The gradual easing of agency frictions helps boosts participation. In turn, by unleashing positive network and scale externalities, the benefits of participation (liquidity, efficiency, etc.) become self-reinforcing. Thus, in the more mature phase of FD, there is a quantum leap in participation, as more clients, players, and transactions make markets increasingly deep, dense, and interconnected. The rising participation also increases the degree to which financial institutions and capital markets complement each other. The whole process is quickened by financial innovation, a major driver of FD that reflects and channels the forces of competition, deregulation, and regulatory and tax arbitrage, as well as theoretical or operational breakthroughs.<sup>9</sup> The gradual easing of finance frictions depicted above provides broad pointers about the order in which various financial activities are likely to emerge, and the shape of the paths they are likely to follow once they emerge. The order of appearance of financial activities should reflect the intensity of the frictions to which they are exposed. The activities that are the least prone to (agency or collective action) frictions should emerge and develop first. On the other hand, those activities that are strongly inhibited by collective action frictions should appear later. However, once a critical mass is reached and they start to develop, rising participation should trigger increasingly important positive network externalities that further boost their development. We would thus expect those activities to be also the ones that have the most explosive (convex) development paths. Since activities that exhibit the highest returns to scale should generally be the ones exposed to the highest collective frictions, scale effects should correlate with the order in which financial activities appear and the shape (convexity or concavity) of their development path.<sup>10</sup> As we will see below, these basic patterns are broadly verified. However, before shifting from analytics to empirics, consider first the dark side of the finance frictions.

# **_b.  The dark side_**

There are two types of finance maladies (that is, failures to complete markets and achieve efficient equilibria). The first one refers to the inability to resolve the agency frictions or collective (participation) frictions that hinder FD. Failures to reduce agency frictions continue to dominate the FD literature. They may occur at the level of the investor (reflecting his inability to monitor or lack of interest in doing so), at the level of the borrower (reflecting problems of

> 9 Indeed, the history of FD is marked by major waves of innovation. Consider, for instance, the role in the exponential ascent of finance in the western world stemming from the invention of Italian banking (based on traderelated bills of exchange) by the Medici in the late XIV century; or the introduction of payments systems based on checking accounts, fractional reserve banking, and central banking during the XVII century; or the development of the government bond market, its seeds already visible in the late middle ages; or the invention of the joint-stock, limited liability company in the early XVII century and the associated mushrooming of stock exchanges; or the emergence of marine insurance and life insurance in the second half of the XVII century; or, in the latter part of the XX century, the development of securitization and derivative products. For an insightful and entertaining rendition of the history of finance in the western world, see Ferguson (2008). For a recently updated review of the roots and dynamics of financial innovation, see Lerner and Tufano (2011). On the role of competition and deregulation in FD, see Rajan and Zingales (2003). Examples of theoretical and methodological breakthroughs that have dramatically influenced FD include double-entry bookkeeping, probability theory, life expectancy tables and actuarial science, and the Black-Scholes option theory.

> 10 The pattern can also be broadly corroborated through comparative historical studies. See, for instance, Ferguson (2008) and Rajan and Zingales (2003).

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