The Determinants of Successful Financial Innovation: an Empirical Analysis of Futures Innovation on LIFFE

Abstract

This paper documents futures innovation on LIFFE by empirically analyzing the individual growth profiles of its futures contracts and the factors that determine contract success or failure. The paper documents considerable heterogeneity across contracts, and finds that contract success can not easily be inferred from the contract's first years of trading. As expected, contract success is highly correlated with the size of the underlying market, as well as with its volatility. The paper also confirms the existence of a first-mover advantage. There is little systematic correlation, however, between bid-ask spreads and futures volume. This suggests that there may be a critical level of trading activity beyond which bid-ask spreads and execution risk vary relatively little. It is further argued that liquidity seems less a cause of contract success (or lack of liquidity a cause of failure), but rather a consequence. These results may provide a useful perspective as exchanges prepare themselves for the planned monetary unification. Successful product innovation will be critical since exchanges may face a drop in demand with reduced monetary uncertainty, and a reduction of the current spectrum of interest rate contracts to Euro contracts only. A related question is whether a futures markets needs a well developed spot market to succeed, or whether the creation of a futures market could help to boost liquidity in a fledgling spot market.