Historically some of the truly radical innovations in finance have come from criminal enterprises…

Prof JR Varma has a blog post which debates Uberisation of finance. They key idea here is whether innovations in finance can/should be ahead of regulation. Moreover, should regulation kill or allow innovation?

He quotes from a paper by Pollman and Barry in regulatory arbitrage. The business is done under the assumption that law shall be changed in their favor overtime. In finance we are seeing a surge in technology which also relies on regulatory arbitrage. So, how do we think this will pan out?

Prof Varma points firstly current finance players are fairly tech savvy and know the game. Second and more interestingly is this thing that historically most finance innovations come from criminal enterprise itself!

A counterpoint to this is that historically some of the truly radical innovations in finance have come from criminal enterprises. Three centuries ago, central banking was created largely by criminals. Johan Palmstruch, the founder of the world’s oldest central bank, the Sveriges Riksbank of Sweden, was sentenced to death before a royal pardon reduced the death sentence to imprisonment.

Another great pioneer of central banking was John Law, who escaped from the English prison where he was held on charges of murder, and went on to preside over the French experiment with central banking in the early eighteenth century. John Law was probably the greatest central banker of his generation, but he spent most of his life roaming across Europe as a fugitive from the law.

The founder of the Bank of England, William Paterson was an exception in this regard (he was certainly of high integrity), but he was a reckless adventurer who would probably not be acceptable to any modern central bank. A lot of modern finance is actually re-purposed criminality – negotiable instruments (bills of exchange) were originally created to evade usury laws, fractional reserve banking is alleged to have evolved out of goldsmiths fraudulently lending out customer gold which was not theirs to lend (though this has been disputed), and so on.

If there is money to be made in fintech, even the threat of a death penalty will not deter would-be entrepreneurs, and it is at this edge of criminality, that we must look for future radical innovations in finance.

Knew about central banks history but not about negotiable instruments! History of Wall Street as per this book also has similar characters. Amartya Sen also in this lecture asked what made finance seen as morally questionable despite its benefits?

There is little doubt that most innovations in finance came due to some regulatory burden. As things are fungible, one can create equity looking debt products (and vice-versa) and many such arrangements. Such innovations and hype it generates are reasons behind much of the financial crises as well. So financial innovation keeps going in circles.

But another terrific insight from Prof Varma…

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