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.

11 Responses to “The bigger societal implications of financial innovations: How the social studies of finance can help illuminate them”

  1. danielbeunza Says:

    Fascinating post Emilio. I agree that the view of bankers as rent-seekers has gained tremendous credence after the banking scandals. But it’s interesting to note that many see innovation as the remedy to this problem. In effect, this is the spirit behind the growing industry known as “fintech”: capital markets dysfunctionality creates an opportunity for industry disruption. See e.g., http://www.economist.com/news/leaders/21650546-wave-startups-changing-financefor-better-fintech-revolution

    • Emilio Marti Says:

      Thank you, Daniel, for your great comment! These “fintech” innovations highlight that there are different types of financial innovations. While financial economists often talk about “financial innovation” in the singular, I prefer speaking of “financial innovations” in the plural. Some of these innovations will benefit society; others, not.

      So “fintech” innovations may well benefit society by reducing the fees that customers have to pay. Interestingly, however, we are here talking again about retail customers. In that respect, “fintech” innovations are related to the ATM, which according to former Fed chairman Paul Volcker was the only financial innovation that has benefited society.

      Once we move to institutional and high-net-worth customers, I think that financial innovations such as HFT, MBS, CDS, etc. play a very different role. As we argue in our paper, many of these financial innovations create ever new opportunities and threats, and thereby help financial firms sell more services…

      Ultimately, this shows that we must look at financial innovations one at a time.

  2. danielbeunza Says:

    Agreed. I would be very interested to have systematic evidence of what institutional investors think of HFT… as far as I know there seems to be divided opinions

    • Emilio Marti Says:

      Good point! Some evidence comes from the 2011 Foresight report that I cite above. This report draws on survey results from 30 “traditional investors”. Almost 60% of these investors assume that HFT has decreased “overall price transparency,” while only about 20% think that price transparence has increased (p. 19). So these investors tend to see HFT quite negatively.

      This view of HFT seems to be a major reason for why 65% of traditional investors increasingly use dark pools (see p. 14). So the fear of HFT, even if it were largely exaggerated (to my knowledge HFTs primarily engage in market making and arbitrage), has fostered the creation of new financial infrastructure such as dark pools. This suggests that HFT may contribute to the further expansion of the financial sector.

      But, clearly, we would need more recent surveys with more participants to clarify that question further…

      • danielbeunza Says:

        Brilliant. Thanks a lot. Exactly what I was hoping for. I suppose these investors are buy side institutional investors like Fidelity but I’ll obviously have to check. Interestingly, HFT is the outcome of the microstructure reforms they pushed for in ’03 given their dissatisfaction with the specialist system. I wonder how they think now about their complaints then.


  3. wow. This is quite interesting. I do think that the relation between SSF and innovation is a crucial one. Returning to the origin of ANT and its own “nerdish case studies” about technological innovation could be a pathway to deal with this. We could consider the buy side as a type of ‘user’ side.

    • Emilio Marti Says:

      Yes, this sounds intriguing! However, when conceptualizing customers as “users,” one would have to take into account the large informational asymmetries that exist between financial services providers and their customers (particularly in private banking, but also with institutional investors). This would definitely complicate the analysis, but also make it more fascinating😉

  4. Juan Pablo Says:

    Really interesting post, Emilio! This is a fascinating topic, not the least because it stresses the need to connect SSF to larger discussions about the type of macro structures that are the bread and butter of sociology (and other fields, such as political science). There is a tension, though, in this connection which is where I think most of the discussion about the politics of SSF is located. The observation that financial innovations create opportunities and risks is very important, but I do wonder to what extent this is unique to finance. Product and process innovations in other industries similarly exploit the ambivalence of creation–namely, that a new product is as much as an opportunity as a potential challenge to extant practices and organisational field structures. There are some particularities with finance that I think we have not altogether studied enough (for instance, how the intellectual property regime may structure particular patterns of innovation; think of the relatively easy propagation of contractual designs and how it coinhabits a field where computer code is increasingly protects; this, again, may simply reflect that finance is about the bricolage of practices across fields that have very different regimes of innovation and property protection). The question then becomes whether financial innovation is simply a particular case of ‘capitalist’ development (e.g. a more calculated and controlled form of Schumpeterian entrepreneurialism) and should be approached as such. In this sense, the crux of SSF’s politics becomes one of engaging with overtly political categories as well as with the type of agencies that populate ‘macro’ accounts of the social. There is a theoretical problem here, though: the theoretical sensibilities of SSF tend not to appreciate these macro actors as coherent wholes. The buy side and investors, for instance, are complex ecologists of interests. The same with the state, regulators and electronic platform developers. So the challenge then is approaching these actors without losing the detail gained so far. It is, however, a great challenge!

  5. Emilio Marti Says:

    Thank you for this astute comment, Juan Pablo! Let me start with the theoretical problem that you mention toward the end. I agree that investors are very heterogeneous and moreover (as Stefan Leins commented yesterday on Facebook) spread around the world. Investors are therefore hard to study at the level of detail that is distinct for the SSF. This is spot on. At the same time, I assume that the data of SSF scholars at least includes some traces of how new tools shape interactions with customers. Based on these traces, SSF scholars may draw out some connections – at least in the discussion section – to more macro discussion about how financial markets are reshaping the economy and society. So I am in favor of a division of labor, in which the SSF stick primarily to what is going on within financial firms, but also – at least in some papers or in the discussion sections – dare to reflect, based on their data, on some of the broader implications that new tools may have (for example, for the growth of the financial sector).

    Your idea to look at financial innovations simply as a particular case of “capitalist” innovation sounds intriguing. However, I think that this would make the challenge of analyzing the bigger societal implications of innovations such as high-frequency trading even more difficult. Moreover, I think that financial innovations have some distinct societal implications (for example, by helping to stabilize an ever-expanding financial sector, as we argue in the paper). For these two reasons, I would favor to theorize about financial innovations first, and once we have done that, we can still consider whether we can enlarge the picture even further by talking about “capitalist” innovations in general.


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