several results providing conditions for the existence of equilibrium with innovation,the available theory has relatively few normative or predictive results.From a spanning point of view,we can guess that there are incentives to set up markets for securities for which there are no close substitutes,and which may be used to hedge substantive risks. This theoretical proposition is consistent with evidence of the pattern of innovation in exchange-traded contracts documented by Black(1986).She shows a relationship between a new contract's viability(measured by its trading volume)and its ability to complete markets(measured by its lack of correlation with large but uninsurable risks.)Grinblatt and Longstaff(2000)study a different innovation(Treasury STRIPS or zero-coupon bonds).They find that investors create new STRIPS primarily to make markets more complete,a conclusion drawn from the observation that STRIPS are created when it would be most difficult to synthesize the discount bonds from existing coupon instruments. Allen and Gale(1988)consider a particular form of market incompleteness-in the form of short sales restrictions-as motivation for innovation by parties seeking to share risk.They show it may be optimal for firms to offer multiple classes of claims ("breaking the firm into pieces")generating value from different investor preferences and needs(selling the pieces to the clientele that values it most.") Cloaked in less academic language,the idea that innovation typically address the unmet preferences or needs of particular clienteles is reasonably well discussed in business practice.For example,one popular book describing the derivatives activities at 12 Portions of this section are drawn from Tufano(1992). 11
11 and innovation.13 This literature attempts to establish conditions under which innovation would occur in equilibrium. In summarizing a wide range of the literature they conclude: At this early stage, while there are several results providing conditions for the existence of equilibrium with innovation, the available theory has relatively few normative or predictive results. From a spanning point of view, we can guess that there are incentives to set up markets for securities for which there are no close substitutes, and which may be used to hedge substantive risks. This theoretical proposition is consistent with evidence of the pattern of innovation in exchange-traded contracts documented by Black (1986). She shows a relationship between a new contract’s viability (measured by its trading volume) and its ability to complete markets (measured by its lack of correlation with large but uninsurable risks.) Grinblatt and Longstaff (2000) study a different innovation (Treasury STRIPS or zero-coupon bonds). They find that investors create new STRIPS primarily to make markets more complete, a conclusion drawn from the observation that STRIPS are created when it would be most difficult to synthesize the discount bonds from existing coupon instruments. Allen and Gale (1988) consider a particular form of market incompleteness—in the form of short sales restrictions—as motivation for innovation by parties seeking to share risk. They show it may be optimal for firms to offer multiple classes of claims (“breaking the firm into pieces”) generating value from different investor preferences and needs (“selling the pieces to the clientele that values it most.”) Cloaked in less academic language, the idea that innovation typically address the unmet preferences or needs of particular clienteles is reasonably well discussed in business practice. For example, one popular book describing the derivatives activities at 12 Portions of this section are drawn from Tufano (1992)
a major bank (Partnoy (1997))provides details on relatively uncommon products designed for a small number of institutional investors. (2)Innovation persists to address inherent agency concerns and information asymmetries:Much of contracting theory (or the security design literature)explores how contracts can be written to better align the interests of different parties or to force the revelation of private information by managers.This extensive literature has been surveyed by Harris and Raviv(1989),and is also covered in Allen and Gale(1994,pp. 140-147).Persistent conflicts of interest between outside capital providers and self- interested managers,and asymmetric information between informed insiders and uniformed outsiders,leads to equilibria in which firms issue a multiplicity of securities. Most of this work deals with innovation in a fairly limited sense,explaining the existence of a few contracts like debt or equity,not scores of different types of corporate securities. However,Haugen and Senbett (1981)argue that incorporating embedded options into securities can mitigate moral hazard problems.This motive for innovation can possibly explain the embedded options in some innovative R&D financings(for a case study of these innovations,see Lerner and Tufano(1993)4and for an empirical analysis see Beatty,Berger and Magliolo(1995)).In these structures,an R&D financing organization is set up with separate shareholders from the "parent,"which retains all decision rights to the day-to-day activities of this separate organization.Attaching warrants exerciseable into the stock of the "parent"of the R&D financing vehicles partially ameliorates the inherent conflicts of interest. Duffie and Rahi(1995)'s survey describes a unified modeling framework to study the impact of innovation on risk-sharing and information aggregation. 4This case study and others mentioned here are also in Mason,Merton,Perold and Tufano(1995) 12
