The nature of financial innovation

Paul Nightingale, Taylor Spears
Work package: 
WP 8
Publication number: 
01 May 2010

Abstract: This discussion paper explores the fundamental structure of financial innovation and how it influences the social distribution of risks and rewards. It uses a novel evolutionary framework that highlights how innovation in financial services differs fundamentally from traditional technologies where the intrinsic physical features of the technology in question largely determine its function. With financial technologies external collective acceptance, rather than intrinsic physics, determines function. This severely constrains the extent to which financial technology can be decomposed into component parts and reliably engineered. As a result, financial technologies are subject to repeated catastrophic failure. The analysis explores the influence of infrastructure, regulation and industrial structure on innovation trajectories and concludes with a discussion of risk management and the roles of regulation that highlights how traditional regulatory approaches such as mandating replication of best practice risk management, are likely to be inappropriate and may be dangerously counterproductive.