Does Financial Innovation Enhance or Inhibit Real Innovation

We present evidence that financial innovation plays a role in increasing the level of real, innovative activity. We focus on non-financial firms' innovation performance, measured by patent-based metrics, and employ an exogenous change in the market for over-the-counter (OTC) derivatives in 1987. Distance from financial centers is used as an instrument for the likelihood of derivatives use. We find that firms with higher likelihood of derivatives use innovate more and have higher quality of innovations. The relationship is stronger for firms that are more likely to have an existing relationship with dealers or banks. Furthermore, we find that these results are driven by a greater ability of financially-constrained firms to invest in more risky ventures such as innovative projects.