In 1973, Fischer Black and Myron Scholes wrote a paper called `The pricing of options and corporate liabilities’. The paper described how to price a stock option. Their relatively simple formula represented one of the most powerful technologies ever given freely to the world. Today, over a million people owe their living to the gift that is now called the Black-Scholes model. They are traders, financial engineers, fund managers, accountants, risk managers, mid-office and back-office clerks, software engineers, consultants and regulators.

The techniques invented by Black and Scholes have led to innovation after innovation. In addition to stock derivatives (contracts that “derive their value from the price of a stock”), people now trade interest-rate derivatives, foreign exchange derivatives, commodities derivatives, weather derivatives and even credit derivatives. Farmers have used the contracts to hedge their exposure to fluctuations in the price of wheat or oranges. Banks have protected themselves against changes in interest rates, making them more sound and secure. Speculative trading desks and hedge funds have used them to generate literally billions in profits.

The constant invention of new products is a great example of how the various companies in an industry were forced to generate repeat innovation in order to sustain above average profits. Although Black and Scholes provided the basic innovation, it took time for everyone in the market to get the people, systems and processes in place to trade stock options effectively. While they where getting up to speed, the first players in the market made a fortune. As more and more trading desks entered the market, the bid offer spread on stock options started to decrease. Profits started to fade away. Firms invented new contracts, such as interest rate derivatives. Profits appeared again, and slowly ebbed away. Today, we are at the beginning of a new cycle based on credit derivatives.

There are two interesting things about the history:

• The whole derivatives industry began with the open sharing of knowledge
• The continued run of extraordinary profits is based upon the continued sharing of knowledge and co-operation between competitors in helping to define new financial derivatives. Some might find the fact that these competing banks, traders and hedge funds compete on anything surprising. The reason for the co-operation is simple. If you want to trade, you have to have someone to trade with. The big market making banks have figured out that it is in their interest to teach their potential counterparties how to use each new type of contract they invent. The structure to facilitate this knowledge sharing relies in part on existing information sharing structures in the form of academic journals. The banks have also created new associations such as the International Swaps Dealer Association (ISDA). To facilitate the exchange of information describing trade details, the banks have also set up the Financial Products Mark-up Language Organization (FpML Organization), which works to standardize an XML schema for describing swaps, caps, floors, credit derivatives, for example. The way that innovations are shared is somewhat informal, but all the components are there:
  1. The players all know who is who:
  2. They know what is going on because they have standardized how to distribute new information into the market.
  3. They very obviously feel that they own a piece of the pie.
  4. There is an environment of reciprocal altruism. The world of Over the Counter derivatives is built on the notion that if my sales team brings you bagels, takes you golfing or shows you how to successfully use new types of derivatives contracts, then you should send a few trades my way.

  The environment has a complex and robust feedback system that stretches from academic review of new pricing models to the very direct feedback of market discipline – get things wrong and you stand to lose a small fortune.

  5. The entire market is primed to expect constant innovation.

The derivatives market is a perfect example of independent agents who were able to create innovation. The financial derivatives industry is a self-organizing system of independent, self-motivated companies and trading firms that, collectively, produce predicable results; in this case, a stream of constant innovation and the associated profits. However, its continued success has been contingent upon a well-defined, structured platform that supports that innovation.