Suppose Mike Milken and Drexel Burnham Lambert Inc. had patented the junk bond. What would happen to housing prices if Salomon Inc. had the exclusive right to trade mortgage-backed securities? What makes a financial innovation any less creative than a new piece of software?
Although too many investment bankers resemble the ego-bloated Masters of the Universe so artfully skewered in ''Bonfire of the Vanities,'' some financial engineers can be as clever and ingenious as their counterparts in computing and biotechnology. Financial markets are huge and awash with opportunities. The right innovation at the right time can spawn a multibillion-dollar market. Synthesize the right security, hybridize for a new financial instrument, put a novel twist in that currency swap, and you can make millions of dollars in pure profit for your firm.
But where biotechnology companies such as Genentech Inc. and software companies such as Lotus Development Corp. have been quick to seek intellectual property protection for their innovations -- and sue to guarantee them -- most commercial and investment banks haven't given the idea a second thought. Texas Instruments Inc. will collect hundreds of millions of dollars from Japanese companies thanks to its basic semiconductor chip patents. You would think the folks at Goldman Sachs & Co. and Morgan Stanley & Co. would have had the smarts to patent their innovations and reap the royalties from the Nomura, Daiwa and Nikko securities firms.
The financial services industry ''has never focused on patents; they have no consciousness or history with patents,'' says Stephen B. Judlowe, a partner of Hopgood, Calimafde, Kalil, Blaustein & Judlowe, a New York law firm specializing in intellectual property issues. ''Why they haven't done it, I certainly have no answer for. The people who manage these sorts of things ought to be paying more attention to it.''
Judlowe is particularly surprised because he was instrumental in procuring a patent a decade ago for Merrill Lynch & Co.'s extraordinarily successful "cash management account" system. The patent was so broad that other firms, like Dean Witter Reynolds, actually paid Merrill licensing fees for the right to build their own CMAs. However, few other financial service firms followed up. The idea of protecting their innovations instead of just marketing them was never a priority. Investment banks that launched a novel and unobvious security in the 1980s knew that a competitor would hit the market with a copycat security a few months later.
That's going to change. As global competition intensifies, as profit margins shrink and as these firms increasingly recognize that innovation is valuable in its own right, they will increasingly turn to intellectual property protection -- patents, copyrights, trademarks, etc. -- to build barriers to market entry. In the same way that patent litigation has been reshaping the semiconductor, biotechnology and software industries, we will see intellectual property protection alter the global flow of capital. It's inevitable, and it will have profound implications for the world's financial markets.
A memo titled ''Protecting Innovative Securities: A Competitive Edge,'' issued this month by the Washington law firm Sutherland, Asbill & Brennan, blueprints how financial innovators can erect intellectual property thickets to guard their new products. Next to the CMA patent, this document is the first formal shot across the bow of the financial services sector. If the courts offer financial innovations the same protection that they offer, say, a biotechnological innovation or a semiconductor chip, then Wall Street and the rest of the world's financial markets are potentially in for the biggest set of shocks since October 1987.
''Patents have the potential for causing the greatest reverberations in the financial industry,'' asserts attorney Peter K. Trzyna in the Sutherland memo. ''Competitors could well find themselves foreclosed from marketing a product or a class of products for 17 years, or perhaps could do so only by paying royalties under a license. Courts are not timid about damage awards. Injunctive relief could require competitors to repurchase securities products to remove them from the market.''
Trzyna and Judlowe argue that you can patent the process by which a new security is made. Let's say the firm has a computer system with special software that generates this innovative security. If that process is patented, under U.S. law, it would be illegal for a Japanese or European financial institution to sell such a security in America -- unless the institution did all the paperwork by hand. What's more, that computer system could be patented in Japan and Europe. The U.S. financial firm could, technically and legally, acquire exclusive rights to its innovation if it so desired.
On a strictly business level, however, what we are likely to see is investment and commercial banks cross-licensing their innovations around the world. And why not? Given the potential sums involved, the risk/reward ratio makes sense. What's a few hundred thousand dollars extra when hundreds of millions are at stake?
''There can be extraordinary benefits from pushing the envelope,'' says patent attorney Judlowe. ''Anyone who is at the threshold of what's permissible makes an error if they don't seek out protection. The bottom line is that someone spends an awful lot of money developing these new products, so if they don't spend the incremental money to try and protect it, I think they're making a mistake.''
So what happens if Drexel did hold the junk bond patent? Or Salomon has a virtual monopoly on mortgage-backed securities? Injecting intellectual property protection would slow the rate of innovation and would ultimately prove to be a conservative force. People would be very careful about buying securities issued by a monopolist. Conversely, investors might be reluctant to buy securities issued by competitors because they wouldn't want the values of their securities to be affected by a lawsuit. Investors would no doubt ask to be indemnified.
At the same time, U.S. firms that have a reputation for innovation would be better able to fend off competition from overseas firms that relied on imitative strategies and lower costs of capital for their successes. The down side, of course, is that we'd have more people in the courts.
''Financial service companies are under such profitability pressures that they would try most anything,'' says Jon Rotenstreich, president of the financial services firm Torchmark Corp. A former Salomon partner and International Business Machines Corp. corporate treasurer, Rotenstreich says, ''What they should really focus on is productivity of basic functions rather than legislate protections for their business.''
That may be true. This is a new sapling of intellectual property law; it's not clear how big it's going to grow. But when you look at what's going on in other innovation-intensive industries and then look at the gigantic sums of money involved in trading, hedges and swaps, you'd have to be a Pollyanna to think that America's lawyers and bankers won't find a way to make money together exploring how to protect their intellectual capital. Michael Schrage is a columnist for the Los Angeles Times.