The Impact of Innovation on Inequality in American Financial Markets


The previous decade encountered a revolution in financial innovation in the US financial markets as a result of which the cost of processing financial data reduced drastically and more sophisticated financial information became more accessible. While that seems like a recipe for financial inclusion, a recently conducted research paper posits that it has led to greater capital inequality. The stock market has become more informed, but is dominated by affluent players and has seen an increase in inequality.


The basic mechanism through which this operates is that as the market now has access to more information, wealthier investors are able to trade in an informed manner. This makes the market more competitive and less valuable for the marginal stock market investor, who now gets lower returns on her relatively uninformed trading. Such investors then exit the market and lose out on the equity premium. This decrease in participation of less wealthy investors has led to growing inequality. The peculiar question here is, why despite a fall in the fees charged by funds as well as information costs, overall participation in the US stock market has gone down in the past decade.


To understand the heterogeneous returns to invest, you need to look at investment patterns. Firstly, the mere act of investing in the stock market has a lot of both explicit money costs in the form of brokerage fees as well as time costs on gaining a simple understanding of financial markets and the paperwork involved. While small investors can pool some of these fixed costs by investing through a fund, the sheer number of funds in the market means that a lot of time and money has to be spent on searching for funds that actually provide value and don’t just benchmark their portfolios to the overall market. Hence, small investors should look for good quality active funds, which is not the case for many due to the aforementioned search costs as well as higher fees. The wealthy are much more likely to delegate their investments to active funds such as private equity and hedge funds. These funds not only spend more on acquiring private information but are also able to undertake sophisticated processing of that information.


As a simplifying assumption, the paper takes the case of participation and information costs. Participation costs refer to the cost of participating in financial markets while information costs refer to the cost spent on acquiring relevant market information. Due to the overall larger amount of investments for rich investors, information costs represent a smaller percentage of their capital and as these costs fall, they are able to easily take advantage by using more and private information. Since wealthy investors are able to trade in a versatile way vis-a-vis retail investors, they are able to beat the returns of smaller investors and passive funds like index funds. The market becomes more efficient and competitive; but for the marginal investor, the ROI t falls because she is likely to be invested in low information passive funds which are not able to compete well enough in the dynamic h market due to several reasons related to their budget allocation towards information acquisition. On the other hand, participation costs have a negative correlation with financial inclusion. Companies like E-trade which rose in the 90s offering lower-cost investing through electronic trading led to a fall in the participation costs. This contributed to an overall increase in the stock market participation during that period.




Overall stock market participation rates have very strong links to capital income inequality that are largely explained by the equity premium. The equity premium is the excess returns to investing in the stock market over investing in risk-free assets like treasury bills. Over long periods of time, it implies that not investing in a diversified portfolio of stocks leads to you missing out on greater potential returns. If most of the people who are invested in the stock market are wealthy, this just amplifies wealth inequality because they will benefit and grow their wealth whereas less-well-off investors are not able to do so.


These findings create complex problems for policymakers who might want to expand access to the equity premium as well as to ensure that a broader class of investors are able to take advantage of lower information costs. One solution might be to facilitate universal access to computers, phones, and the like. Greater internet access has a provable direct correlation with stock market participation. Governments should also spend more on financial education for everyone to reduce some of the basic participation costs. Tackling the impact of information costs is trickier as it is difficult to conceive of regulation of financial information that doesn’t distort market incentives in a way that might plausibly hurt efficiency. Governments might want to look into limited mandatory disclosure of financial information used by active funds like certain data sets to democratize the effect of falling information costs.


Links:

https://ieeexplore.ieee.org/document/7538591

https://ideas.repec.org/p/cpr/ceprdp/6750.html


Further Readings

https://www8.gsb.columbia.edu/faculty-research/sites/faculty-research/files/finance/Macro%20Lunch/Jarmoir%20Nosal.pdf

https://www.researchgate.net/publication/336748397_Who_Benefits_from_Innovations_in_Financial_Technology (the paper being referenced here)


Article by: Shivansh Raman (shivanshsr01@gmail.com)

Edited by: Ayush Bakshi

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