Is the Use of Patents Promoting the Creation of New Types of Securities? October 3-4, 2008

1. Is the Use of Patents Promoting the Creation of New Types of Securities?October 3-4, 2008 Stefania Fusco JSD Candidate Stanford Law School

2. Reason for Investigating This Issue: • Patents = grants of legal monopoly; • Patents => market inefficiencies + reduction of public domain; • Justification for granting patents = they foster innovation; • ISSUE => if patents do not produce (additional) innovation there is no reason to grant them; • Specifically, if after State Streetthere has not been an increase in the level of innovation of securities there is no reason to create proprietary rights on them.

3. Methodology: • Step 1 = create a list of new types of securities for the past 25 years; • Step 2 = find patents and patent applications for securities; • Step 3 = analysis of the findings.

4. Step 1: Creation of a List of New Types of Securities • First issue: • Finding a “benchmark” to identify innovative types of securities; • “(…) most innovations [in this field] are evolutionary adaptations of prior products (…) almost nothing is completely ‘new’ and the degree of newness or novelty is inherently subjective.” Tufano 2002

5. How Innovative Types of Securities Can Be Identified? • From a patent perspective a new type of security should be: • New => it performs a new financial function or an existing financial function but in an enhanced way; • Useful => marketable = it has a definable price and risk; • Nonobvious => no simply packaging; • Talk about this with experts in the field; • Financial innovations can be described in mathematical terms; • Financial Function => Mathematical Function; • THEREFORE: the mathematical models used to calculate price and risk of securities changes when the security under consideration performs a new or improved financial function.

6. Example 1: Transition from MBS & ABS to CDO • Mortgage-Backed Securities (MBS) and Asset Backed Securities (ABS) => credit risk transferring; • Change: built-in credit support; • Collateralized Debt Obligation (CDO) => enhanced credit risk transferring and prepayment risk hedging.

7. Example 2: CDS • Credit Default Swaps (CDS) => provide insurance against the risk of default of a specific company; • No direct predecessor can be identified.

8. A Few Considerations … • Problem: • this method has still a subjective component; • Benefits: • It is linked to the performance of new financial function; • It provides objectivity to the analysis; • It operates systematically across the entire securities population.

9. Results: • Creation of a preliminary list of types of securities which emerged over the past 25 years => 123 types of securities have been identified; • From the preliminary list 66 types of securities have been selected as innovative.

10. Distribution of Innovative Types of Securities between 1980 - 2007

11. Step 2: Find Patents and Patent Applications for Securities Implied: • Reviewing the patents issued and the patent applications submitted after 1998 which were assigned to subclasses 35, 36R and 37 of the general class 705; • Searching the USPTO database based on keywords.

12. Findings 1: • No “diversionary drafting;” • Most of the claimed inventions represented categories of financial innovations other than securities such as: • Risk management (investment, strategies, pension funds and mutual funds, etc.); • Banking (transactions, billing, payments, etc.) • Financial Information Systems (software, e-commerce, data, etc.); • Financing (loans, leasing, mortgages, etc.); • Asset Evaluation (equity, real estate, interest rates, etc.)

13. Findings 2: Number of Patents and Patent Applications

14. Distribution of Patents Applications on Securities Between 1998 - 2008

15. Step 3: Analysis of the Findings • No specific trend in the creation of innovative types of securities; • No increase in innovation after 1998; • After initial “fascination” for patent protection, innovators appear to have lost interest.

16. Conclusion: • At this time, no entirely conclusive determination is possible; • However, it is still of great significance that the number of patent applications has decreased whereas the rate of innovation has remained constant; • More investigation is required => interviews with market participants.

17. Next => Second Possible Research Question • How and why the financial sector has been successful at innovating, absent a significant role for the patent system? • Need to conduct interviews with market participants.

18. Preliminary Interviews With MSCI-Barra’s Employees • MSCI-Barra: • leading provider of investment decision support tools to investment institution worldwide; • Products => mostly indices, portfolio risk and performance analytics for use in managing equity, fixed income and multi asset class portfolios; • Barra models and risk and return portfolio analytics set the industry standard in financial risk management for the world’s largest asset management firms;

19. People Interviewed at MSCI-Barra: • Product Managers • Quantitative Analysts; • Researchers; • Software Engineers.

20. Four Preliminary Findings: • Nobody knew about the possibility of patenting their innovations except for the person who worked in the research department; • They see patent as a non necessary complication => there are other ways to recoup R&D expenditure (consistent with Tufano 1990) + R&D expenditure is low and returns are high; • They did not like the idea of having to disclose => they want to stay ahead of the learning curve (consistent with Herrera and Schroth 2003); • They did not like the idea of creating illiquid securities => a certain amount of imitation is good because it helps the security to became widespread and known by investors (consistent with Herrera and Schroth 2003).

21. The End …