OTC derivatives market: Demand heterogeneity, financial
innovation, and economic welfare
Hong V. Nguyen
Economics and Finance Department
University of Scranton
Scranton, PA 18510 USA
hong.nguyen@scranton.edu
Empirical financial economics and econometrics cannot tell us
definitely if derivatives have been a net benefit to society in the
nearly 4,000 years they have been around. Nevertheless, the
reasons to believe that derivatives have done more good for
society than harm are compelling.
Christopher L. Culp, 2010b, The
social functions of financial
derivatives, in Robert W. Kolb
and James A. Overdahl, eds.:
Financial Derivatives – Pricing
and Risk Management (Wiley:
Hoboken, NJ), p. 66.
Abstract
The rapid growth in the derivatives market in the 1970s and 1980s led to some concern in the
mid-1990s about whether these securities were becoming another means for users to speculate
and the potential negative impact of such activities on financial markets and the economy
(Darby, 1994). About a decade later, the financial crisis and the Great Recession of 2007-2009
took place, which has brought to the fore legislative actions here in the U.S. and abroad dealing
with various aspects of the derivatives market (Dodd-Frank Act, 2010; Allen, 2012).
The purpose of this paper is to provide a framework to review the literature on the role of
derivatives as financial innovation. It considers demand heterogeneity as an independent
determinant of innovation and explains the role of derivatives as financial innovation that adds to
economic welfare. I find that the literature supports the use of this framework and the argument
that derivatives contribute to economic welfare. Not considered in this paper is the systemic
aspects of derivatives use and the policy questions dealing with this risk.
1
Introduction
The financial turmoil of the second half of the 2000s has brought to the forefront the role of
derivatives in contributing to the financial crisis and its impact on real economic activity. While
acknowledging that derivatives may improve economic efficiency, various aspects of this
market, such as the trading mechanism and its transparency, have been subject to close scrutiny,
resulting in regulatory actions here and abroad (Dodd-Frank Act, 2010; Allen, 2012). This paper
reviews and discusses the literature on the economic role of derivatives based on a framework
which links innovation to demand heterogeneity.
The main research question in this review is: “What is the economic role of derivatives?” I
employ a demand framework that views heterogeneity as an important determinant of
innovations (Valente, 2003; Kirman, 2006), which provides a basis for their economic value
(Malerba, Nelson, Orsenigo, and Winter, 2007). This framework is attributed to Lancaster
(1966a and 1966b), who analyzed demand based on characteristics of goods rather than the
goods themselves. Within this framework one can also analyze innovations as new products or
new variants of existing products that result in an increase in economic welfare. These
innovations may include financial products (Bernado and Cornell, 1997), such as derivatives
(Merton, 1992).
While derivatives improve economic efficiency (see, for example, Allen and Gale, 1991;
Merton, 1992; Duffie, 2010), there are external effects from their use that need to be considered
(see, for example, Acharya and Bisin, 2014). I extend the demand heterogeneity framework by
placing derivatives use within the financial system, which is viewed as an interconnected
network of intermediaries (Gofman, 2011). In Figure 1 below, I show the overall framework
relation between the economy and derivatives as financial innovation.
Figure 1
Derivatives as financial innovation
Economy
Real Sector
Financial
Sector
Derivatives as
financial innovation
Improving economic
welfare by meeting
demand
heterogeneity
The organization of the paper is as follows. In Section 2, I use the Lancaster model of
demand to explain the nature of demand heterogeneity and its link to innovation and economic
welfare. I then proceed to discuss, in Section 3, the literature on financial innovation,
heterogeneity, and derivatives use. Section 4 concludes.
2
Demand heterogeneity, innovation, and economic welfare
Heterogeneity on the supply side has also been studied in economics, for example, in the
evolutionary economics literature (see, for example, Nelson and Winter 1982). However, it is
demand heterogeneity that this paper is concerned with. In this section, I review the literature on
heterogeneity and innovation. I take as given the various motivations, such as increasing market
share (Tufano, 1989), of firms in providing the financial products.
