The Knockoff Economy (26 page)

This provision made the patents issued after
State Street
less useful as offensive tools against competitors. But it did not shield the industry altogether. A 2006 study unsurprisingly found an increase in patent suits after
State Street
. The defendants in these suits were typically large finance companies.
³⁰
Several suits involved significant sums.
^*
A number of useful business method patents have been obtained by outside firms, including, importantly, “non-practicing entities”—that is, firms that collect patents and make their money by licensing and litigating them rather than actually using the inventions covered by the patents they own. These firms are sometimes referred to as “patent trolls”: like the troll in the
Three Billy Goats Gruff,
they wait in hiding and demand tribute, in this case, from those who innocently try to use an invention they think is theirs.

So
State Street
has changed some things on Wall Street. But whether the introduction of rules restraining copying led to any significant change in how the industry innovates is less clear. For example, the National Science Foundation, which tracks research and development (R&D) spending across a number of US industries, has measured no significant increase in financial industry R&D investment following the advent of business method patents.
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A survey of data from the US Bureau of Labor Statistics also revealed no trend in the financial services industry of hiring more R&D workers following the introduction of business method patents, as we might expect if the availability of those patents was making a significant difference in industry resources devoted to innovation.
³²

Perhaps it is not a surprise that we find little evidence to link the advent of financial industry business method patents to an industry innovation boom. Even before
State Street
the financial services industry produced a great deal of important innovation. Often-noted examples include the Black-Scholes option pricing formula, which transformed how Wall Street understood and
priced derivatives, the formation of index mutual funds in the 1970s (as described at the beginning of this chapter), the 1980s-era innovations in the use of high-yield or “junk” bonds as means of financing mergers and acquisitions, and the boom in the 1990s in exchange-traded funds (an evolution of the index fund) and asset securitization (a method of financing that pools various types of debt to sell as a bond). In each instance, significant innovations appeared without the prospect of patent protection.

So how do we explain intellectual production without intellectual property in the financial services industry? Back in 2002, former Harvard Business School professor Peter Tufano (now Dean of Oxford’s Saïd Business School) wrote an influential paper that posits a number of interacting reasons. Financial firms innovate to satisfy the unmet needs of particular customers; to lower transaction costs; to avoid taxes and regulation; to take advantage of rating agencies’ rules for assessing the quality of debt; and to take advantage of opportunities offered by new technologies.
³³
And for many of these kinds of innovations, patent protection would be counterproductive, because sharing with rivals is helpful or even necessary to grow markets to the size at which they become efficient and lucrative.

To understand this point, consider the market for a new type of investment security. In most cases, new securities are likely to be much more lucrative if they trade in markets big enough to become standardized and deeply capitalized. In practice, this typically requires a number of firms to enter the market. Patents, however, can act as a barrier to this. If the innovator patents the new security, potential market participants may hesitate to enter the market for fear that the patent might be used against them. This fear might persist even if the innovator is willing to license the patent to its rivals—especially if those rivals worry that, as a consequence of the license fees, they will face higher costs in marketing the security and will be hobbled in competing with the innovator. The result, Tufano argues, is that as a practical matter patents rarely figure in the development of new securities.
³⁴

There are some markets in which financial firms are not pursuing standardization—such as the market in over-the-counter, or OTC, derivatives, which includes the now-infamous “credit default swaps” that grew explosively (in many senses) before the 2008 financial crisis. OTC derivatives are basically bets based on the value of some underlying asset, such as stocks, currencies, or interest rates, that are negotiated directly between private parties.

Many markets in OTC derivatives were deliberately structured to not be standardized in order to keep financial firms’ margins high. Yet even in these markets, firms tend not to rely on patents to protect their innovations. The reason is that although rival firms are free to imitate new OTC derivatives, it takes time for the details of a private OTC deal to leak out. In part, this is because any successful new OTC derivative requires more than just a clever idea—the innovator must also “de-bug” the transaction by making sure that someone on the other side of the trade can’t manipulate the market in his favor. And, importantly, the innovator must also figure out how to
price
the transaction—this tends to be more difficult for OTC derivatives because there is no public market generating thousands or even millions of transactions, and so there is apt to be much less pricing information available.

Once this is done, innovators tend to rely on nondisclosure agreements—that is, contracts—to discourage their counter-parties from disclosing the details of the deal. As the innovator markets the deal more widely, information leaks out, and as rivals learn more, they are almost always able eventually to reverse engineer the deal. Still, this takes time, and the delay means that the originators of new OTC derivative transactions enjoy some first-mover advantage.

And this leads to a broader point about why patents are rarely used for financial innovations: they do not seem to matter much to success in the market. Financial firms that introduce a new and unpatented type of security typically retain a dominant market share for several years, even though rival firms rapidly copy the innovation.
³⁵

Why? It may have something to do with the in-house expertise developed in the process of innovation. Like a football team that has trained and recruited to run a particular offense—and is thereby better able to implement that offense than are its rivals—the innovating firm is more likely (at least until rival firms catch up or hire away key personnel) to have specialized in-house expertise in using the security that will advantage it over rivals.

