by CIO Staff

Robert J. Shiller on Technology’s Impact on Financial Markets

Sep 22, 20035 mins
Risk Management

In 2001, Iempower of New York City created a website and online exchange to allow individuals to finance their educations by selling shares in their future incomes to investors. With this remarkable new market, individuals can hedge some of the risks of their human capital investments, and investors who put such shares in their portfolios can invest in this human capital—that is, participate in the development of labor income. Literally, one can invest in people.

The same year, City Index of London created an online futures market for a U.K. index of home prices. With this new market, homeowners or builders can hedge the risks of their long position in real estate, and investors can add U.K. owner-occupied homes to their portfolios.

In 2002, Goldman Sachs and Deutsche Bank created the Economic Derivatives Market, an electronic marketplace where financial professionals can trade macroeconomic indicators such as nonfarm payroll and retail sales. This lets people hedge macroeconomic risk—risk that the aggregate economy will fail—and investors can participate in national incomes.

Those innovations represent radical expansions of the scope of our financial markets beyond the traditional realm of Wall Street to cover other risks: career outcomes, the value of homes and national economies. These risks to our ordinary riches really matter, and until now there have been no substantial financial or insurance institutions to deal with them.

While none of these markets has attracted much public attention, they represent the beginnings of an important trend. Probably the most important driver of new risk marketplaces is IT, which helps overcome previous barriers.

There should be no surprise in this: Advancing IT helps promote all sorts of activities. But dealing with risks to our homes, our careers and our countries are activities that are especially helped by IT. Dealing in such individual risks—or, in the case of macroeconomic aggregates, the sum of individual risks—requires data on the smallest units of economic activity.

But these markets present new risks that must be managed. Doing this without generating a prohibitive “moral hazard” cost (the economic term for the cost incurred when risk management causes people to be careless about or even welcoming of risks, as when an insured homeowner either neglects the home or deliberately burns it down to collect on the policy) requires extensive surveillance at a fine level.

Consider risks to individual homes. In the past, some of these have been dealt with by homeowners’ insurance, which has covered losses due to objective, verifiable events, such as fires. Insurance focused on the kinds of risks that could be readily verified given the state of information technology, and for which procedures could reasonably be put in place with that technology to catch much of the moral hazard.

With vast new databases now being developed on home sales, and on activities of homeowners, it should now be possible to extend risk management to a broader list of risks to home values, such as the bursting of a housing bubble or a region’s economic decline. A potential problem with this sort of financial market, however, is the creation of moral hazard problems that are much more severe than the risk that a homeowner will deliberately burn down the house to collect. If homeowners no longer have any worry about maintaining the value of the property, there are a million different ways for them to neglect it—ways that cannot be dealt with the way arson has been. But IT provides a way out of this fix: Better databases allow us to write risk management contracts against an index of home prices for the neighborhood in which the homeowner lives. Since the risk corresponds to the neighborhood, no moral hazard arises.

By the same token, allowing people to sell shares in their own future careers carries with it potentially enormous moral hazard problems. People whose careers are insured can just not try hard, not make the tough decisions, and not trouble to keep themselves up to date in their fields. In fact, this moral hazard problem has become endemic to social welfare systems in many countries. But this moral hazard can be dealt with by various methods that are well known in the financial community, if new IT brings down the currently high costs of operating them. For example, we can use the expanding databases on individuals to create indexes of incomes for people in particular sets of circumstances. In this way, risk management contracts are tied to indexes rather than to individual incomes. Once again, IT can be used to control a moral hazard.

Methods to hedge the macroeconomic risks that countries face are also subject to moral hazard problems. Most notably, it has been difficult to know if the data reported by governments is always trustworthy. But the rapid expansion of databases and the software to disseminate that information makes our knowledge of national incomes, and any efforts to manipulate them, much higher.

The beginnings of innovative new markets that we have seen in the past couple of years are based on a recognition of the importance of IT. There is real hope that these beginnings will lead to bigger, better new institutions, which will allow coverage of very real risks against which people historically have had no protection. Markets do not become important until the public senses that they are deep and liquid, and that the prices quoted in this market represent substantial opportunities to buy and sell. Depth and liquidity develop slowly during the years, as more and more people acquire the skills and habits to deal in them. New IT has dramatically expanded other financial markets, and I predict it will do this for risk markets as well.