The Future of Financial Engineering

Andrew Lo's research results and the implication that there are pockets of predictability in the stock market lend support to contrarian strategies of buying losers and selling winners (see Contrarian Investing). But he is less convinced by investment strategies based on the insights of behavioral finance into psychological biases inherent in human cognition, which aim to take advantage of individual "irrationality" As financial engineering attempts to define itself as a field with connections closer to the engineering disciplines than more traditional finance, associations are being set up, and the general engineering community does not quite know what to do. Patenting is becoming a big issue. Recent changes in patent laws and interpretations, along with encouragements for universities to do more patenting have led to an explosion of new patents. Some of these are in financial engineering but it is not clear which can be defended. Certainly, financial patents will have an impact on the efficiency of markets and the rate of financial innovation.

Financial engineering is also having an impact on banking. Innovation in combination with electronic technology is creating a world in which maturity transformation turning short-term deposits into long-term loans, the central function of banks is unnecessary. Economic agents individuals, households, companies will no longer require this service. Their portfolios of assets and liabilities will be broadly matched in maturity terms: short-term assets will match short-term liabilities, longer-term liabilities will offset longer-term assets. As a result, as Peter Martin of the Financial Times suggests, "traditional banking is dying. But the grieving throng around the deathbed face a long and expensive vigil."

Finally, what about market innovations? Financial innovations have been fast and furious over the past two decades. But why are market innovations so slow in coming? We have known for a long time what to do: integrate global markets electronically; pay shares in decimals not fractions; open the specialist books and stock exchanges like the New York Stock Exchange; record and display publicly the questions and answers exchanged by companies and analysts. Indeed, we could even go further and encourage insider trading, bringing insiders' wisdom into the market sooner rather than holding out, waiting for culprits to take advantage of us. It could be done, merely by identifying fewer insiders and letting them trade, at which point they would identify themselves. All of these things and more could be done in a stroke.