Since The 1960 S, The U.s. Financial Innovation And Its Main External Motivation

Since the1960s and1970s, the U.S. and global financial markets have witnessed anunprecedented wave of financial innovations. New money market instruments, financialderivatives, securitized products and new types of bonds and equities emerged and prospered, andwere once welcomed and celebrated by the market. However, after the outbreak of the2008financial crisis, Redidential Mortgage Backed Security (RMBS), Collaterallized Debt Obligation(CDO), Credit Default Swap (CDS) and other financial innovations came under scrutiny and werefiercely criticized for the negative role they played in the outbreak and development of the disaster.With this in mind, this paper aims to explain the innovation influx by performing theoreticaland empirical studies on the advances of financial theories, the development of IT technologies,market volatility, financial regulation and deregulation, tax environment, market competition,financial globalization, and other major factors affecting the U.S. and the global financial marketsin recent decades. This paper also discusses how these external factors may have stimulated andcontributed to financial innovations by influencing the internal innovation incentives of theinnovators. In addition, it analyzes the emergence of several major financial innovations in the U.S.and global financial markets and thereby reveals the importance of the above-mentioned externalfactors in financial innovation practices. It further describes the role of financial innovations in theoutbreak, exacerbation and spreading of the current financial crisis, as well as their negativeimpacts on financial stability.This paper is divided into five critical parts and it is organized as follows.The first part reviews in details the definitions, taxonomies of financial innovations and themajor financial innovation theories to set the stage and lay a solid theoretical foundation for laterdiscussions.The second part discusses the significant advances in financial theories and IT technologies,the volatility of inflation, interest and foreign exchange rates, and the shift of regulatory and taxenvironment; it also studies the intensification of competition, the increasing globalization offinancial sectors, and other major changes the U.S. and global financial markets went through inthe past decades. Moreover, the second part examines in depth the influences of these externalfactors on the operating efficiencies, market share, risk exposure, profitability, cost, liquidity andcompetitiveness of financial market participants, and explores the channel through which thesefactors stimulated financial innovations. The third part carries out empirical studies on money market instruments such as NegotiableCertificate of Deposit (CDs), Money Market Mutual Fund (MMMF), Money Market DepositAccount (MMDA), financial derivatives such as futures, options and swaps, structured financialinstruments such as RMBS and CDO, and the latest financial innovation-mobile payment, whichexperienced noteworthy growth even in the crisis context. Through the studies of these real lifecases, the relationship between financial innovations and the major external factors is furtherexhibited and testified.In the fourth part, the emergence, expansion and explosion of the housing, mortgage andfinancial market bubbles are studied and the roles of RMBS, CDO and CDS in the whole processare given special attention. This part also provides an update on the latest development of severalmajor financial instruments and technologies after the outbreak of the financial crisis andsummarizes the post-crisis regulation reform efforts made by the international and U.S.financialregulators.The final part draws conclusions on the studies of the paper and provides suggestions on howfinancial innovations should be dealt with.