The future of finance
The Economist, Dec. 11, 1999

Our final schools brief examines the role of technology and theory in shaping the future of finance. Within 20 years, financiers will succeed in disaggregating risk. That will transform financial instruments and institutions 

BILL SHARPE, a professor at Stanford University in California, is a proponent of “nuclear financial economics”. Rather as nuclear physics makes sense of the world by looking at the smallest particles of matter, so breaking down financial instruments into their smallest constituents can lead to powerful insights into the pricing and allocation of even the most complex risks*. This approach, which studies the most basic forms of financial claims and contracts, promises to shape the future of finance.

Particle finance would be intractable without new technologies to model and manage almost any conceivable risk. But once financiers can strip out risks at will, a great prize is within their grasp, because firms can lay off the kind of risk they want to, and to just the degree they want to. In the same way, investors can take on precisely the risk that most suits them. This is a technocrat’s ideal of how finance might achieve new levels of efficiency. Is it feasible?

The answer depends on two strands of change that are transforming modern finance. As previous briefs have described, theoretical breakthroughs enable financiers to invent and price new instruments. And new computing and telecoms technologies have helped investors allocate their capital more efficiently. The result has been an explosion of markets, deals, and innovation.

The financial physicists have not yet exhausted the potential of the forward and options contracts that are the building blocks of modern risk management. There are, for example, nascent markets in weather-linked contracts, telecoms bandwidth and in corporate-earnings insurance. At the same time, the spread of existing technologies is hastening an upheaval among financial institutions and making it easier for risk to end up with the people most willing to bear it.

Weather eyes

First, consider the new markets in risk. They rely on computing, clearly, but their importance lies less in their mechanics than in their effect on the firms making use of them. Before recent developments in financial theory, the typical firm had few choices about how to manage risk. Gradually, however, they began to buy derivatives as protection against movements in prices and interest rates. For example, those operating internationally realised that by hedging their exposure to changes in foreign- exchange rates, they could make their profits less volatile and hence more valuable to investors.New ideas and instruments are continuously extending this frontier. Until recently, an ice-cream maker could do little about the risk of a cool summer, which would lower demand for its products. Similarly, energy companies suffer during mild winters, because they lead consumers to turn down their central heating. 

The risk of adverse weather seems inevitable, but financial wizards have come up with a way to avoid it. Over the past few years traders have done around $4 billion of weather-related deals tailored to firms’ needs “over the counter”. Since September, the Chicago Mercantile Exchange has traded weather-linked derivatives whose value varies with the temperature, measured by an index of warmth in four large American cities. Deregulation of the American and European energy markets has created a deep pool of demand for such instruments.

Such contracts are just the beginning. Farmers are accustomed to using derivatives to guard against the financial risks of fluctuating commodity prices. But imagine the scope for contracts linked to, say, how many growing days are lost in a season, or to low rainfall. In principle, finance can take the techniques developed to manage risks to do with price, and apply it to what used to seem unavoidable business risks.

Destocking

This promises to unbundle the risks of corporations in the same way that conventional financial products have unbundled the risks of financial institutions. There is a twist, however. When financiers package business risks as securities of some form or other, they are tinkering with the components of existing securities, such as debt and equity, that today pass aggregated risks to investors. Given the new technology of finance, some of the financial instruments that are taken for granted today may eventually become obsolete. Equity, for example, might be replaced by a series of risk-linked contracts offering specific payouts. Loan agreements might routinely include contingencies that affect the interest rate.To understand why, consider the mechanism by which firms typically try to protect themselves from harm: insurance. Chart 1 shows how a firm is exposed to losses. In a normal year, it will experience numerous small set-backs that cause small losses—the firm expects these to happen, just as a bank expects some of its loans to go sour, so these might be called “expected losses”. Insurance premiums paid up-front to cover these expected losses are equivalent to a tax-efficient (but non-interest-earning) bank deposit that is drawn down as the losses occur. In other words, the company has every expectation that most of the premium will be claimed back.

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But firms can also suffer larger, more expensive reverses, which are a nightmare for managers. The odds that catastrophe might wipe out the entire business are very small. But there is a bigger chance of some event that might seriously dent profits. And financial markets hate the unexpected. Securities analysts, who will discount a surprise gain as a one-off, will panic if presented with an unexpected loss. From the firm’s perspective, therefore, an unexpected loss may be even worse than it looks.

This gives a company an incentive to lay off any risk that is not intrinsic to its core business. Last year, for instance, British Aerospace (BAe) paid around $70m for an insurance policy that helped take 3 billion ($4.8 billion) of aircraft-leasing risks off its balance sheet. In the six weeks after BAe took out the policy, its shares outperformed the stockmarket by around 15%, presumably because the policy meant that its profits would depend not on some extraneous financial variable, but on what it is best at—building aircraft.

This sort of insurance is being sought by companies, but it is also being promoted by sophisticated insurers, such as Marsh & McClennan, SwissRe, AIG, XL Capital and Ace. They specialise in pricing the tiny odds of very rare events. They also want to improve their traditional insurance business by wrapping it up with financial protection—foreign-exchange contracts, for example—that used only to be available from the capital markets. They can do this effectively because these risks are uncorrelated with normal insured risks. By packaging them, the insurer creates a portfolio that is more attractive for an investor. In other words, these are “win-win” deals.

