Innovation in the International Financial Markets
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The University of Michigan
IAN H.GIDDY**
Columbia University
Abstract.New financialtechniquesand instrumentsare createdwhen both thedemandfor and thesupplyof those instrumentsbecome sufficientlylarge.Newfinancialinstruments appearalmost always to representnew combinationsor packages of a relativelysmall context these packages are designed to numberof financialservices. In the international cope with controlson internationalfinancial transactions andwith the peculiarinterest banks. Thisapproach,whenappliedto andexchangerisksfaced by international firms and a widerangeof new internationalinstruments,seems to explainwhysome havefailedand others have succeeded. * Innovations in international financial markets arise when firms, usually finan- INTRODUCTION: OF cial institutions, find it profitable to offer or employ a technique or instrument A THEORY INTERNATIONAL finanthe international functions which better fulfills one of the four provided by cial sector: 1) liquid and standardized instruments for effecting payments in indi- FINANCIAL INNOVATION vidual currencies; 2) mechanisms for conducting monetary exchange between different currencies; 3) institutions and markets for channeling savings into investments across national boundaries; and 4) mechanisms for allocating, diversifying, and compensating for risk. The objective of this paper is to develop a theory of innovation in financial markets and to focus on factors which determine the creation and likelihood of success of such innovative instruments. Innovation of any kind involves, among other things, the production of new infor- Generationof mation. The conditions for the socially optimal level of information generation New and the optimal subsequent pricing of that information have been considered by Information Arrow[1], Demsetz [19], and Johnson [32], as well as others. While often costly to produce, new information can be used by any number of people without additional cost: it is a public good. The socially optimal price of a public good is zero. Indeed, the more easily new information is disseminated, the more likely its price will quickly fall to zero, thus reducing or eliminating private incentive to produce easily duplicated innovations. This is Arrow's"appropriabilityproblem." [1]Three ways to reconcile this dilemma have been proposed: the government can create the information itself; the government can award prizes1 to innovating firms in exchange for the right to disseminate the information freely; or private firms may be able to appropriate the returns through the creation of patent-protected temporary monopolies. Where government intervention is absent or patent laws provide poor protection (as is often the case in international business), there is either little incentive for innovation or the market for innovation is internalized and the value of innovations exploited within the firm2(hence the existence of large, mulBusiness andFinanceat the Graduate School *GunterDufeyis Professorof International The Universityof Michigan.His teachingand research
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