12 a major bank (Partnoy (1997)) provides details on relatively uncommon products designed for a small number of institutional investors. (2) Innovation persists to address inherent agency concerns and information asymmetries: Much of contracting theory (or the security design literature) explores how contracts can be written to better align the interests of different parties or to force the revelation of private information by managers. This extensive literature has been surveyed by Harris and Raviv (1989), and is also covered in Allen and Gale (1994, pp. 140-147). Persistent conflicts of interest between outside capital providers and selfinterested managers, and asymmetric information between informed insiders and uniformed outsiders, leads to equilibria in which firms issue a multiplicity of securities. Most of this work deals with innovation in a fairly limited sense, explaining the existence of a few contracts like debt or equity, not scores of different types of corporate securities. However, Haugen and Senbett (1981) argue that incorporating embedded options into securities can mitigate moral hazard problems. This motive for innovation can possibly explain the embedded options in some innovative R&D financings (for a case study of these innovations, see Lerner and Tufano (1993) 14 and for an empirical analysis see Beatty, Berger and Magliolo (1995)). In these structures, an R&D financing organization is set up with separate shareholders from the “parent,” which retains all decision rights to the day-to-day activities of this separate organization. Attaching warrants exerciseable into the stock of the “parent” of the R&D financing vehicles partially ameliorates the inherent conflicts of interest. 13 Duffie and Rahi (1995)’s survey describes a unified modeling framework to study the impact of innovation on risk-sharing and information aggregation. 14 This case study and others mentioned here are also in Mason, Merton, Perold and Tufano (1995)
Ross(1989)invokes agency issues to explains some financial innovations.He notes that agency considerations make borrowing costly or limited and,as a result, individuals contract with opaque financial institutions.When a shock(such as a change in taxes or regulation)occurs,financial intermediaries may find it efficient to sell off low-grade assets.Because outside investors cannot easily assess the value of these assets,the institutions turn to investment banks to place these securities with their network of clients.These investment banks innovate,creating new pools of these low- grade assets.Agency considerations interact with marketing costs to produce innovation. Throughout history,information asymmetries have prompted a number of innovations.Throughout much of the nineteenth and early twentieth century,firms disclosed very little credible financial information.Over time,market forces and governmental action materially increased the quantity and quality-and thus lowered the cost-of information about firms.Early innovations tended to substitute for(or economize on)the use of costly information,while later innovations capitalized on its lower cost.One of the earliest innovations,the nineteenth century practice of issuing assessable stock,provided some mechanisms to squeeze information from firms.An assessable share-holder committed to supply a certain amount of money to the firm,but doled out the cash to the firm in response to regular assessments.(Dewing (1919).Issuers of assessable common stock were forced to return to their investors regularly and make the case for continued commitment,because each investor held the option to fail to make the assessment and forfeit his interest.The nineteenth century firms'almost complete reliance on secured debt for debt financing(see Ripley cited in Baskin(1988,pp. 13
13 Ross (1989) invokes agency issues to explains some financial innovations. He notes that agency considerations make borrowing costly or limited and, as a result, individuals contract with opaque financial institutions. When a shock (such as a change in taxes or regulation) occurs, financial intermediaries may find it efficient to sell off low-grade assets. Because outside investors cannot easily assess the value of these assets, the institutions turn to investment banks to place these securities with their network of clients. These investment banks innovate, creating new pools of these lowgrade assets. Agency considerations interact with marketing costs to produce innovation. Throughout history, information asymmetries have prompted a number of innovations. Throughout much of the nineteenth and early twentieth century, firms disclosed very little credible financial information. Over time, market forces and governmental action materially increased the quantity and quality—and thus lowered the cost—of information about firms. Early innovations tended to substitute for (or economize on) the use of costly information, while later innovations capitalized on its lower cost. One of the earliest innovations, the nineteenth century practice of issuing assessable stock, provided some mechanisms to squeeze information from firms. An assessable share-holder committed to supply a certain amount of money to the firm, but doled out the cash to the firm in response to regular assessments. (Dewing (1919). Issuers of assessable common stock were forced to return to their investors regularly and make the case for continued commitment, because each investor held the option to fail to make the assessment and forfeit his interest. The nineteenth century firms' almost complete reliance on secured debt for debt financing (see Ripley cited in Baskin (1988, pp
215-216))may also be interpreted as a costly contracting choice that substituted for more precise monitoring prevented by inadequate disclosure. Later nineteenth century innovations took advantage of the presence of cheaper and more reliable information.Later preferred stocks conditioned their holders'voting rights on firms'failure to comply with covenant terms (Johnson(1925)and Wilson (1930),both cited in Dewing(1934)).These covenants,especially after 1900,were more likely to be tied to financial ratios,as were bond covenants keyed to working capital tests or asset maintenance tests(Dewing(1934)).Finally,income bonds,popularized in the late nineteenth century,were completely linked to the availability of accounting information.These unsecured obligations required issuers to pay interest only if the firm earned positive accounting profits in the current period.This early history shows how innovations were a response to information asymmetries.Certain innovations forced the revelation of information and others exploited the low cost information generated through other processes. (3)Innovation exists so parties can minimize transaction,search or marketing costs. Merton(1989)discusses how the presence of transaction costs provides a critical role for financial intermediaries.Financial intermediaries permit households facing transaction costs to achieve their optimal consumption-investment program.Merton uses this argument to explain how equity swaps can be an efficient way to deliver returns to multinational investors.A similar explanation is invoked by McConnell and Schwartz (1992)who provide a clinical study of one particular innovation,LYONS (liquid yield option notes).Lee Cole,the Options Marketing Manager at Merrill Lynch noticed that retail investors tended to place most of their money in low-risk securities and then buy a 14
