IF STANDARDISATION IS one way to make financial innovations catch on, mutation is another. By experimenting furiously with new products, the industry can hit on iterations that work. And once something has taken hold, a host of incremental changes follow as firms compete for custom. “Any good idea is immediately copied and propagated like a virus,” says Robert Litan of the Kauffman Foundation. “If its a bad virus, then you have a pandemic.”

The industry does little patenting. On the retail side there is some attempt to protect new technologies, but for capital-markets businesses this is not a priority. In a global ranking of firms assigned patents in America in 2011, drawn up by IFI CLAIMS Patent Services, the first financial firm in the list was American Express—in joint 259th place.

Special report

One reason may be that in the capital markets ideas require liquidity to take off: the more institutions that imitate an instrument, the deeper liquidity is likely to be. Another is that copying is easy. “A financial product is about as conceptual as you can get,” says Wilson Ervin, a senior adviser at Credit Suisse. “You just need paper and ink.” A patent has to be published after a year or so, enabling rivals to design around it. In any case, monetising an idea immediately opens the door to copying because of disclosure requirements under securities laws. Mr Ervin reckons that firms have a window of three to four months before rival products appear. It does not help that clients shop around to see if they can get the same sort of thing cheaper from another firm.

There are cultural and technical barriers to using patents, too, according to Karen Hagberg of Morrison and Foerster, a law firm. The targets for enforcement would be other financial institutions and they are hesitant to sue each other. As a result, in the past courts have been asked to decide relatively few patent-litigation cases in the financial-services industry. Without an existing body of law to provide some insight into how courts would decide relevant issues in the future, such as what constitutes an infringement and how to calculate damages, it is riskier to call in the lawyers. Instead, products are left to spawn and mutate at their own pace, and not always in a healthy way.

Few instruments so encapsulate the mutability of financial products as the exchange-traded fund, or ETF. No one has a bad word to say about the concept. Invented in the late 1980s by the Toronto Stock Exchange, the ETF is in essence a cheap mutual fund: a basket of securities that tracks an index, is wrapped in a fund structure and is listed on an exchange so that investors can trade in and out whenever they want. They are cheap and tax-efficient, and they allow retail investors access to diversified portfolios of assets that had previously been the sole preserve of institutional investors. “If you were inventing the mutual-fund industry today, it would look like this,” says Salim Ramji, a consultant at McKinsey.

Even so, the product did not gain momentum immediately. According to Dan Draper, who runs Credit Suisses ETF business, the spark to spectacular growth came only after the dotcom bust had underscored the importance of diversification. The rise of fee-based financial advice also pushed more investors towards ETFs. In recent years the instrument has built up huge momentum (see chart 3), and the 2007-08 financial crisis did nothing to slow it. The number of ETFs on the market in America has mushroomed from 343 in 2006 to 1,098 in December 2011. A recent McKinsey report forecasts that global assets under management in exchange-traded products, a broader universe of listed portfolio-tracking products, could grow from about $1.5 trillion in 2010 to $3.1 trillion-$4.7 trillion in 2015.

Finances infectious creativity is again on full display. You can buy ETFs that are sharia -compliant, that invest in clean-energy stocks, that focus on emerging-market local-government debt, and many, many more. “Well stop creating ETFs when you stop having ideas,” boasts the website of iShares, BlackRocks ETF arm. Other exchange-traded products allow investors to gain exposure to commodities, from gold to palladium. In August 2011 the SPDR Gold Trust briefly wrestled the crown for the worlds largest ETF from a fund tracking the S&P 500.

Such vibrancy looks like a victory for the investor over the fund manager. Yet ETFs have lost some of their lustre recently as the debate about their potential risks has become more vocal. That debate started in spring 2011 as both the IMF and the Financial Stability Board (FSB), a global watchdog, voiced concerns about the instruments hidden trapdoors. It was given further impetus by fierce disagreements within the industry about what kinds of products should bear the label “ETF”. And it demonstrates just how hard it is to control the development of a financial innovation.

Roughly speaking, there are two worries about ETFs. One is that they have become remarkably successful, and the other is that they are opaque. Their success is something that regulators fret about more than the industry does: in finance, anything systemic is a potential threat. The absolute size of the ETF market is relatively modest compared with estimated global assets under the control of fund managers of $100 trillion or more. But the institutions at its heart—in particular, investment banks such as Deutsche Bank and Société Générale—are huge, which makes people worry about how an ETF crisis might play out more broadly. And the rapid take-up of ETFs in itself is enough to cause concern. “If something is growing fast over a period of several years and attracting a broader set of players and new entrants, that is an alarm bell,” says Nigel Jenkinson of the FSB.

If ETFs had remained the “plain vanilla” products they were in their earliest incarnations, the regulators would have found little to get alarmed about. What troubles them is the instruments opacity. The industry is still dominated by physical products, with fund managers going out and buying each individual constituent of the index they are tracking. But there is a slice of the ETF market, making up a little over 10% of global assets under management and concentrated in Europe, that is “synthetic”. This means that the returns generated by the fund come from a swap with a counterparty, often an affiliate of the fund manager. Instead of using investors cash to buy the underlying securities, the money is put into a basket of collateral whose returns are swapped with a counterparty for the returns of the index being targeted.

