Tuesday, September 30, 2008

Financial Regulation through Patents

One reason this meltdown has been so bad is because every financial institution has been affected. They all are exposed to instruments linked to mortgages, and all are severely leveraged. I have seen numbers that there are $1 trillion in mortgages tied up in this meltdown, but that there is $62 trillion in paper linked to the performance of those mortgages. Leverage.

Now imagine if only Bear Sterns was exposed. Lehman, Merrill, Goldman, etc. had no exposure. Or only exposure as a counterparty to Bear. Would we be in this mess? No. There would be diversification across the industry.

Convergence of strategy, mimicry of products, and correlation of assets magnify and to some degree create unsound market conditions. One firm develops a hot new product, e.g. Mortgage Backed Securities or Credit Default Swaps. It rakes in great returns and collects huge fees. Everyone else copies that firm, drives down the margins, and over saturates the market. That particular market collapses, and people move on to the next hot new financial product.

Now let's re-imagine that only Bear Sterns had a particular mortgage backed financial product, and further that no one else could sell that product. Get rid of convergence and mimicry and reduce correlation. But how can do this?

Business Method Patents.

Yes, the much laughed at Business Method Patent. So now, when Bear develops its great new financial product tied to mortgages, they patent it so that no one else can copy it. Goodbye convergence. Goodbye correlation.

Three great things come out of this: (1) Other firms have to develop their own products, encouraging competition, (2) The market for this product is effectively capped, and (3) If this product tanks (or the market underlying the product tanks), damage to the macro-economy is limited (because the market has been capped).

As always, the devil is in the details, e.g. defining the product in a narrow enough sense that it doesn't cover all products tied to mortgages but broad enough that it reduces convergence and correlation.

I will try to check with an inside source at the USPTO for his or her thoughts.

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