Felix Salmon had a hard time thinking of any good recent financial innovations. How about: housing futures, the elimination of futures pits (this had more to do with exchange competition than the technology, which had been available for years), hedge fund replication and low cost beta funds, macro futures, carbon trading, the Roth IRA, continuous workout mortgages, weather futures and Weatherbill, microfinance, alternative currencies, angel investor pools and ycombinator, savings-linked lotteries, ticket options, Bowie Bond-like instruments, and, not least: indexing, mutual funds and ETFs, despite some frayed edges.
A lot of course comes down to how a tool is used. Pooled securitization is fundamentally diversification, but always comes with the possibility of risks concentrating. Prices may alert us to risks, providing negative feedback, but large markets can also drive and amplify underlying events.
Although the pathologies are the examples that most readily come to mind, there is still a flow of beneficial innovation that isn’t reducibile to new communications technology.
Not to mention prediction markets, which Felix had been sympathetic to in the past. Maybe he was just embarrassed to cite them or other examples that aren’t really part of “serious” finance, but surely we can count prediction markets as a “good” innovation in spite of their relatively limited commercial success (perhaps because of their small scale?). Â Prediction markets are the quickest way to incentivize the release of dispersed information on a very wide range of topics. Â We don’t need to list examples here, but there is little reason to believe that such mechanisms will not at some point assist in decisions that will, for example, save lives.
Some prediction markets are more daunting than others in terms of their potential side-effects, although Felix at one time declared that “It’s Time For Political Event Swaps.” *  Maybe that wasn’t so crazy. Brokering pre-existing trillion dollar risks is more sustainable than borrowing 30x and betting on black. One of many questions is whether such contracts are to be lumped with those innovations that exist merely to evade regulations. After all, the purpose of tax futures and the like expressly is to allow people to mitigate the financial impact that new laws may have on them. The difference is that such contracts do not allow you to “evade” anything. If you have a winning tax futures position, you still pay your higher taxes, and additional taxes on your hedge. The position does not present a negative externality as when innovations are used to exercise market power and maximize leverage, increasing systemic risk. To be sure, our general trust of markets has not risen in the past two years, but the collapse can largely be explained in terms of specific leverage, transparency and agency problems absent from many markets. Not to say that prediction markets might not exhibit their own negative side-effects if they become influential enough, but by virtue of their typical binary format and objective settlement, they should be more resistant to runaway prices than traditional assets.
The time to be “short” prediction markets was late 2007, before Erikson/Wlezien, before 538.com, before New Hampshire, and before most people realized what was happening in finance. Maybe it’s not “time” for political event swaps or other new, challenging markets, but given a realistic, open approach, its not time to bury them either
* The Portfolio.com site that remains erroneously attributes the post to Ryan Avent, who it seems took over the “Market Movers” column when Felix left.
