Optimal Patenting and Licensing of Financial Innovations

Recent court decisions, starting with the State Street decision in 1998, allow business methods to be patentable and now give financial institutions the option to seek patent protection for financial innovations. This new patentability paradigm and the heterogeneity of characteristics associated with financial innovations pose an immediate decision problem for senior management: what to patent. We present a parsimonious decision framework that answers this question. We show that for innovations with certain characteristics, it is optimal not to patent, even if the option of patenting and licensing is available. Our model emphasizes the role of embedded real options that arise from certain types of financial innovations. The model provides an explanation of observed patenting behavior of financial institutions and the success of a wide class of innovations, including swaps, credit derivatives, and pricing algorithms.

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