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So what's new

New research by Sapnoti Eswar examines whether using derivatives to mitigate risk prevents firms from innovating.

By Sapnoti Eswar 20 November 2014

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A common conception in business is that innovation is a ‘good thing’ and essential for obtaining a competitive edge. But maybe not all innovation is beneficial. Take the financial markets, which have come under scrutiny in recent years, with the innovations of investment bankers and other financial services firms linked to the recent financial crisis.


Now, research by London Business School PhD student Sapnoti Eswar is investigating whether financial innovation has an even broader impact across business sectors. Could the expansion or proliferation of new complex financial products be stifling productive innovation elsewhere? Could financial innovation insidiously squash the development of ideas that might have a profoundly positive impact on the organisations that produce those ideas?


Eswar is looking at large or medium-sized firms, where part of their activities involves innovating to either improve their performance or create new technology for downstream firms. These firms may be able to use complex financial products, such as derivatives, to hedge risk. However, if they become over-reliant on this insurance mechanism, it could dampen their desire to invest in and produce innovative technology.


“To a certain extent they’re safeguarding shareholders or investors against fluctuations in return,” Eswar says. “But it may also be that their incentive to invest in real innovation is diminished. So while they’re doing a good thing for shareholders by reducing the volatility of return in the short term, they may also be inclined not to take on riskier activities in the form of R&D that have longer term pay-offs.”


To test her idea, Eswar took as her example the supply of derivatives by investment banks in 1999 to gold producers in the gold markets, when there was a sudden increase in the complexity of the products being supplied by investment banks. “I need to see an external supply impetus, where for some reason banks either create a derivative or supply an excess amount of these derivatives,” she says. “Then firms will choose whether they want to buy these derivatives, or continue innovative activities and file patents, or both.”


So a firm conducts its business activities and uses derivatives at a certain level to mitigate risk. It also has a level of innovation output. Both the use of derivatives and innovation output can be measured. Then a supply shock happens. Now, after controlling for natural changes in derivative usage and other factors affecting innovation output, Eswar can determine the impact of the novel financial product on innovation output.


This work has significant implications for firms that innovate as well as market regulators and governments that view cross-sector innovation as broadly beneficial to society. Notwithstanding Eswar’s caveat that her work is at a preliminary stage, and a number of outcomes possible, it may indeed transpire that using these derivatives to safeguard against small shocks and protect returns to investors prevents firms from innovating. And that innovation may be the very thing that actually makes their business more profitable in the long run and protects them from external market shocks in the future.


“We usually speak of financial innovation in good ways, in the sense that it has helped economies to grow and to make capital more accessible to constrained firms and therefore boosted economic development and growth,” says Eswar. “So it has some real effects that we usually think of as positive. The only negative implication that I’ve read of up to now is that it tends to make markets more volatile, with more frequent price fluctuations.


“My paper suggests that there might be negative real implications to financial innovation, which might mean that we need to curb the supply of excessively complex financial derivatives.”


This leaves us with a conundrum. If firms are unwilling to rein back hedging activities and take on more risk, what then? The logical conclusion is that we limit some of the innovative activities of financial firms, in order to preserve the risky but ultimately beneficial innovation in other firms.

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