A taxonomy of the 'dark side' of financial innovation: the cases of high frequency trading and exchange traded funds

Abstract

This paper develops a taxonomy of the ‘dark side’ of financial innovation and applies it to two recent high-profile financial innovations; exchange traded funds (ETFs) and high frequency trading (HFT). The first half of the paper develops the taxonomy by categorising the negative effects of financial innovation as: 1) predatory schemes; 2) abuse of financial innovation; 3) unintended consequences of financial innovation. The second half of the paper applies the taxonomy to ETFs and HFT, thus allowing for a better understanding of the risks posed by ETFs and HFT. We explore these risks with examples and in the context of current efforts to reform financial regulation following the 2007–2008 ‘credit crunch’. In the latter case, we draw on a G20 survey that explored the capabilities of regulators to mitigate the negative effects of financial innovation.