Toward a supply-side theory of financial innovation

Innovation. The word is evocative of ideas, products and processes which have somehow made the world a better place. Prior to the global financial crisis, many viewed financial innovation as unequivocally falling into this category. Underpinning this view was a pervasive belief in the self-correcting nature of markets and their consequent optimality as mechanisms for allocating society's resources. This belief exerted a profound influence on how we regulated financial markets and institutions. This paper examines the influence of this market fundamentalist thinking on the regulation of OTC derivatives markets in the US during the pivotal period between the enactment of the Commodity Futures Trading Commission Act (1974) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010). More specifically, it traces how the conventional 'demand-side' view of financial innovation played an important role in blinding policymakers to a host of pressing regulatory challenges. The objective of this paper is to start us down the path toward a more complete theoretical account of the nature, sources and potential private and social welfare implications of financial innovation. It also aspires to move us incrementally toward a more constructive equilibrium between the important insights of financial theory and how we conceptualize and pursue the objectives of financial regulation. Journal of Comparative Economics 41 (2) (2013) 401-419. University of Oxford, Faculty of Law, Linacre College, St. Cross Road, Oxford OX1 3JA, United Kingdom. (C) 2013 Association for Comparative Economic Studies Published by Elsevier Inc. All rights reserved.