The question posed by this book, simply put, is: Why can’t the financial markets seem to get their act together? Why, in spite of reduced risk in the underlying economy, in spite of the march of innovation and the contributions of financial engineering, do we not enjoy reductions in financial risk that we find in other areas of our lives? Why are markets actually becoming more crisis-prone?
One answer can be found in the effects of innovation. It is undeniable that innovation has had some positive effects on the markets. It has improved the markets by making them mechanically more efficient. The markets are more liquid and quicker to react to information. Information flows more freely and is distributed more widely, and prices are readily available to virtually all participants. Trades are executed nearly instantaneously worldwide at transaction costs that are a small fraction of what they were a few decades ago. And, whether developed with the intent of better meeting the demands of investors or, more cynically, to stave off commoditization and maintain profitability, we are awash in new and innovative instruments.
But the positive effects of innovation come at a price. Innovation increases complexity. Many innovative instruments are in the form of derivatives with conditional and nonlinear payoffs. When a market dislocation arises, it is difficult to know how the prices of these instruments will react. Innovation and mechanical efficiency have also ...