Is financial innovation (e.g., financial derivatives) good or bad? How does it fuel crises?

Okay, let's talk about this topic.

Financial innovation is like a very sharp Swiss Army knife. Used well, it can help you solve many problems; used poorly, it can hurt you badly. So, it's not inherently "good" or "bad"; the key lies in who uses it, how it's used, and whether it's regulated.

First, let's talk about its "good" side. (Why does it exist?)

The original intention of financial innovation is very noble, primarily to solve two problems: managing risk and improving efficiency.

The most typical example is financial derivatives. Let's understand it with a simple example:

Scenario: You're a corn farmer. What do you fear most? After half a year of hard work, you get a bumper harvest, but the price "plummets" below your cost line, leaving you with nothing.

I'm the owner of a feed mill. What do I fear most? What if a natural disaster causes a significant drop in corn production, and the price "skyrockets," causing my production costs to explode and potentially leading to my factory's closure?

Our needs are opposite: You fear falling prices, I fear rising prices.

This is where "financial derivatives" (here, referring to the simplest "forward contract") come into play.

We can sign a contract now, agreeing that three months from now, regardless of the market price of corn, you will sell me 100,000 catties of corn at a price of 2 yuan/catty.

• For you (the farmer): You've locked in your future income and no longer have to worry about prices plummeting. You've transferred the "risk of falling prices" to me.
• For me (the feed mill owner): I've locked in my future costs and no longer have to worry about prices skyrocketing. I've transferred the "risk of rising prices" to you.

You see, through such a simple contract, both of us have eliminated future uncertainties and can focus on production with peace of mind. This is the most original and core benefit of financial derivatives—risk management. It allows participants in the real economy to focus on their core business.

In addition, it can increase market liquidity (making buying and selling easier) and help discover future prices (people's expectations for the future are reflected in contract prices).

So, how does it fuel crises? (How a good hand was played badly)

The problem is that this "Swiss Army knife" became increasingly complex in its functions and was used by some for other purposes, mainly due to the following points:

1. Leverage: Using 1 unit of money to move 100 units of business

This is the most crucial and dangerous point.

Derivative transactions usually don't require you to pay the full amount. For example, with the corn contract above, when we signed it, we might only need to put up a few thousand yuan each as "margin" to lock in a transaction worth 200,000 yuan (100,000 catties * 2 yuan/catty).

This is leverage.

• Benefit: "Using a small force to move a great weight," accomplishing big things with little money.
• Drawback: Your gains and losses are drastically amplified. If market prices move sharply against you, you might lose far more than just those few thousand yuan in margin; it could be a huge amount that wipes you out.

When financial institutions like banks and funds use massive leverage for "gambling" instead of "hedging," a wrong bet can lead to astronomical losses.

2. Complexity: Products designed to be unrecognizable even to their creators

Initially, derivatives were as simple and easy to understand as the example above. But later, financial geniuses packaged, sliced, repackaged, and recombined various derivatives... creating extremely complex "new species," such as the protagonists of the 2008 financial crisis: CDOs (Collateralized Debt Obligations), CDSs (Credit Default Swaps), and so on.

How complex were these products?

It was like a "black box." You put money in, knowing it was roughly tied to US real estate loans, but what quality of loans were inside, how many layers of nesting there were, how big the risk truly was... not to mention ordinary investors, even the bankers selling these products might not have fully understood.

When no one could understand the risks, people blindly trusted the AAA ratings given by rating agencies and bought them with their eyes closed.

3. Detaching from the real economy, a self-perpetuating casino

When the primary purpose of derivative trading ceased to serve farmers and factory owners and instead became chips for financial institutions to bet against each other, the financial market transformed into a massive, self-perpetuating casino detached from the real economy.

Everyone was betting on whether a certain index would rise or fall, or whether a company would default. Money circulated idly within the financial system, not genuinely invested in production and innovation. Because of "leverage," the stakes in this casino were amplified hundreds or thousands of times.

4. Systemic Risk: One falls, infecting many

When all financial institutions became interconnected through complex derivative contracts, a vast "intertwined" network was formed.

Bank A bought derivatives from Bank B, Bank B bought products from Investment Bank C, and Investment Bank C had another transaction with Bank A...

At this point, if one key player in the chain (like Lehman Brothers back then) collapsed due to a losing bet, it would be unable to fulfill its contracts with all other counterparties. Then, its counterparties would immediately face massive losses and might also collapse...

This is like a domino effect: one falls, and the whole row follows. It's also like an infectious disease, rapidly spreading throughout the entire financial system, causing all institutions to lose trust in everyone, stop lending to each other, and the market's blood (capital) instantly freezes—this is a financial crisis.

Summary

• Is financial innovation good or bad? It's neutral, a powerful tool. Used for risk management in the real economy, it's an "angel"; used for unregulated, high-leverage speculation, it's a "devil."
• How does it fuel crises? Through "high leverage," it amplifies stakes; through "complexity," it conceals risks. Ultimately, when one link explodes, it triggers "systemic risk" through close interconnections between institutions, leading to a chain reaction and market collapse.

Therefore, the question is not whether to have financial innovation, but how to cage it with "regulation," so that it serves the real economy instead of becoming a destructive casino.