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A brief history of financial innovation

Modern money matters have come a long way. And probably have a long way yet to go. Here are five trends which have revolutionised our economies.

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Does history repeat itself? Opinions differ, but at least one thing is certain – no, make that five things. When it comes to finance, you can count on one hand its broad themes of progress: substitution, securitisation, banking, hedging and automation. That’s a bit abstract, so let’s look closer at reality.

What’s money: Substitution 
It’s amazing that we can give pieces of paper in exchange for homes, cars, clothes, meals and the like. Special pieces of paper – banknotes, namely – but still, they have little intrinsic value. No wonder it took so long for paper money to become common: in the West only since the 1600s. And even at that, up until the mid-1900s most currencies were backed by gold or silver, i.e. they could be cashed in for fixed amounts of either precious metal. Since then, however, most paper money is backed only by itself, by the willingness of people to accept it (or not). In any case, paper is easier than barter: just picture trying to swap cattle for cars or clothes. Over time, trading cows gave way to trading coins, which yielded to paper, which more recently moved to plastic and now to smartphones. For consumers, substitution’s driver is ease of use: imagine trying to fit a cow in your pocket!

Share the wealth: Securitisation
Securitisation, according to Investopedia, has its modern roots in the 1970s, when mortgage-backed bonds debuted in the USA. But in a broader sense, the concept dates to the invention of joint-stock corporations, which came into their own with the creation of various East India companies starting about 1600. Financing voyages half-way around the world to trade gunpowder for spices and silk was too big and too risky for single investors. So they created shares, with limited liability. Soon thereafter share trading started, informally in coffee houses around Europe and then on newly-established stock exchanges, which have become bedrock of modern financial markets.   

Safety in numbers: Banking
Banks today are even more self-evident than stock exchanges; their origins are only a couple centuries older, starting around 1400 in what is now northern Italy. Their main functions – saving and lending – date back to the dawn of history, but modern banks made them user-friendly and widely available. Banking has since become so ubiquitous, it’s easy to overlook the value of its features: safe storage, which beats a mattress or an enormous wallet; ease of transactions, much more so than cash or coin; reliable, reasonably-priced lending; and the consumer-side of securitisation, i.e. buyers of securities.

Where there’s a winner there’s a loser: Hedging
Medieval merchants were the first to get on this. There were fortunes to be made when a ship came in, and fortunes to be lost when it sank. So they developed a primitive form of insuring against the latter. Farmers followed suit starting in the 1800s, selling ‘future delivery’ contracts to lock in a price well before harvest. Insurance and hedging have since boomed into major industries. An entire subsector has grown up around financial derivatives, that stretches from relatively easy-to-understand futures, calls and puts to arcane (but widespread) instruments such as credit default swaps and barrier reverse convertibles.

FinTech is icing on the cake: Automation
Robots are everywhere these days. Just as the Industrial Revolution mechanised life – by replacing workers with machines – the Internet Revolution is digitalising it, by replacing workers with computers. In finance, Exhibit A is the cash machine: a combination machine-computer that’s been around for 50 years now. No longer must we queue for a teller during business hours. (How did we live without them?) Pocket calculators arrived around the same time, preceded of course by adding machines and abacuses, followed by vast computer systems. Online banking came in around the millennium, and this seems to be the straw that broke the back of banks’ physical networks. Fewer and fewer customers need to visit their bank in person, so more and more branches have closed. In America, estimates the US Federal Reserve, about 1% of branches are shut every year. In Switzerland, reports the Swiss National Bank, the decline is similar. The latest wheeze in automation is called financial technology, or FinTech. This is more of the same: allowing things like investing, borrowing, mortgage initiation to be done with a minimum of human intervention. Interest is huge – 2018 global investment in the sector topped USD 80 billion.