This blog post continues our expert analysis of complex investments and their regulation.
A new paper from Alp Simsek of MIT makes an argument that financial innovation always increases market risks. (See the WSJ article on the paper here, and the paper here.) Essentially, the argument boils down to this:
- New financial products create new disagreements about valuations and outcomes;
- These products are new and therefore disagreements are bound to be wide;
- New products amplify speculation on existing disagreements;
- They also allow traders to purify their bets (and speculate on more narrow outcomes) or in economic terms, the traders opportunity set has increased;
- When traders are able to make purer bets, they make larger bets
The traditional argument for financial innovation is that it allows for risk sharing, and that those who don't want to take certain risks can trade them to others who want them. This paper is interesting because it shows that aggregate risks are increased by the endogenous introduction of new financial products (by amplifying old disagreements and introducing new disagreements).