Sample Undergraduate 2:1 Finance Literature Review

Innovative Financial Instruments

1. Introduction

This review aims to study and examine the literature available on the research topic, i.e. innovative financial instruments, contrasting and comparing different information sources to obtain a good understanding of the subject. The information sources used for this literature review have been first identified in the online space with the help of appropriately formulated keywords and phrases. These sources have thereafter been closely scrutinised in order to select ones that are relevant, free of bias and have been cited several times. The review firstly takes up innovation and thereafter attempts to examine the evolution of innovative financial instruments over the years.

2. Innovation

Innovation very broadly refers to the process of creation of new products, services and processes that can provide commercial benefit and competitive advantage to business organisations (Gallouj & Djellal, 2010). Innovation has been widely accepted and acknowledged to be one of the most important determinants of organisational success and process that has over the years led to numerous advantages and benefits for human society (Gallouj & Djellal, 2010). Various experts like Schumpeter (1934) and Peter Drucker (1993) have written and theorised extensively on innovation, its various aspects and its benefits to modern society.

Smith (2010) stated that innovation is critical not just for organisational and business success but for its very survival. It is not exclusive to big brands or organisations but is important and essential for all players (Smith, 2010). Whilst innovation, as a phenomenon and a process has existed since historical times and has been instrumental in the continuous alteration of human society, it is being driven at present by specific forces that include commoditisation, globalisation, increasing turbulence, the digital revolution and social media (Tidd, 2009).

3. Financial Innovation

The examination of available literature on financial innovation inform that the majority of experts consider the process to be the creation and spreading of various types of new financial products, markets, processes and invitations (Tufano, 2003). It has however been argued that this view of financial innovation is rather narrow and needs to be viewed from a more holistic perspective (Tufano, 2003). Financial innovation can thus be described as the process, which can be conducted by any organisation and involves the development, adoption and promotion of new, both radical and incremental, platforms, products, processes or enabling technologies that result in the implementation of novel ways or alterations to the carrying out of financial activities (Adam & Guettler, 2015).

It is important to deal at some length with financial instruments in order to develop this review of literature. Financial instruments essentially represent monetary arrangements or contracts between parties, which can be traded, created, modified and settled (Armstrong et al., 2012). They can be manifested in various forms like cash, shares or bonds. The international accounting standards, whilst IAS 32 states that a financial instrument can be a contract that results in the emergence and development of a financial asset for one entity and the generation of an equity instrument or a financial liability for another (Armstrong et al., 2012). Numerous types of financial instruments are currently in use; these include simple bonds, convertible bonds, equity loans, convertible debentures and convertible preferred equity certificates, amongst others (Armstrong et al., 2012).

An examination of available literature reveals that financial innovation has been a persistent and critical element of the economic environment over centuries. There is little doubt that financial markets continuously generate and produce a range of novel products, which include several different types of derivatives, exchange traded funds, variations of tax deductible equity and alternative risk transfer products (Asante et al., 2017). The adoption of a long term view results in the surmise that financial innovation, like other forms of innovation is essentially a process that is ongoing process, wherein private firms and businesses respond to arbitrary and gradual alterations in the economy and attempt to achieve differentiation in their products and services (Asante et al., 2017). Innovation increases or decreases and some periods are characterised by sharp spurts of activity, whereas others periods are often characterised by a easing and reduction of activity (Beck et al., 2016). Viewed objectively the Schumpeterian method of innovation, especially financial innovation stands for a normal and ongoing element of a process maximising activity (Beck et al., 2016).

4. Evolution of Financial Innovation and Innovative Financial Instruments

The Mesopotamian civilisation functioned as a centre for financial innovation and played a particularly vital role in the generation and development of financial innovation in historical times (Fostel & Geanakoplos, 2016). Societies, in those days operated primarily as gift economies, alongside the use and practice of the barter trade system (Fostel & Geanakoplos, 2016). Whilst some individuals provided valuable products and goods to their family and friends free and without cost, others engaged in trade and exchanged their goods for other products that were viewed to be of equal value (Fostel & Geanakoplos, 2016). The idea of commodity money was thus introduced in approximately 3000 BC and facilitated individuals in purchasing goods and services to exchange of commodities like gold and precious metals that were considered to be valuable (Arthur, 2017). This sort of trade resulted in the development of primitive types of financial arrangements, especially personal loans that were compensated through the payment of interest (Arthur, 2017). Sophisticated financial arrangements developed over time, including the creation of banking firms; this resulted in the creation of two specific financial instruments, i.e. bank deposits and acceptances (Gubler, 2011). The perusal of historical records reveals that early types of annuities were traded in Egypt between approximately 1600 and 1100 BCE (Gubler, 2011).

Batiz-Lazo (2011) stated that contingency claims comprised another principle in finance. Individuals, who transferred ownership of their money to the future to diverse types of financial arrangements, simultaneously brought about exposure to themselves to risks on account of future uncertainties. This resulted in the development of contingency claims, which could be used by both lenders and borrowers to enter into other financial agreements that required a specific party to make a payment on the basis of an outcome of an event (Batiz-Lazo, 2011). These systems continued to have their limitations in the absence of a medium of exchange; metal money emerged in approximately 1000 BCE in China and modern coins were introduced for the standardisation of money and the facilitation of trade between 700 and 600 BCE in Turkey (Bernholz & Vaubel, 2014). This made it possible for market participants to trade their contractual claims to third parties (Bernholz & Vaubel, 2014). Lenders who faced sudden and unexpected circumstances and required infusion of cash could market their loan contracts for coins (Bernholz & Vaubel, 2014). True negotiability was actually developed in China in the 11^th century with the introduction of paper money (Nejad, 2016). The development of state sponsored paper money in the 11^th century made finance easier (Nejad, 2016).

