intermediation and payments, help create value and thus enhance welfare. when we focus on this fact, we can finally understand why we are uncomfortable with some past developments in the financial industry. problems seem to have arisen when a product or service is insufficiently anchored in intermediation or facilitation of payments. innovation is useless or even harmful, if financial institutions lose sight of the needs of their clients, or more broadly the society. technology - driven innovations are more likely to be beneficial, because, when the innovator is deliberating on the application of technology, the client cannot usually be ignored. on the other hand, in the case of modality - driven innovations, one can easily lose sight of the client when cutting and dicing existing businesses. for example, securitization now has a bad name because of its perceived role in the financial crisis. nevertheless, securitization is conceptually beneficial, because it aims to bridge the gap between the risk preferences of lenders and the actual risk profile of borrowers. the only condition is probably that the investment bank arranging the transaction must find takers for all the tranches. in this regard, some resecuritized products, which inflicted enormous pain during the recent financial crisis, are suspect because they include unsold tranches of original securitization vehicles, tranches that investment banks could not sell to willing buyers or found too unattractive for their own books. considering that financial institutions enhance welfare through intermediation, relevance of any developments to intermediation should be a good starting point. this perspective is particularly important for modality - driven innovations. iv. dealing with undesirable outcomes unfortunately, the world of finance is complex. as a result, one or two simple tests cannot separate all the wheat from the chaff. in this regard, one of the most difficult issues involves the claim that certain instruments or practices provide a public good, namely the better functioning of markets through enhanced liquidity or more efficient price discovery. for example, in the case of high - frequency trading ( hft ), one can argue that the increase in the speed and execution serves no socially useful purpose, because most of the hft transactions are netted out and, therefore, very little intermediation actually takes place. 2 on the other hand, one could argue equally persuasively that trial and error carried out by hft facilitate price discovery, performing a useful function for market

participants that wish to trade in cash instruments. after all, nobody has doubts on the usefulness of the stock market, even though the market itself does not perform any intermediation between savers and firms in need of capital. if there were only long - term buy - and - hold investors, market liquidity, or the supply of immediacy, would be constrained. the fact that stocks can easily change hands facilitates the capital - raising activities of firms. this is a difficult issue, but for policymakers, the fact that the “ first - best ” solution is elusive cannot be an excuse for not acting on potentially harmful activities. “ second - best ” or “ thirdbest ” solutions will have to be pursued. instead of focusing too heavily on the welfare effects of individual innovations, on which sensible people can disagree, we could consider incentive issues behind developments in the financial industry, especially purported innovations that while hft in equity markets has been intensely debated, that in foreign exchange markets has been little discussed. for recent discussions on the latter, see bank for international settlements, high - frequency trading in the foreign exchange market, 2011. bis central bankers ’ speeches are modality driven. very often, modality - driven innovations are the result of efforts to circumvent regulations, taxes, and accounting rules imposed on the financial industry. one of the lessons learned from the recent financial crisis is that such innovations tend to mask the build - up of excessive risk in the economy with dire consequences. v. concluding remarks as i said at the beginning, innovation is the key to growth. financial innovation can also promote growth, so long as it facilitates the activities of other economic agents. the invisible hand may bring into line the interests of the financial industry and the broader society, but the recent financial turmoil has shown that too often, improperly aligned incentives in the financial industry can stand in the way. in this regard, senior management of financial institutions, each time their traders and bankers come up with innovative proposals, should at least reflect on how the new products or services could add value to activities in the broader economy and facilitate intermediation, before giving the go - ahead. meanwhile, central banks must better understand the incentive structures in the financial industry, and ponder if their actions might be distorting incentives, giving rise to modalitydriven innovations that hardly benefit the society as a whole. doing so should allow us to avoid those policy decisions – for example, maintaining excessively loose monetary policy for