Innovations in Financial Products

The worldwide financial industry is a hotbed of innovation in product design. How do new financial products come up? Why do new financial products come up? If we know designs of numerous products which have proved to be extremely useful internationally, can we create all of them in India on a very short horizon? What drives the sequencing through which new products come about?

At the outset, it is easy to tell why new financial products come about: they come about because people in the economy find them useful. If we look at a stream of new products like index funds, index futures, index options, etc., we see a common thread where these products are extremely successful internationally because they fulfil basic economic objectives of people in the economy.

A closely related issue is that of transactions costs. Financial products do not exist in a vacuum; they are created by financial intermediaries who would typically need to hedge away most of the risk generated by having sold the product. For example, few finance companies would be comfortable with selling options on TISCO naked: they would prefer to be hedged by some mechanism (such as owning shares of TISCO, or some dynamic trading strategy). When ICICI sells index warrants, they are exposed to risk unless they hedge that risk away (either by using index futures or by directly investing in all the index stocks). Someone who sells futures on Nifty Junior would find it very useful to hedge himself by buying futures on Nifty, since the two indexes are closely correlated.

All this hedging involves trading, and brings up the problem of liquidity. Suppose the hedging that is required for the creation of product A involves trading on the market for B. It is desirable that the market for B is highly liquid. If the market for B is illiquid (i.e. the hedging involves large transactions costs) then product A will become expensive and less attractive. Here we see the peculiar nature of financial innovation:

  1. As long as the market for B is illiquid, it will be hard for A to come about. The market for B will have to have a minimum level of liquidity, otherwise A will become too expensive and will not succeed.
  2. Once A succeeds, it fuels liquidity of B, because users of A implicitly generate trading in B.
  3. Once A succeeds, other new products can be conjured, on the assumption that A is available.

The economist Robert C. Merton has coined an evocative phrase ``the spiral of innovation'' to describe the dynamic tension of this process:

"As products such as futures, options, swaps and securitised loans become standardised and move from intermediaries to markets, the proliferation of new trading markets in those instruments makes feasible the creation of new custom--designed financial products that improve ``market completeness''; to hedge their exposures on those products, their producers, financial intermediaries, trade in these new markets and volume expands; increased volume reduces the marginal transaction costs and thereby makes possible further implementation of more new products and trading strategies by intermediaries, which in turn leads to still more volume. Success of these trading markets and custom products encourages investment in creating additional markets and products, and so on it goes, spiraling towards the theoretically limiting case of zero marginal transaction costs and dynamically--complete markets."

In India, the best example of these linkages is seen in the relationship between the underlying spot market, index funds, index futures and index options:

  1. The prerequisites for an index fund are (a) program trading facilities and (b) an index where all components are liquid and convenient to trade. These conditions are now fulfilled, and index funds have now come to exist in India.
  2. Once index funds come to exist, they make it possible for people to sell options on the index while being covered (i.e., they would own units of the index fund before selling somebody the right to buy the index). This could happen on exchanges which trade index options or over the counter.
  3. Index futures make the implementation of index funds easier,
  4. Index funds generate an order flow for index futures markets, and help make them more liquid,
  5. Index futures markets enable index options markets,
  6. Access to index futures and index options makes index funds more attractive, since users can couple their investments in index funds with risk management using the futures & options,
  7. Index options make possible innovative new products like ``guaranteed return funds'' (i.e. an index fund bundled with a put option protecting against some level of downside loss) or ``index linked bonds'' (i.e., an instrument which is 95% debenture and 5% invested in call options on the index),
  8. These new products in turn generate order flow for index futures and index options markets,
  9. In all this, a steady stream of arbitrage keeps the spot, futures and options prices in line with each other. As volumes grow, the sophistication of arbitrageurs increases, and prepares them to similarly function on the next phase of development of the market.

This set of products is a perfect illustration of the process that was outlined early in this article. The key ingredients here are new products which are useful to economic agents, a building--block approach towards obtaining low--cost implementation of new products, and a spiral of innovation in which the innovations all reinforce each other.

This perspective, of innovations driving what is traded and influencing the order flow coming to markets, has a significant impact upon the growth of the securities industry. So far, the major driver of change in the securities industry in India has been the pressing problem of reorganising market mechanisms so as to bring down the enormous trading costs which were present. In this, the complexity of instruments, and product development, was just not an issue. Transactions involved onerous costs even if they were as simple as buying 100 shares of TISCO (the costs were brokerage, gala, impact cost, counterparty risk, backoffice cost and bad paper risk). These costs were so high that the first problem which stared in the face of the securities industry was to find ways to reduce them; in addition, these high transactions costs also served to make more complex instruments and trading strategies infeasible.

Today in India, the enormous transformation of markets has given us new market practises in trading, clearing, and settlement. This collapse of transaction costs is a very significant achievement. We are now close to having an Indian securities industry where normal market practise in trading, clearing and settlement are equal to the best practises in the world, and superior to those found in many OECD countries.

As we approach the end of this phase of development in the securities industry, the question arises about what lies next. If our objectives in trading were limited to trading TISCO, then there is no frontier that lies beyond a world with electronic trading, clearing corporation and depository.

In order to understand the energy and dynamism of the worldwide securities industry, we have to take a bigger view of trading. Here the universe of financial instruments and trading strategies is not static. Instead, financial instruments are crafted to solve problems for real people while being constrained to be implementable in the light of existing levels of transactions costs. In such an approach, we would have a steady stream of innovations which make up a spiral of innovation. In this spiral, each step is implementable, each step strengthens liquidity in other instruments in the economy, and each step paves the way for further innovations that follow it.

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