14 215-216)) may also be interpreted as a costly contracting choice that substituted for more precise monitoring prevented by inadequate disclosure. Later nineteenth century innovations took advantage of the presence of cheaper and more reliable information. Later preferred stocks conditioned their holders' voting rights on firms' failure to comply with covenant terms (Johnson (1925) and Wilson (1930), both cited in Dewing (1934)). These covenants, especially after 1900, were more likely to be tied to financial ratios, as were bond covenants keyed to working capital tests or asset maintenance tests (Dewing (1934)). Finally, income bonds, popularized in the late nineteenth century, were completely linked to the availability of accounting information. These unsecured obligations required issuers to pay interest only if the firm earned positive accounting profits in the current period. This early history shows how innovations were a response to information asymmetries. Certain innovations forced the revelation of information and others exploited the low cost information generated through other processes. (3) Innovation exists so parties can minimize transaction, search or marketing costs. Merton (1989) discusses how the presence of transaction costs provides a critical role for financial intermediaries. Financial intermediaries permit households facing transaction costs to achieve their optimal consumption-investment program. Merton uses this argument to explain how equity swaps can be an efficient way to deliver returns to multinational investors. A similar explanation is invoked by McConnell and Schwartz (1992) who provide a clinical study of one particular innovation, LYONS (liquid yield option notes). Lee Cole, the Options Marketing Manager at Merrill Lynch noticed that retail investors tended to place most of their money in low-risk securities and then buy a
series of call options.Merrill Lynch's LYONs allowed investors to replicate this payoff without having to incur the commission costs of rolling over their call option positions at least four times a year. Many of the process innovations in payment systems technologies are aimed at lowering transaction costs.ATMs,smart cards,ACH technologies,e-401k programs and many other new businesses are legitimate financial innovations that seek to dramatically lower the sheer costs of processing transactions.By some estimates,these innovations have the potential to lower the cost of transacting by a factor of over 100. For example,by one estimate,a teller-assisted transaction costs over $1.00 and the same transaction executed over the Internet would cost about $0.01.15 New businesses like Instinet,Open-IPO,Enron OnLine,Ebay,or the host of B- to-B exchanges are innovations that aimed at lowering the transaction costs faced by buyers and sellers.These transaction costs are search or marketing costs,which can include a variety of components-the sheer costs of identifying buyers and seller, information costs,and transaction costs of order processing.Ross's(1989)analysis of securitization keys off the expensive process of marketing in conjunction with agency considerations.Madan and Soubra(1991)examine how financial intermediaries attempt to maximize their revenues net of marketing costs,which leads them to design multiple products that appeal to wider sets of investors. History shows that as marketing costs fall,financial innovations exploit the easier access to buyers and sellers of securities.For example,during World War I,the U.S government instituted a massive program to fund its war-time efforts through selling i5 The Economist,Online Finance Survey,"May 20,2000.Page 20 15
15 series of call options. Merrill Lynch’s LYONs allowed investors to replicate this payoff without having to incur the commission costs of rolling over their call option positions at least four times a year. Many of the process innovations in payment systems technologies are aimed at lowering transaction costs. ATMs, smart cards, ACH technologies, e-401k programs and many other new businesses are legitimate financial innovations that seek to dramatically lower the sheer costs of processing transactions. By some estimates, these innovations have the potential to lower the cost of transacting by a factor of over 100. For example, by one estimate, a teller-assisted transaction costs over $1.00 and the same transaction executed over the Internet would cost about $0.01.15 New businesses like Instinet, Open-IPO, Enron OnLine, Ebay, or the host of Bto-B exchanges are innovations that aimed at lowering the transaction costs faced by buyers and sellers. These transaction costs are search or marketing costs, which can include a variety of components—the sheer costs of identifying buyers and seller, information costs, and transaction costs of order processing. Ross’s (1989) analysis of securitization keys off the expensive process of marketing in conjunction with agency considerations. Madan and Soubra (1991) examine how financial intermediaries attempt to maximize their revenues net of marketing costs, which leads them to design multiple products that appeal to wider sets of investors. History shows that as marketing costs fall, financial innovations exploit the easier access to buyers and sellers of securities. For example, during World War I, the U.S. government instituted a massive program to fund its war-time efforts through selling 15 The Economist, “Online Finance Survey,” May 20, 2000. Page 20