The trial of FTX founder Sam Bankman-Fried on fraud charges is another example of seemingly promising financial innovations that have devastating consequences, both for those directly affected and for the larger financial ecosystem of which cryptocurrencies were until recently a part.

The jury’s conviction shows us that FTX – and perhaps the cryptocurrency markets in general – was an intentional fraud or a kind of trust game that relied on participants having to willingly suspend their disbelief in order to keep the wheels turning to keep. Regardless of the underlying merits of blockchain technology, the failure of FTX and some of its brethren fits well with recent examples of financial crises large and small caused or exacerbated by innovation.

While failed advances in the industry are nothing new, consider the financial sector over the past few decades. The savings and loan crisis of the 1980s had myriad causes, but the rise of a significant market for new “junk” bonds was certainly a factor. Similarly, the 1987 Black Monday stock market crash was accelerated by “portfolio insurance” program trading strategies designed to hedge risk in falling markets. The global financial crisis of 2007–2008 began with a sharp decline in the prices of mortgage-backed securities (and related derivatives) tied to American residential real estate and then spread to global capital markets. And the “crypto winter” is with us; Cryptocurrency prices have plummeted and – in the case of FTX and other failed exchanges – investors who lost money are left wondering who they might seek compensation from.

In the economics literature, financial innovation is typically viewed as a pure good, a defensible view in that it lowers the cost of capital for productive investment and eliminates frictional costs associated with middlemen and other toll collectors that are prevalent in modern finance. Creativity of this kind can even realize other social goods; To the extent that greater access to capital and a level playing field are achieved – particularly through democratized peer-to-peer channels that bypass institutional gatekeeping by subject matter experts – greater trust in the economy and financial system logically follows. However, these benefits can be difficult to quantify and may be more hypothetical than real.

Could it be that financial innovations actually do more harm than good through negative consequences that can wipe out any gains associated with expanding access to capital and reducing the cost of capital? Or could it be, as with other new technologies such as VCRs, that such innovations are occasionally used for less palatable purposes (in the case of home videos, pornography) before being “tamed” and eventually contributing to a net social benefit?

The current evolution of commercial lending in the United States highlights the potential for systemic risks and net societal losses resulting from innovation. For centuries, commercial lending was a straightforward affair between bank and borrower. An expanded regulatory framework in the 20th century led to greater oversight of commercial banks’ lending activities, as lenders were responsible for managing the risk they initiated.

The development of syndicated financing, both loans and bonds, separated lending from the distribution and storage of risk to achieve lower borrowing costs. Specialization between parties led to greater efficiency as the ultimate risk takers had lower cost structures, fewer regulatory burdens or greater risk management expertise. Unfortunately, distributed financing also led to more aggressive financing terms and borrower-friendly provisions – those who structured the deals did not have to live with them – which led to machinations by companies and financial sponsors aimed, among other things, at favoring borrowers at the expense of creditors, with unforeseen consequences .

Therefore, with the explosive growth of private lending or “direct lending,” credit markets are returning to sourcing, structuring and holding risk under one roof. Morgan Stanley estimates that the private lending market, which grew from $875 million in 2020 to $1.4 trillion in early 2023, will grow to $2.3 trillion by 2027. However, there is an important difference in this new banking architecture: direct lenders and other fund-based private credit providers are not subject to the same regulation as depository institutions. It takes little imagination to imagine a future 2008-style “Lehman moment” where the New York Fed doesn’t know exactly who to call to find out about market conditions, to figure out where the biggest systemic risks are exist, or to offer financial support.

Without predicting exactly what, when and how a systemic crisis might develop due to the growth of private credit, market signals can provide a clue to how innovation can lead to mispriced risks and their consequences. The rapid growth of private credit as an asset class poses the risk of a bubble as it increasingly displaces regulated commercial lending due to more competitive pricing, lower cost structures and regulatory arbitrage. Direct lenders’ almost unlimited access to institutional investor capital will facilitate further growth as banks withdraw from lending to companies.

This growing competition between alternative lenders for opportunities creates the risk of poor loan selection and risk mispricing; Credit spreads should reflect the risk of loss, but the supply/demand dynamics of funds that are structurally incentivized to deploy capital – as opposed to banks that may choose to lend to other sectors or simply buy government bonds with depositors’ money – can hinder regulatory risk management and lending pricing. Furthermore, estimating the repayment of defaulted loans in a new market with low liquidity, opaque pricing, heterodox financing conditions and no prior experience with instability is an impossible task, leading to further mispricing and misallocation of capital. When the inevitable industry-wide emergency occurs, the socialization losses will be even more damaging than after the 2008 financial crisis.

As with “progress” of any kind, one need not allege fraud or nefarious intent to ask, “Cui bono” – in whose interests is this creativity being used? Are adaptations in the financial services sector intended primarily to achieve their stated purpose on behalf of customers or counterparties, or does the “alpha” resulting from innovation fall almost exclusively to the innovators? The alleged innovation efficiencies should be contrasted with larger systemic impacts that often result from poorly designed and self-serving innovations.

As the financial sector has evolved from a service function for trade into a significant economic sector in its own right, it is crucial to keep an eye on its essential utility function – a function in which, in addition to direct economic actors, the economy and society at large have an interest have. Customers and counterparties. To fully consider and internalize the costs and consequences of a new financial product or invention, we do not need to stifle creativity. On the contrary, limiting the number and severity of future financial crises will increase confidence in the financial assets needed to sustain free enterprise and maximize benefits for all.

Richard J. Shinder (@RichardJShinder) is the managing partner of Theatine partner, a financial consultancy. He writes on economic, financial, geopolitical, cultural and corporate governance-related topics.

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