Instrument NOUN
1. A tool or implement, especially one for precision work: ‘a surgical instrument’ ‘instruments of torture’ ‘writing instruments’
2. A measuring device used to gauge the level, position, speed, etc. of something, especially a motor vehicle or aircraft: ‘a new instrument for measuring ozone levels’ ‘myriad instruments and switches’
4. A means of pursuing an aim: ‘the failure of education as an instrument of social reform’”
— Oxford English Dictionary
In Week 9 of “Financial Innovation,” we turned attention to new financial products and instruments. As the dictionary suggests, “instrument” means rather many things: tool for precision work, measuring device, and means to an end. Our readings and discussions this week suggest the relevance of all three meanings to an understanding of new financial products and instruments.
Products or instruments are claims. I give you my money; in return, you give me a claim on some future performance. For instance, I lend you my money; in return, you give me a debt agreement in which you promise to pay interest and repay my loan on some schedule. Another for instance, I pay my monthly fire/auto insurance premiums and get a claim in which you promise to replace my destroyed property in event of disaster—disaster insurance is basically a put option. For yet another instance, I invest in the common stock of your highly-levered company and look forward to uncertain dividends and capital gain when I sell the stock sometime in the future—and I get to vote in the election of directors and in other matters that come before the shareholders’ meeting. What is all too easily lost in fancy analysis is the basic quid pro quo (Latin for “this for that”). The basic question to ask in studying any new financial product or instrument is, “What are the gives and gets here?”
Valuation: Cash is King. To value a claim (i.e., a new financial product or instrument), you must lay out the cash “gives and gets” over time, and discount them back to the present at a rate consistent with the risk of those cash flows. Every simple and/or sophisticated model in financial economics is some variation on this approach.
Design of new products and instruments is a marketing problem. Breakthrough research in marketing over the past 50 years affirms that consumers are willing to pay more for products that have trusted brands and features that address their unique needs. Thus it is with financial instruments and products. We can suppose that the issuer of a new financial product or instrument has clarity about its own requirements; but to find the needs of the investor is a discovery process. To aim to discover new unmet needs in the market implies that markets can be incomplete. Today, virtually all products and instruments are customized to some extent. They might exploit special “windows of opportunity” caused by market volatility, regulatory change, and technological change. They might serve special needs of the issuer such as speed to market, confidentiality (through bank loans or private placements),
What constitutes “success” of an instrument? We have not delved very deeply into the attributes of success or failure in financial innovation, though some interesting discussion along these lines developed in class this week. Also, the article by Mark Flood offered some insights. Flood compared the success of market index funds to the failure of Canadian coin futures. The latter was redundant and offered no special advantages of holding claims on bullion. Therefore, trading in the futures stagnated and halted. But redundancy might also apply to market index funds, since any consumer can construct his or her own portfolio of the market. However, the exception in that case is that index funds can achieve the benefit for consumers at lower cost (time and money) and greater convenience than doing it oneself.
From the standpoint of an issuer of a new product or instrument, success can be defined in terms that are internal and external to the developer of the new claims. From an “internal” standpoint, success depends on the fit between the claims offered and the firm’s ability to service those claims. Also the new instrument might help to resolve an inefficiency about the value of the firm—the use of Structured Investment Vehicles is an effort to let the market value specific assets in a firm, thereby resolving an inefficiency. And of course, the issuer will deem that success depends on the money raised, on the sales volume for the instrument, the price, and on “reputation”—reputation embodies a range of considerations consistent with the issuer’s mission, values, and sensitivity to social impact.
From the standpoint of the investor, success depends significantly on price and quality, where price is framed by the investor’s appetite for risk and return, and where quality is framed by performance against a host of expectations. In the case of the market index fund, convenience proved to be an overriding aspect of quality.
