A Side Effect of Financial Innovation

Abstract

Financial innovation often involves the creation of new instruments that bundle existing securities such as mutual funds or exchange traded funds. In this paper we argue that while the creation of such assets has advantages such as lowering transaction costs, there can also be negative side effects. Investment in the new instrument may reveal information about future demand for the underlying securities, as the fund managing the instrument often needs to mechanically re-balance its position. Informed arbitrageurs may trade, exploiting their knowledge of this re-balancing. In general equilibrium, this trading activity can make the price of the underlying securities less informative and more sensitive to re-balancing shocks. We show that this loss of information may outweigh the direct gains from lower transaction costs that uninformed investors achieve. So welfare of uninformed investors may be lower. We argue that the potential effect on the market for the underlying securities may be substantial. To illustrate our mechanism, we analyze two episodes of financial innovations in the oil and volatility markets. The magnitude of the effect can be gauged by the fact that introduction of the new instrument in the oil market led to a temporary violation of a no-physical arbitrage condition.