That spooks plenty of people because it exposes investors to counterparty risk. If the swap counterparty defaults, that leaves the investor holding the contents of the collateral basket as security. This collateral may not bear even a passing resemblance to the assets that the ETF is ostensibly tracking. And some regulators worry that banks purposely choose synthetic structures so that they can dump their illiquid assets into the collateral basket and get funding that they otherwise could not.

The fear that some investors may not understand what they are getting themselves into extends to other products. Exchange-traded notes, or ETNs, may sound like ETFs, but they are essentially unsecured debt instruments issued by banks. Another set of ETFs that are souped up by leverage and seek to make daily returns are particularly exposed to an effect called “compounding”. Imagine a 10% rise on a $100 investment on day one, followed by a 10% fall on day two: the value of the investment will end up being $99, not $100, as many people intuitively assume. Now add in leverage designed to double the movements of the investment, so each day sees a 20% swing: the result will be an investment worth just $96. This compounding effect is also at work in “inverse” ETFs, which are designed to make money when markets fall. The risks inherent in leveraged and inverse products manifest themselves most in times of volatility.

In October BlackRock put itself on the side of the angels by issuing a paper calling for better disclosure around derivatives-backed products, so that investors are clear about the identity of counterparties, the composition of collateral and so on, and for the use of multiple counterparties rather than a single swap dealer. It also outlined proposals for a formal classification of exchange-traded products so that only some instruments can be called ETFs. “I fear that an exchange-traded product will break down one of these days and the worry is that it will poison the entire sector,” says Mark Wiedman, the head of iShares.

BlackRocks boss, Larry Fink, has sounded warnings based on his own experience helping to pioneer mortgage-backed securities. “I do believe we have some responsibility for making sure that the market does not morph itself, the same way when I started in the mortgage market 35 years ago, watching a great market morph into a monster,” he told a conference in November.

Rivals claim that BlackRocks approach is self-serving: it is one of three dominant providers in America and offers a range of products made up almost exclusively of physical ETFs. Providers of synthetic ETFs argue that there is plenty of counterparty risk in physical funds, too, because the funds securities are routinely being lent out to other investors in return for collateral. Derivatives have long been a feature of the ETF market in Europe. They are allowed by the EUs UCITS fund-management directives, which means that the synthetic products are tightly regulated. For example, the rules require the overnight market value of the collateral to be at least 90% of the value of the securities. And although much of the debate focuses on the retail investor, this product is heavily used by institutional investors too.

Like the Red Queen in Alice Through the Looking-Glass, the regulators will always have to keep running just to stand still

There are also perfectly good reasons to use derivatives when it is hard to run a fund as a physical structure, perhaps because of restrictions on investing directly in an asset such as commodities. “The row over synthetic versus physical ETFs is not helping regulators to have a clear view,” says Patrice Berge-Vincent, a French regulator who is preparing a report on the product for IOSCO, a global body of securities supervisors. “It depends on each individual ETF as to how dangerous things are.”

Providers of leveraged products, meanwhile, point out that leveraged mutual funds have existed for more than 15 years. ProShares, a provider of leveraged funds (or exchange-traded instruments, in BlackRocks proposed taxonomy), is irreproachably clear about the risks of compounding. Michael Sapir, its boss, believes that his customers are knowledgeable and use the products appropriately to manage risk or pursue investment opportunities.

That said, it is difficult to argue against a call for more transparency or against the model of innovation governance exemplified by the debate on ETFs. Regulators congratulate themselves on having made the industry more introspective and point out that disclosure practices have improved immeasurably since they started waving red flags in the spring of last year. Most people in the industry seem to think that the end result of this debate will be some kind of product classification. Among customers the wind seems already to be blowing in favour of physical products. “Client demand is changing,” says Mr Draper at Credit Suisse, which converted four swaps-based funds to physical ones last year.

Perpetuum mobile

It is in the nature of finance that experimentation never stops, however. So it is with ETFs. The pressure to innovate will intensify as competition increases. The McKinsey report reckons that the number of ETF managers in America has grown tenfold in the past decade. That guarantees the industry will keep pushing forward with new products.

Mr Wiedman believes that there is still lots of room for growth in physical ETFs, not just in equities but in fixed income, too. Products could also move into ever more exotic areas in order to deliver higher returns, which may yet shove the pendulum back in the other direction and require the use of more derivatives to replicate the desired exposures. Intriguingly, there is plenty of talk of active ETFs that would combine elements of discretionary stock selection and the tracking of a benchmark. No one is sure how this would work, not least because it would require managers to reveal their strategies to marketmakers, but this is one of those rare areas where patents have been filed.

All of these possibilities will require continuing vigilance on the part of financial watchdogs. Like the Red Queen in Alice Through the Looking-Glass, the regulators will always have to keep running just to stand still. The FSB paper points out that branching out from equities into other asset classes means moving into markets where liquidity is thinner, for example. If an ETF is active, presumably sometimes investors do not know what is in their portfolio as managers make discretionary bets: that hardly sounds transparent. Fiercer competition will also encourage providers to make more money from lending securities, which means that even investors in physical products could end up exposed to rising levels of counterparty risk.

And all forms of growth will increase the weight of ETFs in determining stock prices, a prospect that worries people like Mr Litan. He argues that less liquid, smaller stocks already get buffeted by wider movements in index-tracking ETFs of which they are constituents, and that buying and selling bundles of stocks leads to excessive correlations between them. Whatever the merits of this argument, it opens the door to others: about the efficiency of modern markets, the consequences of passive investing, and in particular the role of the most turbocharged financial innovation of all: high-frequency trading.