The bigger societal implications of financial innovations: How the social studies of finance can help illuminate them
June 25, 2015
From Emilio Marti, Cass Business School
I learned more about high-frequency trading from scholars, who do social studies of finance (SSF), than from any other discipline. SSF scholars reconstruct the history of this financial innovation, bring in the perspective of practitioners, take into account and weigh insights from economic theory, and discuss the implications of high-frequency trading for the social construction of liquid markets. So I learned a great deal about whether high-frequency makes the economy more efficient and stable (the short answer: yes for efficiency, no for stability). At the same time, many people are also concerned about how financial markets and financial innovations are transforming the economy and society. Unfortunately, SSF scholars hardly talk about these bigger societal implications. In this post I show why this is a pity, and how SSF scholars could help illuminate these bigger societal implications.
My ideas partly build on a paper, co-authored with Andreas Scherer, on financial regulation and social welfare that is forthcoming in the Academy of Management Review (for an unedited and publicly available version of the paper see SSRN). Our starting point is that existing research shows that the growth of the financial sector is one of the major drivers of income inequality. In the US, investors spend around $528 billion (4% of GDP) for financial services each year (Bogle 2008). These fees feed the super-high wages of some finance employees. In the US, wages from the financial sector account for 25% of the rising GDP share of the top 0.1% (Bakija et al. 2012). For the UK between 1998 and 2008, super-high wages from the “City” account for 60% of the rise in income among the top 1% (Bell and Van Reenen 2010).
What is puzzling, however, is why investors (both private and institutional) are willing to spend so much on financial services. Indeed, over the past 50 years (back to Fama 1970), financial economists have consistently shown that low-fee/passive investment solutions make more sense for most investors, compared to the high-fee/active investment solutions that most investors end up buying. Kenneth French (2008), in his presidential address to the American Finance Association, speaks of “a futile search for superior returns” in which investors lose an average of 0.67% of return per year.
In our paper, we argue that financial innovations such as high-frequency trading may help why financial service firms can sell so many high-fee products. Financial innovations keep financial markets in a constant state of flux, thereby creating new opportunities and threats for investors. For example, some ten years ago, many investors saw mortgage backed securities as an excellent opportunity that they would miss with a passive investment strategy. Today, many investors perceive high-frequency trading as a threat and they seek “active” help from dark-pool providers and algorithm developers to fend off “predatory” high-frequency traders (Foresight 2011). By keeping financial markets in a constant state of flux, financial innovations allow financial services firms to showcase their expertise and to sustain demand for their services.
We argue that researchers from different disciplines should further explore whether financial innovations help sustain the growth of the financial system and, if so, how. And I think that the SSF could contribute to this endeavor in important ways. At the moment, however, SSF scholars rarely connect their studies of the emergence of new financial tools and practices to broader questions about the size of the financial system. Indeed, as Philip Roscoe notes in a 2010 post on this blog: “There is not, as far as I’m aware, any surprise registered in Donald MacKenzie’s work – or Yuval’s or Daniel’s – that derivative markets exist at all.” This narrow focus relates to the fact that SSF scholars mostly analyze how sell side people and brokers interact with each other.
Who is missing? The buy side! Investors! They are the customers of financial service firms and they pump hundreds of billions into the financial sector each year (as mentioned, $528 billion for the US alone) in what French (2008) describes as a “negative sum game.” Here, SSF scholars should follow the money. This would require that SSF scholars extend their focus and also include the buy side into their analysis. So far, SSF scholars have at most studied retail clients (see Poon 2009), but ignored big investors and the fee streams they generate. Specifically, I would be highly interested to learn how new tools help financial service firms sell ever new products. With this, SSF scholars could start to explore how financial innovations and the tools they produce contribute to the growth of the financial sector.
Ultimately, these ideas link back to the debate about whether the SSF are merely, as Karel Williams formulated it, “nerdish case studies” that neglect the “political” dimension of what is going on around financial markets (see Daniel’s 2010 post). I think that taking into account how tools shape the interaction between the buy and sell side would preserve the distinct SSF approach – ethnographic studies focused on tools – while producing insights that are relevant for the broader community of scholars interested in how financial markets are transforming the economy and society.