Finally, there is a third dimension of evaluating success that should matter to us: social welfare. Innovations can spawn positive and negative externalities. For instance, innovations could be used either to promote or reduce crime. Tax evasion and fraud have been abetted by bearer bonds and secret off-shore bank accounts. Complexity in the design of instruments may help to transfer value from unwitting or unsophisticated market participants. On the other hand, innovations could promote greater transparency, accountability, and speed of transactions (e.g. blockchain technology). Measuring the social welfare impact of an innovation may be difficult, but nonetheless belongs in the mindset of decision-makers in the public and private sectors.
Trend #1: Plain è Complex. Over time, claims have grown more elaborate, from “off the rack,” one-size-fits-all to highly-tailored. In this course, we have seen examples of the transformation of instruments in various ways:
· Mortgages: Before the 1930s, house purchases were typically financed with five-year balloon payment loans. After that, the 30-year self-amortizing mortgage became the standard. The Federal Housing Administration had intervened in the mortgage market to lower the risk of financial panics by mandating longer terms and avoidance of balloon payments.
· Government bonds: The article by Niall Ferguson highlighted the development of the government bond market in Europe. Up through the mid-18th Century, a government typically would borrow from bankers and in its own currency. With the Napoleonic Wars, it became necessary for governments to finance themselves more broadly, thus creating a public debt market. As wars, depressions, and other calamities came and went, governments sought to finance themselves even more broadly, from investors outside national borders and in currencies other than home. Thus emerged the Eurobond market. And as inflation ate away at the wealth of bondholders, governments issued income-protected bonds. The reading by Robert Shiller described the innovation of government bonds indexed to a basket of commodities in post-Revolution America. Then the innovation lay dormant for two centuries until high inflation reappeared. In 1997 the U.S. Treasury auctioned $7 billion in 10-year Treasury Income-Protection Securities. By 2010, some $550 billion in TIPS were outstanding. ((See Fleckenstein, Longstaff, and Lustig, at https://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/Fleckenstein_Longstaff_Lustig.pdf.))
· Corporate bonds: Up to the late 19th Century, firms typically borrowed from bankers. But to finance large capital-intensive projects, such as railroads, canals, and public utilities, companies turned to bond underwriters, such as J.P. Morgan, to sell bonds to the public—typically, these were payable in gold and in the home currency. After World War II, the advent of large dollar balances overseas prompted U.S. firms to issue Eurobonds denominated in dollars and many other currencies. To finance rapidly-growing firms, issuers offered investors convertible bonds that could be exchanged for the firm’s common stock at a fixed price.
· Equity financing: Until the late 19th Century, corporate ownership came in one flavor: common stock. Then in the wake of a wave of bankruptcies, railroads began issuing preferred stock to give risk-averse investors priority over common stockholders in the event of liquidation in bankruptcy. Then, to promote investment in capital-intensive industries (such as public utilities), the government permitted cash-rich corporations to exclude 85% of dividends if they invested spare cash in other corporations (this increased the appetite of corporations and institutions to invest in preferred stock).
Tailoring typically starts with a “plain vanilla” security and adapts it to the interests of issuer, investor, or both. Here are some dimensions that tailoring might take:
1. Schedule of payments: Today, many loans amortize equally over time. But income bonds pay interest and principal only if the issuer has cash available to make the payments. If not, default is not triggered. Some extendible bonds carry the right to extend the amortization schedule. Other structures such as balloon-payment zero coupon bonds require no principal payments until the final date.
2. Basis: Interest on debts and preferred stock dividends can be a rates that are fixed or floating. Floating rate issues, issues whose rates are indexed to some external benchmark, and adjustable-rate preferred stocks are attractive to investors who fear rising inflation rates.
3. What is paid: Some bonds issued by highly-levered firms “pay in kind” (i.e., in more bonds) until the firm earns enough money to pay in cash. Some unusual bond issues have paid in a commodity instead of cash or were redeemable in cash at a value indexed to a commodity: in 1973, the government of France issued a bond with a redemption value indexed to the price of gold, and the Confederacy issued bonds payable in cotton. Some issuers offered their investors “dividends” paid in tickets, discounts at retail outlets, and consumer goods. From time to time, banks lured depositors with a free toaster or other kitchen appliance to open an account.