This broad trend in finance is known as “alternative risk transfer” (ART). It involves the ever-closer proximity of insurance and the capital markets, once almost entirely separate activities. Chart 2 shows how an array of financial and risk-management techniques fit this convergent pattern.
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After the revolution

On its own, ART could turn the financial industry upside down. But there is also a second revolutionary influence at play: technologies that are external to the industry, particularly telecoms and computing. As these become more powerful, they enable information and ideas to be communicated across vast numbers of people at very low cost. Plenty of traditional businesses, including auction houses and bookshops, are scrambling to react and finance is no exception. Already, new information technology is eroding the distinction between different parts of finance, such as banking and insurance. As the Internet matures, financial intermediaries risk seeing their margins flattened; and entirely new business models will emerge.Take online banking. Much of its appeal lies in the relative cheapness of high-volume transactions—a result of the low marginal costs of electronic processing. So too for stockbroking, mutual funds, pensions and life and car insurance. Until now, consumers have had little choice but to pay high prices for these services. Banks even take consumers’ deposits and make a profit on them. In future—fiercely as the incumbents will fight the trend—little money will be made from transactions, while deposits will pay near-market rates. In Britain, customers of E*Trade, an online broker, already receive better interest rates on spare cash in their accounts than they would from their bank. Accounts that make best use of credit balances are appearing.

But information technology also has a more profound potential. A conventional financial exchange is useful for so-called “price discovery”—matching buyers and sellers to find the market-clearing price. But imagine a vast electronic exchange on which literally millions of bids and offers are constantly flickering. It could be globally available on the Internet. Intelligent matching-systems of this kind mean that there is almost no cost to finding the best price available at a given time. Moreover, intelligent automated assetmanagers might seek out the instruments that best fit an investor’s desired risk profile.

These technologies enable the financiers to exploit their unbundling skills to the full. Harnessing the Internet, ART providers and other firms will parcel risks into different classes of securities. They may keep some themselves, but mostly they will sell them on to different types of investor.

Corporations’ insurance programmes will routinely include coverage of non-standard contingencies. Intriguingly, it will become normal for contracts to include protection not just against loss, but against the failure to gain. Business risks such as strikes, productivity or the failure of oil and gas exploration will in due course be covered as routinely as are property and workers’ liability.

Furthermore, firms will strike financial deals with a greater variety of institutions. Large pension funds, for example, have distant time horizons, and so are well-equipped to absorb risks that extend far into the future. These funds might directly sell a “catE-PUT” (decoded, a Catastrophe Equity Put Option), ie, a derivative contract giving protection against some specified catastrophe—an earthquake, say. If it happens, the insured company has the right to sell new shares to the pension fund at a set price. At present this cushion against misfortune is provided by common equity, hence such contracts would become a partial substitute for equity.

For today’s financial intermediaries, all this promises turmoil, as well as innovation. The engineering and pricing techniques needed to operate in the high-margin, sophisticated markets of ART and structured insurance are costly to assemble and maintain. 

But technology also has the power to demolish existing boundaries between different parts of the financial world. Banks are no longer the only providers of credit. Insurers are competing with investment banks to serve big corporate clients. Mutual and pension funds are making direct equity investments, bypassing securities firms. Many of the best financial firms 20 years hence will rely on intellectual more than monetary capital. Their skills, above all, will lie in packaging and marketing. Investors will measure their performance not simply in terms of their returns on capital, but also in terms of how risky they are.

If these trends play out, capital markets will approach a state of theoretical perfection. Thanks to the diversification made possible by the Internet, the rewards will go to those who assume the risk of doing badly in bad times. There will be an unprecedented degree of risk-sharing. Far more risks will end up with those investors most willing and best able to hold them. These developments could deliver a new level of efficiency and stability in the global economy.

Or not

Unfortunately, plenty of factors could yet spoil the party before it has begun. Consider five:

Recession. There is a direct connection between efficient financing and economic growth. Indeed, unless financial activity increases as a proportion of GDP, countries struggle to develop their economies. Correspondingly, if the world economy entered a recession, causing markets to tumble, the finance revolution could temporarily grind to a halt.

Governments. Upset by the speed at which they are losing control of central elements of state authority (the currency, say, or tax receipts), governments might clamp down on both financial and technological innovation. Financial scandals, such as the sale of inappropriate products to consumers, might lead to tougher regulation and stifle markets.

Privacy and security. A global finance industry will depend on large amounts of data about consumers. If these data are abused, there might be insufficient trust to achieve a mass market. Problems with security on the Internet are a particular danger.

Systemic risks. Some of the new financial technologies are, in effect, efforts to bottle up considerable uncertainties. If they work, the world economy will be more stable. If not, an economic disaster might ensue. Nobody knows how markets might react to a blow-up far bigger than, say, last year’s $3 billion debacle at Long-Term Capital Management (LTCM), a hedge fund. But fears of a widespread meltdown might lead regulators to constrain full cross-border financial activity.

Asymmetric information. Investors will have to be confident that they are not being sold exposure to risks that are far nastier than they appear. To get a lower price, for example, firms’ managers might be tempted to withhold information, or misrepresent the risks they face.

Which way will the future go? Thanks to technology, particularly the Internet, finance has the potential to reach both a new level of sophistication and breadth of participation. To some extent, the money men hold their destiny in their own hands. The prize is a glittering one. If only they can avoid speculative excesses of the sort that crippled LTCM and restrain their greedier impulses to mis-sell contracts and policies, it is surely attainable.

* See "Nuclear Financial Economics", published in "Risk Management: Problems & Solutions". McGraw-Hill, 1995.