Commercial practices in the city state of Northern Italy became increasingly sophisticated between the 12^th and the 13^th centuries, resulting in the frequent use of bank deposits and acceptances, which spread with the growth of trade and commerce in Europe (Nejad & Estelami, (2012). The emergence and development of capitalism, characterised by entrepreneurial control, the growth of joint stock companies and free competition resulted in the need for the creation of new financial instruments (Nejad & Estelami, (2012). Two such innovative financial instruments, namely bonds and equities were introduced in the 16^th century in Russia and France (World Economic Forum, 2012). The use of such equities and bonds became widespread over time as companies, in addition to governments also began to issue bonds and created various types of securities, like preferred stock and convertibles to meet investor needs (World Economic Forum, 2012). Cheques were introduced in London by the middle of the 17^th century (World Economic Forum, 2012).

Securities trading markets were developed in Amsterdam and Antwerp in the early 17^th century (Sandor, 2012). Innovation of several sophisticated and complex financial products occurred in the 17^th 18^th centuries (Sandor, 2012). Financial activity has increased significantly since then resulting in the development of sophisticated and innovative financial instruments (Sandor, 2012). Firms progressively introduced floating rate notes, zero coupon bonds and other types of securities (Appel, 2015). Currency swaps developed in the 1960s and securitised loans were developed in the 1970s (Appel, 2015). Collateralised dent obligations were created in the 19810s, followed by other innovation (Appel, 2015).

It needs to be kept in mind that the innovative financial instruments have attracted very considerable debate and discussion in the years following the financial crisis. Various experts have averred that the indiscriminate use of innovative financial instruments, especially mortgage backed securities, securitisation, special purpose vehicles, collateralised debt obligations and credit swaps played an instrumental role in the aggravation and expansion of the financial crisis. This has resulted in the conduct of extensive study on the subject and to various types of suggestions and recommendations.

5. Summary

Financial innovation, as is evident from the previous discussion has taken place since historical times. The pace of such financial innovation increased in the first half of the 1600 and again in the 20^th century. Whilst some financial innovation have indeed been novel and changed the ways in which industry works, others have actually been incremental developments of existing products and services. There is little doubt that financial innovations of various types have led to substantial alterations in the working of human society and in the ways of conducting trade and business. Numerous types of innovative financial instruments, both radical and incremental have been developed over time and are in wide use today.

References

Adam, T., & Guettler, A., (2015), “Pitfalls of and Perils of Financial Innovation: The Use of CDS by Corporate Bond Funds”, Available at: https://edoc.hu-berlin.de/bitstream/handle/18452/5222/13.pdf?sequence=1 (accessed September 14, 2018).

Appel, S., (2015), Experience with financial instruments in the period of 2007-2013 an the new framework for the period of 2014-2020, Brussels: European Commission.

Armstrong, M., Cornut, G., Lenglet, S.D., Millo, M., Muniesa, Y.F., & Pointier, A., (2012), “Towards a practical approach to responsible innovation in finance: New Product Committees revisited”, Journal of Financial Regulation and Compliance, Vol. 20, Iss (2): pp. 147-18.

Arthur, K.N.A., (2017), “Financial innovation and its governance: Cases of two major innovations in the financial sector”, Financial Innovation, Vol. 3, Iss (10): pp. 1-12.

Asante, K, Owen R., & Williamson, G., (2017), “Governance of new product development and perceptions of responsible innovation in the financial sector: Insights from an ethnographic case study”, Journal of Responsible Innovation, Vol. 1, Iss (1): pp. 9-30.

Batiz-Lazo, B., (2011), Technological Innovation in Retail Finance: International Historical Perspectives, New York: Routledge.

Beck, T., Chen, T., Lin, C., & Song, F. M., (2016), “Financial Innovation: The Bright and the Dark Sides”, Journal of Financial Intermediation, Vol. 72: pp. 28-51.

Bernholz, P., & Vaubel, R., (2014), Explaining Monetary and Financial Innovation: A Historical Analysis, NY: Springer International Publishing.

Drucker, F. P., (1993), Management: Tasks, Responsibilities and Practices, NY: Harper Paperbacks.

Fostel, A., & Geanakoplos., (2016), “Financial Innovation, Collateral and Investment”, American Economic Journal: Macroeconomics, Vol. 8, Iss (1): pp. 242-284.

Gallouj, F., & Djellal, F., (2010), The Handbook of Innovation and Services, Cheltenham: Edward Elgar.

Gubler, Z. J., (2011), “The Financial Innovation Process: Theory and Application”, Delaware Journal of Corporate Law, Vol. 36: pp. 55-119.

Nejad, M., (2016), “Research on financial services innovations: A quantitative review and future research directions”, International Journal of Bank Marketing, Vol. 34, Iss (7): pp.1042-1068.

Nejad, M.G., & Estelami, H., (2012), “Pricing financial services innovations”, Journal of Financial Services Marketing, Vol. 17, Iss (2): pp. 120-134.

Sandor, R.L., (2012), Good Derivatives: A Story of Financial and Environmental Innovation, John Wiley & Sons: Hoboken, NJ.

Schumpeter, J. A., (1934), The theory of Economic Development, Cambridge, Mass: Harvard University Press.

Smith, D., (2010), Exploring Innovation, 2nd edition, NY: McGraw Hill.

Tidd, J., (2009), Managing Innovation: Integrating Technological, Market and Organizational Change, 4th Edition, NY: Wiley.

Tufano, P., (2003), “Financial Innovation”, Handbook of the Economics of Finance, Vol.1, Iss (1): pp. 307-335.

World Economic Forum, (2012), Rethinking financial innovation, World Economic Forum: Geneva.