As a finance professor, I craved scientific “truths” for my classroom: powerful, elegant, and timeless ideas. Powerful, so they could be useful and show I am essential. Elegant, so they could be both beautiful and show me to be clever. Timeless, so they would stand the test of time and allow me to teach them again next year. Many concepts in finance meet these tests. The law of one price — that two assets with the same cash flows have the same price — serves as the bedrock of much of valuation.
Perhaps the most timeless concept, advanced by my former colleague and Nobel laureate, Bob Merton, is that of the functional perspective. Financial systems, be they from centuries ago or today, whether in developed or developing countries, deliver a core set of functions. They permit us to pay for goods and services, move money from today to tomorrow, move money from tomorrow to today, help us manage risk, and so on. With a functional perspective we can see that many diverse products are actually substitutes and that many institutions, while seemingly different, deliver the same core functions.
Consider the various products and institutions that allow you to pay for goods and services: government-issued cash; cheques; cryptocurrencies; postal and private money orders; debit, credit and stored-value cards; barter systems; PayPal; Venmo; direct deposits . . .
While not identical, each delivers the same core functionality. By stripping them back to their function, we can better understand potential competition, how technology might change the playing field, how institution-based regulation can lead to unevenness, and more. The functional perspective gets us out of the dangerous problem of seeing everything as sui generis.
Having a big picture perspective and a set of timeless skills serves us well. But applying these theories is messy. As a financial engineer, I appreciated option pricing models, but without reliable volatility measures these only provide bounds on valuation. Similarly, I found stylised descriptions of securities contracts are helpful, but when they ignore substantial and material aspects of the contracts they only give rough indications of value.
We know from research that the history of financial innovation is as much about the failures as the successes
Time also is cruel to the application of theory. Sadly for teachers hoping to reuse old PowerPoint slides, specific applications of apparently timeless principles quickly pass their use-by dates. Fintech reminds us that while functions are timeless, the pace of change is relentless. About 16 months ago, a team from Oxford Saïd and I worked with a World Economic Forum subgroup to produce a report on the application of fintech to small and medium-sized enterprises. A few weeks ago, a friend noted our report was “out of date”. The school has launched two fintech initiatives in the past two years and will announce a bigger one later this year, but we must accept much of our content will quickly need to be refreshed.
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The half-life of solid theory is long, but of our applications the half-life is short. We cannot be content with saying “we will just study the surviving innovations” because we know from research that the history of financial innovation is as much about the failures as the successes. Fintech is even more problematic, because the innovations are not coming primarily from financial institutions that we know, but from start-ups we do not and, in some cases, from organisations with little experience of the financial system. While their naivety might lead to some dead ends, it might allow a clever few to construct new and powerful businesses. This will force us to rewrite our notes.
What are the implications for deans, teachers, and students? As with most things, navigating change requires a sense of balance. We must teach and learn enough theory to understand the timeless. But we must become deeply engaged with fast-moving practice, not only to see how theory might be applied, but sometimes how it is challenged by the messiness of business.
In this time of rapid change, we need to forge substantial links between practice and academia, through frequent speakers, encouraging faculty to work with practitioners, bringing in practice-based faculty, and by adding live cases, projects and experiential teaching to our curriculums.
We will have to tear down walls. Finance has long been the province of economics, but data science may play a greater role. For example, there is a long history of theory and research on efficient markets, but how does access to new data and algorithms change the notion of “public information” on which efficient markets depend? What is public in a world where privacy is a challenged concept? The collision of timeless theory and out-of-date examples makes this one of the most exciting times to study and practice finance.
The writer is the Peter Moores Dean and a professor of finance at the University of Oxford’s Saïd Business School