2.1 Demand heterogeneity and innovation
Webster’s Third New International Dictionary (unabridged edition, 1993) defines innovate as “to
introduce as or as if new,” and innovation as “something that deviates from established doctrine
or practice” or as “something that differs from existing forms.” The idea of innovation as an
important dimension of capitalism has first been articulated by Schumpeter (1939), who defines
innovation as “doing things differently in the realm of economic life.” (p. 84). Innovators play an
important part in what Schumpeter called the process of “creative destruction.” While it causes
disruption to markets by making existing capital obsolete, the process makes it possible for
economic growth and welfare to improve over time (on Schumpeter, see, for example, McGraw,
2007). Von Hippel (1988) discussed the process of industrial innovation in several industries
such as thermoplastics. That technological innovation contributes to economic growth and
welfare is a well-established idea (Solow, 1957; Romer, 1990). In what follows, I review the
literature on the impact of demand heterogeneity on innovation.
While assuming homogeneity in certain cases may simplify the analysis without sacrificing
realism, Valente (2003, p. 1) has suggested that “assuming homogeneous products requires a
centralized pricing mechanism … it is also a severely limiting factor in the possibility of
analyzing product-embodied innovations.” Bresnahan and Greenstein (1999) view demand
heterogeneity as having played an important role in determining the structure of the computer
industry. Langlois (2001) emphasizes that standardization has its limits due to the demand for
variety. According to Adner and Levinthal (2001 p. 611), “[r]elatively underexplored … is the
effect of the demand environment on the development and evolution of technology …” Kirman
(2006, pp. 89-90) considers it “odd that heterogeneity does not play a greater role in economic
models. In so many other disciplines it is fundamental. In the theory of evolution, variation, that
is, heterogeneity even of a limited sort is crucial.” Windrum, Ciarli, and Birchenhall (2009) have
formulated a model in which demand heterogeneity determines the evolution of environmental
technologies.
2.2
Demand heterogeneity, innovation, and economic welfare: The Lancaster model
I now discuss the Lancaster model to formalize the role of demand heterogeneity as an important
and independent determinant of innovations. Lancaster (1966b) viewed the consumers as
engaging in consumption activities by using goods, which generate the characteristics that they
desire. In Lancaster’s scheme, the utility function (U) depends not on the goods themselves, but
on the characteristics of these goods, that is,
U = U(z)
(1)
where z is a vector of characteristics transformed from a vector of goods, x, through the matrix
B:
z = Bx
(2)
There is a relation between goods and consumption activity, denoted as vector y, through the
matrix A:
x = Ay
(3)
For example, the consumption activity is driving (say, to go from point C to point D), two
characteristics may be the speed and comfort, and two of the goods are a car and gasoline. The
same good may be used in more than activity, such as gasoline used in lawn maintenance activity
in the case of a lawn mower.
For simplicity, one may assume that there is a one-to-one correspondence between
consumption activity and good, that is, one good for each activity and each activity using one
good, then the consumption technology is the B matrix, transforming goods into desired
characteristics that maximize the utility function, U(z), subject to the usual budget constraint
facing the buyer. Individual buyers are faced with the same efficiency frontier defined as the
minimum cost of buying the goods that allow then to reach the highest possible values of the
desired characteristics. But they may each pick a different point on this frontier depending on
what characteristics are valued more. The following figure shows two characteristics on the axes,
with the frontier being drawn as a smooth curve for ease of discussion.
Figure 2
The efficiency frontier
Characteristic 2
A
B
X
C
I
Characteristic 1
Points A, B, and C show three of many possible points on the frontier that can be obtained
from using goods to transform into levels of characteristics 1 and 2. The buyer who picks point
A value characteristic 2 more relative to the buyer who picks point B. The buyer may combine
two or more goods, such as goods B and C to reach the preferred levels of characteristics at point
X on the frontier. This approach views preferences as being not so much over the goods
themselves as they are over the desired characteristics obtainable from these goods. What
characteristics are desirable would depend on each individual buyer’s preferences. This is a
major source of heterogeneity among buyers. As prices of goods change, the shape of the frontier
would vary and the selected points would also change. For simplicity, I assume constant prices,
and focus on innovation, discussed in the next section.
By focusing on characteristics rather than the goods themselves, Lancaster (1966b) made it
possible to discuss demand heterogeneity as an independent determinant of innovations.