4. Security: Equity has a claim on the residual value of the company, after the claims of liabilities are honored. Secured debt has a specific claim, typically on land and buildings (as in mortgages) or on inventories and receivables (as in working capital loans). Some loans are unsecured, and rely on the “full faith and credit” of the issuer. Subordination of a claim in the event of liquidation is typically accompanied by a higher interest rate. Security is enhanced through the use of sinking fund provisions that require the issuer to make periodic payments into a legally-protected fund in advance of principal payments—typically, sinking fund provisions are associated with lower interest rates to investors.
5. Currency of payment: Issuers in emerging economies find it difficult to issue securities payable in their home currencies and therefore issue in U.S. dollars or currencies of other developed economies—the massive Eurobond market is a testament to the willingness of issuers to tinker with currency of payment. Dual currency bonds pay interest in one currency and principal in another.
6. Options: Most securities are riddled with contingent commitments. The right to convert the bond into equity or another kind of security, or to exchange common stock into bonds represent call options. In the event of a change-of-control transaction, some bonds permit the holder to put the claim back to the company for full repayment, regardless of the amortization schedule. Provisions that either permit the early redemption of a bond issue or prohibit it are hugely significant to institutional investors. “Drop-lock” options shift the interest rate on a bond from floating to fixed if market rates fall to a particular level: these anticipate interest-rate declines. In class, and in a presentation by Dr. Hamilton Moses, we discussed catastrophe bonds—these impound options for payoffs that trigger in the event of an epidemic or other disaster.
7. Control features: In any financial instrument, the issuer will have made choices about subtle control trade-offs, including who might exercise control (for example, creditors, existing shareholders, new shareholders, or a raider) and the control trigger (for example, default on a loan covenant, passing a preferred stock dividend, or a shareholder vote). How management structures control triggers (for example, the tightness of loan covenants) or forestalls discipline (perhaps through the adoption of poison pills and other takeover defenses) can reveal insights into management’s fears and expectations. Clues about external control choices may be found in credit covenants, collateral pledges, the terms of preferred shares, the profile of the firm’s equity holders, the voting rights of common stock, corporate bylaws, and antitakeover defenses.
The implication of the trend toward tailoring is that the design of most instruments today is bespoke. Therefore, it is best not to make too many assumptions about the intent of the counterparty. Read the fine print!
Trend #2: Mediated è Direct-to-market. The article on consumer finance by Ryan, Trumbull, and Tufano showed that consumers have gained greater access to the financial system over time. But with this greater access came greater risk to the consumer, through the elimination of buffers of volatility. “Do-it-yourself” finance carries rewards (e.g. lower cost) but also possibly higher risk. Through the late 20th Century, it was true (and to some extent still is) that a person, firm, for government seeking to issue claims would need the assistance of an underwriter, advisor, or intermediary. This reflected the need for specialized skill of investment banks as well as the advantages of network economics that they could exploit. And it also grew out of the wave of securities regulation that began in the 1930s, in the effort to prevent fraud in the market. But in the late 20th Century, issuers began to go more directly to the capital markets. This has been reflected in several smaller trends:
· Corporate finance: However, since the 1980s, large firms have tended to internalize the advisory function, relying on investment banks for distribution and certification of claims through opinion letters. Capital-intensive firms raised funds directly from investors through dividend-reinvestment programs. And some firms offered sales of stock directly to customers through direct stock purchase plans. Smaller firms work directly with venture capitalists or through crowdfunding processes to raise money. In 2012, Congress passed the Jumpstart Our Business Startups Act, which eased various securities regulation and made it possible for younger companies to offer securities without the benefit of an intermediary.
