Thinking outside the Box to Get inside the Black Box: Alternative Epistemology for Dealing with Financial Innovation

Abstract

This paper seeks to ignite debate surrounding the computerization and change in organizing financial markets and, due to the emergence of trading algorithms, investigates those as disruptive innovation and its side effects. First, we frame the computerization of financial markets as disruptive innovation. Second, we analyze how an extension of a disruptive innovation generates latent effects that contradict the original principles. Third, we argue the necessity to explicitly consider the epistemological nature of financial innovations. This leads to our conclusion that there is a necessity to extend the epistemological dimension of financial innovation, in order to think outside the box to get inside the black box of financial innovation. Key words Black box; disruptive innovation; epistemology; financial innovation; financial markets; flash crashes Joeri 2016) and there are no well-defined regulations (Coombs 2016). Heeding MacKenzie's (2003) advice to open up the black box, we analyze the construction of algorithms, conceiving them as a disruptive innovation, reflecting on why their evolution from computerization of the financial market to trading algorithms caused epistemological issues that have not been solved and led to the emergence of the flash crashes. Innovation has been widely researched since the seminal works of Schumpeter (1934). However, the process of how innovations emerge and are managed is a perpetual issue. Innovation can be incremental (it presents minor improvements) or radical (it is new to the market or new to the company) if it refers to a product or service from a company's perspective; it can be disruptive or non-disruptive if it refers to a technology in a given market. Disruptive innovation generally emerges from a technological niche that is underestimated or even ignored by the mainstream companies operating in an industry. In this paper, we define a disruptive innovation, in line with Christensen (1997, 2006), as an innovation that disrupts the current market by serving a market segment that was not initially considered by the established firms, that disrupts the dominant configurations, creates new values that leads to changes to existing markets, and that establishes new working practices. This technology starts as a radical innovation, and then, building on a value network, subsequently captures the market of the mainstream technology and becomes dominant, moving into a phase of incremental innovations. For a large part of the literature, a disruptive innovation is a technology that changes the performance metrics along which it competes (Daneels, 2004; Pinkse, Bohnsack, and Kolk 2014) or it changes the business models of the firms in the market (Habtay 2012). Building on this literature, when they first emerged, financial algorithms, in line with Christensen (1997, 2006, 2009), created new values and led to changes to existing, and the creation of new, financial practice. Like many successful innovations, the financial algorithms and market subsequently evolved incrementally. H...

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