Innovation is expressed in a shift outward in the efficiency frontier, allowing buyers to reach
higher levels of characteristics at the same or lower cost. According to Lancaster (1966a, pp. 2023), “innovation in the true sense occurs in the consumption technology, and this takes place
primarily through the introduction of new goods or new variants and product differentiation …
This change [innovation] does lead to increased welfare, but the direction from which change
comes, the incentives for change, and the analysis and measurement of change differ
considerably between production and consumption.”
The contribution of innovations to economic welfare in connection with heterogeneity has
been examined in the literature. Bresnahan and Greenstein (2001) emphasize “the distinction
between inventions that solve general problems and the complementary inventions that solve
particular ones. Both must occur for economic welfare to increase … Invention of general
purpose enabling technologies, such as computer hardware and software, telephone transmission
technologies, or data networks, permits but does not compel invention of valuable uses.” (p. 96).
Some specific areas of study are medical and pharmaceutical product innovations. Trajtenberg
(1989) conducted an economic analysis of computed tomography scanners in which demand was
a motivator. Concerning pharmaceuticals, Malerba, Nelson, Orsenigo, and Winter (2007) have
suggested that “many industries face a diverse set of customers and no single design ever
emerges that satisfies all needs … If one aggregates across different kinds of drugs, the
pharmaceutical industry remains relatively unconcentrated because a variety of different types of
drugs are needed to meet the diverse requirements of different humans with different ailments.”
p. 372.
3
The financial system, innovation, and economic welfare
In this section, I explain the financial system as a network of intermediaries and how innovations
to the system lead to an increase in welfare.
3.1
The financial system: Intermediation, diversification, and risk management
Almost 6 decades ago, Gurley and Shaw (1955) emphasized the role of financial intermediation
in the process of economic development: “[D]evelopment is associated with debt issue at some
points in the economic system and corresponding accretions of financial assets elsewhere.” (p.
515). Bencivenga and Smith (1991) explain that the financial system promotes growth by
enabling more savings to go toward capital investment through financial intermediation. This
view is supported by Rajan and Zingales (1998), who found that industries that relied more
heavily on external finance grew faster than other industries in a financial system with better
intermediation services. The reason for this is that financial intermediation provides valuable
opportunities for external financing of investment projects with positive net present values that
may go unfunded otherwise. Bhatt (1989) considered credit market developments as
contributory to economic growth in both developing and developed countries. Levine (2004)
suggests that a financial system contributes to growth and welfare by providing opportunities for
the diversification and management of risk.
Financial intermediation provides a number of characteristics desired by firms and
individuals. They include safety in holding assets that bridge the gap between the present and the
future; allowing diversification to minimize risk through and maximize returns through
participation in a large number of intermediated assets. The access to one’s assets at a short
notice has also been part of what the financial system does, with important consequences for the
real economy. Financial record keeping also facilitates such intermediary activities.
3.2 Financial innovation
I use the concept of financial technology, viewed in an analogous way to the consumption
technology, to explain how financial innovation contributes to economic welfare. Frame and
White (2004, p. 118) state that financial innovation “represents something new that reduces
costs, reduces risks, or provides an improved product/service/instrument that better satisfies
participants' demands.” Tufano (2003, p. 3) defines it as “the act of creating and then
popularizing new financial instruments as well as new financial technologies, institutions and
markets.” According to Allen and Gale (1994, p. 6): “The theory of financial innovation deals
with the provision of opportunities for risk sharing or intertemporal smoothing …”
Lancaster (1966a) viewed his analysis as also being applicable to situations of risk where
desired characteristics that may be valued differently by potential buyers, such as maximum gain
versus maximum loss. He considered it as extending the expected utility maximization analysis
of Von Neumann and Morgenstern (1944).
Financial innovation has a long history, going back to the times of Babylonia and Assyria,
thousands of years BCE (Allen and Gale, 1994). Financial innovation can take many different
forms. Double-entry bookkeeping that is traced back to the Middle Ages may be considered a
financial innovation of a process nature, considered important for the development of capitalist
organization with respect to financing (Basu, Kirk, and Waymire, 2009). The ATM (automatic
teller machine) is a computer-related innovation (in the 1960s and 1970s) that has improved the
financial infrastructure with respect to liquidity demand. New forms of financial intermediation,
such as mutual funds, may be considered financial innovation (Ackermann, 2013).