· Consumer savings: Until 1977, consumers deposited their savings into banks and trust companies. But with the wave of inflation of the late 1970s, and Regulation Q that prevented interest payment at rates greater than 5%, consumers were motivated to place their funds elsewhere. Into the breach stepped The Reserve Fund, founded in 1971, which allowed investors to earn a return on short-term and liquid debt securities and also enjoy check-writing ability on their investment—this was a direct competitor to bank checking accounts. Merrill Lynch actually patented its design for the Cash Management Account—Fortune magazine said the CMA was “the most important innovation in years.” ((“Merrill Lynch Quacks Like a Bank”, Fortune, October 20, 1980.)) Since then, money market funds have proliferated to almost 700, representing over $2.7 trillion in assets under management in 2011.
· Investment management: Investors have always had the ability to place funds directly in the markets. But to do that well required the advice and management by experts. Then, research found that about 80% of active managers failed to beat the market each year. And modern portfolio theory advised investors to hold passive, well-diversified investments—this led to the invention of the index fund by Jack Bogle in 1975. In 2005, exchange-traded funds debuted. Both innovations entailed direct-to-market investing. The application of artificial intelligence and algorithmic trading are likely to reduce the intermediation of investment advisors—we looked at online advisors such as Betterment and other firms.
Trend #3: static è cyclical rates of innovation. From the end of World War II to 1971, financial instrument design seemed to adhere to standard models such as fixed-rate secured debt with few “bells and whistles.” Then, profound changes in financial markets (such as new technology, globalization, floating currencies, deregulation, etc.) seemed to unleash a new dynamic in which capital market conditions exert a major influence on innovation in financial instruments. Market sentiment oscillates between depressed and manic, as researchers in behavioral finance reveal. In “cold” market conditions, instruments that are standard and “plain vanilla” seem to appeal to issuers and investors. In “hot market” conditions, the more complex and unusual instrument designs emerge.
“Hot markets,” like bubbles, are frequently defined in retrospect rather than while they are happening. Examples would be the Reagan stock market of the 1980s, the equity market for technology issues in 1998-2000, the housing market in the mid-2000s, and perhaps today. Hot markets are not equal to capital market bubbles, though they share some characteristics: high prices, high trading volumes, and “new era” thinking.
The relationship between market conditions and financial innovation warrants research. Therefore, I can only offer a hypothesis based on my observations over the past few decades that the amplitude of the cycle has increased: as markets swing over time from hot to cold to hot again, the swing from “plain vanilla” to exotic designs has increased.
What’s going on here? We have seen the drivers of financial innovation at other points in this course—the familiar list is applicable here as well. A powerful motive is profit-seeking through completing a market—money market funds, index funds, exchange-traded funds, high-yield bonds, and Eurobonds would be examples. The issuance of new instruments can also profit from exploiting market inefficiencies and cognitive biases. Risk management is another important driver, exemplified by virtually any instrument that embeds an option, such as variable rate insurance policies, convertible bonds, and income-contingent student loans. Finally, innovation in new instruments can assist in the legal avoidance of taxes and in regulatory arbitrage. In addition to other examples in this post, consider the following cases, drawn from the hot market of the 1980s:
· In 1988, Prudential Insurance issued the first-ever “death backed bonds”—bonds backed by loans to life insurance policy holders. Demand was so strong that the size of the issue was doubled from $220 million to $445 million. In essence, Prudential securitized and sold its portfolio of loans to policy holders. The loans are repaid out of the proceeds of a life insurance policy issued by Prudential, making the risk of default very low. It may be attractive for firms to splif-off specific assets if they believe that market inefficiency causes the firm to be undervalued: through the split-off, particular assets can be valued independently and the inefficiency eliminated. An executive said that the loans are illiquid; “There’s not a lot you can do with them…there’s a lot you can do with a big lump of cash”—liquidating this portfolio was “changing lead into gold.”
· In 1984, the Student Loan Marketing Association (“Sallie Mae”) issued $5 billion in 38-year zero-coupon notes. The notes were sold mainly in Japan, where implicit interest was not taxed. Nor were capital gains on bonds taxed at maturity. Because of the great demand, the issue was priced at a premium, and yielded a lower return than 30-year U.S. Treasury bonds. This issue completed the market.