But perhaps a deeper explanation relates to the market power of large banks. Many of the markets that together comprise “Wall Street” are dominated by an exclusive cohort of US investment giants—firms like Goldman Sachs, Morgan Stanley, and Citigroup—and an equally exclusive group of foreign-based firms, including Deutsche Bank, Credit Suisse and HSBC. These firms control large shares in particular lines
of business, and, importantly, their clients can be “sticky.” Investment banking is driven by relationships, and many clients have long-term ties to their bankers that span a variety of product areas. As a result, even if innovations can freely be copied, a large bank can capture a lot of the return on its investment in innovation simply by virtue of its control over a large amount of the particular business at issue and its enduring client relationships.
³⁶

Consistent with this, the leading innovators in most areas of the financial services industry have been the biggest firms. There appears to be a strong link between innovativeness and market share—large firms appear better placed to capture benefits from innovation, even in the face of copying. For that reason, when a relatively small bank innovates, it has a strong incentive to partner with a large bank—the larger institution is able to capture a greater share of the returns from the innovation, which the smaller institution will share. In some instances, banks will be incentivized to sell innovations to the institution that has a leading role in the particular line of business addressed by the innovation.
³⁷

Financial innovation is a complex topic. But the bottom line is relatively simple. Much of the innovation that we see in the financial services industry has been led by firms responding to
market
incentives, rather than the incentives created by IP rules. As these innovations are introduced, they eventually spread. The prospect that rivals will copy the inventions does not destroy the incentive to create them in the first place, and indeed in some situations copying enhances the value of these innovations by creating a larger market for them. Investment firms locked in a competitive market for clients innovate to serve clients better, and their rivals imitate those innovations to remain competitive.

Robert Merton, the Nobel laureate who formulated the pricing model that helped spark the huge growth in derivatives transactions, described the financial industry in terms of an “innovation spiral” in which one advance begets the next.
³⁸
Merton wasn’t thinking explicitly about the role of law. But his point fits well with what we’ve described here. The financial industry’s innovation spiral has proceeded mostly without protection against copying, and this history suggests that innovation in finance may be much more resilient in the age of copying than the standard justification for IP rights suggests. Imitation has not killed innovation in the financial world—and in some instances it may have even spurred it.

Databases are collections of materials organized for easy search and retrieval. Lawyers, for instance, rely heavily on Westlaw and Lexis-Nexis; likewise many scientists conducting research in human genetics use the OMIM (Online Mendelian Inheritance in Man) database maintained by the Johns Hopkins School of Medicine.
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Many of us use databases on a regular basis, maybe even daily, but do not think about the economics of them much. Yet databases are a surprisingly big business—and one that has interesting things to teach us about innovation.

Databases may not seem all that creative. Yet how to organize the material, and what to include, can make a big difference in how successful a database is. The content in some databases is copyrightable—for example, the huge collections of news articles available via Lexis-Nexis or the DowJones “Factiva” database. But in many other instances, the content of databases is, at least in the United States, uncopyrightable because it is composed of basic facts. This is a contrast with Europe, where factual databases
are
protected against copying. Yet the surprising thing is that the database industry is growing on this side of the Atlantic, and stagnant on the other. The freedom to copy has not killed the American database industry. If anything, it seems to have strengthened it. Let’s take a look at why.

That databases can often be legally copied has been true since the Supreme Court decided a case called
Feist Publications v. Rural Telephone Service.
⁴⁰
Feist
involved the familiar telephone white pages. (The white pages are really just a database distributed on paper.) The question in
Feist
was whether others could copy the names and numbers in the white pages. In a manner reminiscent of decisions denying copyright protection to recipes, the Supreme Court held that copyright does not protect mere facts. Original ways of selecting and organizing those facts could be copyrighted, but not the underlying data. And, in the case of the white pages, the Court thought the organizational scheme—an alphabetical listing—was so lacking in originality that it could not be protected by copyright either.

So
Feist
established that anyone is free to copy the white pages. The impact of the decision wasn’t confined to the phone book, however.
Feist
overturned a line of earlier cases that had held that even databases composed
wholly of facts could be copyrighted. The theory behind these decisions was that it is hard work to collect facts into a useful database. To allow others to copy would be unfair. But the
Feist
Court rejected this “sweat of the brow” theory for databases. The Constitution, held the Court, allows copyright only for “original” works that show some spark of creativity. And there is nothing original or creative about a fact.

In the wake of
Feist
there was a campaign to change American law to grant databases some legal protection against copying. The proponents of database protection made the standard argument that we have referred to often: if we don’t grant property rights in facts, people will copy them freely. And free and legal copying will destroy the incentive to spend time and money to collect facts in the first place.

Unsurprisingly, these people predicted that the Supreme Court’s decision would doom the US database industry to decline. And soon they were able to bolster their case by pointing to developments in Europe. Following
Feist,
database protection proponents in the European Union warned that weak national copyright laws there posed the same risk of underprotection that
Feist
had created in the United States. And the European Union responded, granting strong protections to fact-based databases.

The EU rule, passed in 1992, establishes protection for an initial period of 15 years, and allows extensions under certain circumstances. Notably, however, the EU law protects only databases whose makers are European or who come from third-party countries that have “comparable protection” to that in Europe. That rule shuts out American database producers. With the new EU rule in place, database protection supporters in the United States warned that the EU database industry, aided by the new protections, would outcompete its American counterpart.