The greater efficiency in the allocation and use of resources made possible by financial
innovation adds to economic growth and welfare (see, for example, Allen and Gale, 1994;
Tufano, 2003; and Levine, 2004). Financial innovation improves financial intermediation and
the efficiency of capital allocation, and generates faster economic growth. According to
Michalopoulos, Laeven, and Levine (2009, p. 27): “Institutions, laws, regulations, and policies
that impede financial innovation slow technological change and economic growth.” As Shiller
(2012) has put it, financial innovation contributes to the “good society.” As an idea that can be
used over again and again, the benefits of financial innovation to society may be greater than just
the sum of the benefits of the individual market participants (see, for example, Haliassos, 2013).
Ideas are important for sustained economic growth, as Romer (1990) has shown.
A channel for financial innovation to affect economic growth has been offered by Froot,
Scharfstein, and Stein (1993). Hedging with derivatives allows a company to maintain a steady
cash flow, which is important in cases where external finance is costly. Adam (2002) obtained
evidence that shows that hedging with derivatives increases the likelihood of a company having
adequate internally generated funds for financing its capital investment. Goderis, Marsh,
Castello, and Wagner (2006) found evidence indicating that banks used credit derivative
products to diversify their risk exposures that would then make it possible for them to increase
lending. Hirtle (2007) studied the use of credit derivatives by banks and found that it increased
bank credit supply and lowered the spreads for borrowers.
Research on financial innovation is of a more recent origin, going back to the 1970s and
early 1980s (see, for example, Silber, 1975 and 1983). The empirical work that is systematic in
terms of hypotheses and statistical testing is limited, especially as related to the economic value
of derivatives as financial innovation. In addition, the empirical evidence comes mostly from
economy-wide studies and is limited to financial innovation in a broad sense, and not specific to
financial derivatives. As Frame and White (2004) have put it: “A striking feature of this literature
[on financial innovation] … is the relative dearth of empirical studies …” (p. 116). However,
from this limited evidence, they conclude that “the welfare consequences of financial innovation
… are largely positive, especially with product and process innovations.” (p. 134). Below, I
review some of this limited evidence, both macroeconomic and microeconomic, on the
contribution of financial innovation and derivatives.
As Tufano (2003) has pointed out, financial innovations are often introduced by large
commercial and investment banks. A study by Lerner (2006) shows that a significant percentage
of financial innovations from 1990 and 2002 was carried out by large financial institutions, such
as Goldman Sachs and JP Morgan. Atkeson, Eisfeld, and Weill (2013) examine the question of
why larger institutions provide intermediation services in the OTC derivatives market, and point
out that the larger institutions make it possible for smaller market participants to share risks.
Tufano (2003) has surveyed the literature on financial innovation from several perspectives.
He acknowledged that measuring the social welfare impact of financial innovation, including
derivatives, was problematic. He suggested that the area of industrial organization may be
relevant and fruitful to the task of estimating the social welfare impact, an area of research that is
relatively new at the present time. Together with Lerner in a more recent paper (Lerner and
Tufano 2011), Tufano suggested that a counterfactual approach to the measurement of the social
value of financial innovation may be fruitful, even though it may be hard to do. With this
approach, one assumes away the existence of financial innovations like derivatives and then tries
to ascertain how much welfare would be reduced. To look at it in a different way, one can ask
how much society is willing to pay over and above what it pays for the current financial
technology to have the new innovation rather than to go without it. This is the sort of
counterfactual approach that Fogel (1964) used to estimate the impact of the railroads on
American economic growth in the 19th century.
One of the earliest empirical studies of financial innovation is that of Garbade and Silber
(1978). They reviewed the impact of the advent of the telegraph and the trans-Atlantic cable in
the 19th century and explained that such technological changes improved the functioning of
financial markets and economic welfare. Dynan, Elmendorf, and Sichel (2006) show that
financial innovation helps smooth consumption over the business cycle and has a stabilization
effect on the economy. Michalopoulos, Laeven, and Levine (2009) examined a sample of U.S.
industries over the period 1967 to 2000. They used labor productivity growth in the financial
sector and in the industrial sector to measure financial innovation and technological innovation,
and found that these two measures are positively correlated. The inference here is that to
encourage technological innovation, you need financial innovation; and to encourage financial
innovation, you need to have technological innovation. Labor productivity growth is important in
contributing to the rise in the standard of living in the U.S. and elsewhere (see, for example,
Jones, 2014).
