Collateral-Motivated Financial Innovation∗

This paper proposes a collateral view of financial innovation: Many innovations are partly motivated by alleviating collateral constraints for trading (speculation or hedging). We analyze a model of investors with disagreement. The trading need motivates them to introduce derivatives, which are endogenously determined in equilibrium. In the presence of a collateral friction in cross-netting, the derivative that isolates the variable with disagreement is “optimal” in the sense that alternative derivatives cannot generate any trading. Financial intermediation arises as a way to mitigate this collateral friction, leading to asset-backed securities and tranching. This view of financial innovation is distinct from “completing markets”: We demonstrate that in an economy with N states, investors may prefer to introduce more than N securities, and yet still don’t complete the markets. More broadly, this collateral view highlights the common theme behind a variety of innovations with strikingly different appearances: the invention of securities (e.g., swaps), legal entities (e.g., special purpose vehicles), legal practice (e.g., the superseniority for derivatives), as well as the efforts in improving cross-netting. JEL Classification Numbers: G11, G23.