SECURITIES INNOVATIONS: A HISTORICAL AND FUNCTIONAL PERSPECTIVE

• Published date: 01 January 1995
• Author: Peter Tufano
• DOI: http://doi.org/10.1111/j.1745-6622.1995.tb00265.x
• Date: 01 January 1995

Journal of Applied Corporate Finance

WINTER 1995 VOLUME 7.4

Securities Innovations: A Historical and Functional Perspective

by Peter Tufano

Harvard Business School

90

JOURNAL OF APPLIED CORPORATE FINANCE

SECURITIES INNOVATIONS:

A HISTORICAL AND

FUNCTIONAL PERSPECTIVE

by Peter Tufano,

Harvard Business School*

90

BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

*This article is a condensed version of “Securities Innovations: A Historical and

Functional Perspective,” which appeared in the book, Cases in Financial Engineer-

ing: Applied Studies of Financial Innovation (Prentice Hall, 1995) by Scott Mason,

Robert C. Merton, Andre F. Perold, and Peter Tufano. The recent case studies

discussed in this article are described in greater detail in the book. I would like to

thank Don Chew for his editorial assistance.

1. John Moody, “Preferred Stocks as Investments,” Annals of the American

Academy of Political and Social Sciences, 35 (May, 1910), p. 545).

2. The concept of functional analysis was introduced in Merton, “Operation

and Regulation in Financial Intermediation: A Functional Perspective,” in P.

Englund, ed., Operation and Regulation of Financial Markets (Stockholm: The

Economic Council, 1993). The ideas underlying the functional perspective have

been developed in the co-authored volume, Global Financial Systems: A Func-

tional Perspective (forthcoming HBS Press, 1995) by D. Crane et al.

provisions—as providing the principal impetus for

modern securities innovations. But the limits of

such a purely institutional approach are suggested

by the historical record of innovation that, in the

U.S., stretches back at least 150 years. Innovation

predates many of these relatively recent institu-

tional factors—the U.S. income tax, for example,

was not introduced until 1913. By focusing exclu-

sively on the present, institutionally-based explana-

tions fail to capture what appear to be timeless

aspects of securities innovation.

The rich history of financial innovation, com-

bined with a multitude of institutional explana-

tions, leads us to seek more basic explanations

for the phenomenon. In this article, I adopt the

functional approach suggested by Robert C. Merton,

which decomposes financial products and institu-

tions into a set of “permanent” functions that they

deliver.2 This approach calls attention to similari-

ties among diverse securities. For example, the

dynamic trading strategy of portfolio insurance

must be compared with exchange-traded put op-

tions and explicit guarantees by insurers, because

even though the three are cloaked in different

institutional garb, they address a common prob-

lem: risk management. Similarly, in the 19th cen-

tury, three quite different innovations—voting trusts,

bond covenants, and preferred stocks—all at-

tempted to resolve conflicts between stockholders

and bondholders.

he past two decades have produced a

remarkable number and variety of seem-

ingly new securities. Collateralized mort-

gage obligations (CMOs), high-yield

bonds, municipal bond swaps, exchangeable bonds,

Nikkei put warrants, adjustable-rate and auction-

rate preferred stocks, PERCS, SuperShares, interest-

rate swaps, and natural gas derivatives—all these are

just a few of the inventions of the past 20 years.

But innovation is not new to the U.S. financial

system. In 1910, John Moody, founder of Moody’s

ratings, lamented the bewildering innovations of his

own day:

Twenty-five years ago it was comparatively easy

to acquire a sound knowledge of the general invest-

ment field...[but now] the different types of securities

have multiplied in number to an almost unlimited

extent...[T]he different types of [securities] which are

daily sought for investment nowadays are often so

different...that not only must each class be judged by

itself, but a great many issues of the same general

class have distinct traits which go far to affect directly

their position and value as investments.1

Eighty-five years later, many observers must share

Moody’s sentiments as they puzzle over financial

engineers’ latest handiwork.

Some finance scholars have identified “institu-

tional” factors—such as particular tax or regulatory

T