3.3 Derivatives as financial innovation
Culp (2010) suggests that derivatives as a risk management tool have been around for about
4,000 years. Van Horn (1985) looked at financial innovation as reducing inefficiencies and
expanding markets, and listed futures and options among the products of financial innovation.
Writing in the mid-1980s, Miller (1986, p. 463) singled out financial futures to be the “most
significant financial innovation” over the preceding twenty-year period. Derivatives as financial
innovation provide various ways of dealing with the problem of managing risk and uncertainty
(Stulz, 2003). The spanning role of these financial instruments in completing markets is an
important economic function in providing risk sharing opportunities (see, for example, by Allen
and Gale, 1991; Cuny, 1993; Duffie and Rahi, 1995). Acharya, Viral, Brenner, Engle, Lynch,
and Richardson (2009) viewed derivatives as “the ultimate financial innovation.” Carvajal,
Rostek, and Weretka (2012, p. 1895) study a model in which competitors innovate with assetbacked securities to satisfy “heterogeneous risk-sharing needs” of investors with respect to
current versus future consumption.
Merton (1992, p. 17) best summarizes the economic role of financial innovation:
In general, innovations in financial products and services can improve economic
performance in three basic ways: by meeting investor or issuer demands to “complete
the markets” with new securities or products that offer expanded opportunities for risksharing, risk-pooling, hedging, and inter-temporal or spatial transfers of resources; by
lowering transactions costs or increasing liquidity; and by reducing “agency costs”
that arise from either “information asymmetries” between trading parties or
principals’ incomplete monitoring of their agents’ performance. All three of these
driving forces behind financial innovation are consistent with its working to improve
economic efficiency [bolded emphasis added].
Two of the functions listed in the above quote (risk sharing and hedging, and lower transaction
costs) have been examined by Pesendorfer (1995). He models the process of innovation by
financial intermediaries as one in which existing standard financial instruments are to create new
securities, what he refers to as “customer-tailored instruments,” consistent with the Lancaster
notion of “new variants” of existing goods to expand the efficiency frontier with respect to
desired characteristics. In support of his view, Pesendorfer (1995) provides two examples of
financial innovation: zero coupon bonds created by Merrill Lynch and Salomon Brothers in
1982, and collateralized mortgage obligations (CMOs) introduced by First Boston and Salomon
Brothers in 1983. These innovations are consistent with an increase in consumption/investment
and an improvement in economic welfare (Shiller, 2012; Cass and Citanna, 1998).
3.4
3.4.1
Empirical evidence
Financial innovation and economic welfare
Research on financial innovation is of a more recent origin, going back to the 1970s and early
1980s (see, for example, Silber, 1975 and 1983). The empirical work that is systematic in terms
of hypotheses and statistical testing is even more limited, especially as related to the economic
value of derivatives as financial innovation. However, from this limited evidence, Frame and
White (2004, p. 134) conclude that “the welfare consequences of financial innovation … are
largely positive, especially with product and process innovations.”
Michalopoulos, Laeven, and Levine (2009) examined a sample of U.S. industries over the
period 1967 to 2000. They used labor productivity growth in the financial sector and in the
industrial sector to measure financial innovation and technological innovation, and found that
these two measures are positively correlated. The inference here is that to encourage
technological innovation, you need financial innovation; and to encourage financial innovation,
you need to have technological innovation. Labor productivity growth has been considered
important in contributing to the rise in the standard of living in the U.S. and elsewhere (Jones,
2014). Garbade and Silber (1978) reviewed the impact of the advent of the telegraph and the
trans-Atlantic cable in the 19th century and explained that such technological changes improved
the functioning of financial markets and economic welfare. Dynan, Elmendorf, and Sichel
(2006) show that financial innovation helps smooth consumption over the business cycle and has
a stabilization effect on the economy.
Tufano (2003) has surveyed the literature on financial innovation from several perspectives.