· In 1984, Salomon Brothers created Certificates of Accrual on Treasury Securities (CATS), in which they purchased a portfolio of U.S. government bonds, and stripped out claims only on their interest and principal payments, and issued the claims in bearer form (i.e., with no identification for taxation) in Europe. Europeans paid a premium for the CATS, viewing them as risk-free securities with the added advantage of privacy. In addition to completing the market, this issue seemed to enable the avoidance of taxes (some European governments claimed it promoted tax evasion).
· In 1985, Chubb Corporation issued $150 million of Convertible Exchangeable Preferred Stock. These securities could be converted at the investor’s discretion into Chubb’s common stock, or exchanged at Chubb’s discretion into convertible subordinated debentures. Chubb was losing money and could not take advantage of the tax advantage of interest payments, therefore, it did not issue the debentures directly. And if Chubb’s performance continued to deteriorate, it wanted the option to force the exchange of the preferred stock into common stock. Investors were attracted by a relatively high dividend yield and by the prospect of a turnaround in Chubb’s performance. This is an example of tailoring for risk management.
Thinking critically. One point of view is that much of the tailoring in the innovation of new financial products and instruments that one observes is frivolous or rent-seeking (pocket-picking). This view holds that innovation in the design of financial instruments is a market-discovery process and that issuers will seek to design products to extract the highest price from investors, regardless of their need for the innovative feature.
· Complexity makes it difficult to understand the “gives and gets” of a new financial product or instrument. The Consumer Financial Protection Bureau is pursuing the payday loan industry for greater transparency and simplicity in its presentation of costs to the consumer.
· Information asymmetry creates the “lemons problem” of the kind that threatens buyers of used cars. The issuer of a financial instrument knows more about the risks of that instrument than does the buyer. This asymmetry stokes adverse selection, in which buyers are willing to offer only low prices and are unwilling to pay more for genuinely good used cars. Credit rating agencies, securities analysts, financial journalists, and expert financial advisors reduce (but don’t eliminate) the asymmetry.
· Cognitive biases and emotion can steer an investor away from a rational decision. Knowing this, issuers (or their representatives) can exploit the investor’s weaknesses. High-pressure sales operations (see the “boiler room” in the movie, Wolf of Wall Street) exploit the fear of missing out (FOMO) and urge the investor to act now to “get in on the ground floor!” Bernie Madoff created the largest Ponzi scam in history by appealing to affinity (people he knew in religious, cultural, and community organizations). Walt Disney Company sells “Disney Dollars,” legal tender for purchases at its theme parks and found that these are rarely converted back into local government currency; Disney also sold shares of stock with the familiar animated characters gracing the certificates—in both cases, consumers with children rarely cashed them in and instead held them as mementoes.
Questions for innovators in new financial products and instruments:
The Oxford English Dictionary says that an instrument is a tool for precision work, a measuring device, and/or a means of pursuing an aim. Owing to their complexities, some instruments are extraordinarily precise tools. And to the extent that financial instruments resolve market inefficiency or incompleteness, they serve as measuring devices for value. And certainly, many (if not most) issuers and investors would transact in new financial products and instruments to pursue overarching goals. These attributes raise some considerations for the financial entrepreneur:
1. What is the problem that this new product or instrument solves? How does it solve this problem better than the older products or instruments? From what one sees happening in the fintech world, the benchmark of comparison should not only be the incumbent processes, but rather, the best new processes available in the markets.
2. Toward which segment of the market are you targeting these instruments? Many instruments are aimed to complete market demand. Is the targeted segment deep enough to warrant the effort?
3. How do the novelties within this new instrument affect their cost and benefit? For instance, flexibility is always costly to issuers to provide it, and always beneficial to the investors—in such a case, how would the flexibility affect the cost to the issuer and the return to the investor?
4. Can you estimate the risk associated with the new product or instrument? The complexities of new instruments may prevent a rigorous assessment of risk. Dr. Moses asserted that the risk associated with the World Bank’s pandemic bonds could not be estimated by any actuarial method.
5. Does the new instrument create value? If so, for whom?