He acknowledged that measuring the social welfare impact of financial innovation was
problematic. He suggested that the area of industrial organization may be relevant and fruitful to
the task of estimating the social welfare impact, an area of research that is relatively new at the
present time. Together with Lerner in a more recent paper (Lerner and Tufano, 2011), Tufano
suggested that a counterfactual approach to the measurement of the social value of financial
innovation may be fruitful, even though it may be hard to do. With this approach, one assumes
away the existence of financial innovations like derivatives and then tries to ascertain how much
welfare would be reduced. To look at it in a different way, one can ask how much society is
willing to pay over and above what it pays for the current financial technology to have the new
innovation rather than to go without it. This is the sort of counterfactual approach that Fogel
(1964) used to estimate the impact of the railroads on American economic growth in the 19th
century.
In summary, the empirical literature seems to speak to a welfare-improving role for the financial
system and the innovations to the system (financial innovation).
3.4.2
Derivatives and economic welfare
OTC markets, including the OTC derivatives market, are large, judging by the value of the
securities traded through these markets. According to Nystedt (2004, p. 42), “[t]he United States
has some of the largest and most innovative OTC issuers, while also being home to some of the
world's largest ODE (organized derivative exchange) markets.” Schinasi, Craig, Drees, and
Kramer (2000) provide a good discussion of the various aspects of the OTC derivatives market.
Figure 3 below shows that the OTC derivatives market is very large, with total notional amounts
of more than $600 trillion.
Figure 3
OTC derivatives market, 2007 and 2013
Note: Data used in constructing the charts come from Bank for International Settlements (BIS), Statistical
release: OTC derivatives statistics at end-June 2013, November 2013, Table A, p. 5.
The nature of heterogeneity suggests that trading mechanisms may differ between
homogeneous derivative products and heterogeneous ones. According to Carvalho (1997, p.
481), “exchange-traded derivatives are created to cover risks of a more generic or homogeneous
nature. In contrast, hedging against more specific bets that have to be tailored to specific
customers may be obtained in "over-the-counter" (OTC) deals.” Similarly, Nystedt (2004, p. 5)
has stated that “[c]ontrary to the highly standardized and usually cleared contracts offered by
traditional organized derivative exchange (ODE) markets, OTC derivatives can be individually
customized to an end-user's risk preference and tolerance.” Switzer and Fan (2008) document a
substitution relationship between trades in OTC markets and trades in a central futures exchange
with respect to the Canadian dollar, that is, as trades of futures in the central exchange increase,
trades of forwards and swaps in the OTC market would decline. Their evidence also shows a
complementary relationship between the two markets in terms of the risks hedged: OTC trades
hedge against idiosyncratic risk while central exchange trades hedge against systematic risk.
Thompson (2010) has argued that decentralized clearing may still be efficient as the moral
hazard problem of protection sellers may be counteracted by the adverse selection problem of
protection buyers so that full information may be revealed in bilateral arrangements. Similarly,
Golosov, Lorenzoni, and Tsyvinski (2013) studied decentralized (bilateral) trading which they
consider to be common with many OTC derivatives, and found that it is possible for bilateral
trading to attain efficiency with low-cost learning.
McConnell and Schwartz (1992) studied a successful financial instrument introduced by
Merrill Lynch in 1985, known as LYON (Liquid Yield Option Note), which gave investors a
way of enhancing their returns for a given risk profile and a way for corporate issuers (including
American Airlines, Motorola, and Marriott) to raise funds from these retail customers.
Kanemasu, Litzenberger, and Rolfo (1986) studied stripped Treasury securities as “a prominent
example of security innovation in response to an existing set of government securities that was
not sufficiently tailored to meet investors’ preferences.” (p. 3).
Brewer, Jackson, and Moser (1996) estimated the value of interest rate derivatives and found
it to be positive in that their use lowered the cost of borrowing to consumers. Writing five years
later and using bank holding companies as their sample (Brewer, Jackson, and Moser, 2001, p.
64), they concluded that “derivative usage appears to foster relatively more loan making, or
financial intermediation.” However, they did not ascertain the value of this intermediation to
society in terms of greater capital investment and consumption. Black, Garbade, and Silber
(1981) found that the innovation of GNMA’s pass-through securities reduced mortgage interest
rates.
4
Conclusions
This paper has attempted to show that financial innovation is based on demand heterogeneity and
contributes to economic welfare. Derivatives, as financial innovation, allow market participants
to share risks and to facilitate financial intermediation. In so doing, they facilitate the timing of
consumption and investment, and improve the living standard of a country.
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