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Markets for the Digital Generation

The main story on the capital markets page of the FT today was titled: “World Cup offers investors a sporting chance”

It’s a big question for many large companies but most sports fans do not care. Does commercial sponsorship of big sporting events yield any benefits to the corporations who are doing it?

Official sponsors of this year’s soccer World Cup in Germany have paid up to €45m each for the privilege of becoming an official partner of the tournament and seeing their names beamed into billions of television sets around the world for a month.

The article describes a structured principle-protected basket equity-linked note that is designed to pay-out or outperform if the shares in companies who are major sponsors of this summer’s soccer World Cup in Germany outperform their peers. The investment thesis is that the boost to their respective businesses on the back of the exposure afforded them through their sponsorship of this event will trickle down to their bottom line and ultimately to their share price.

Assuming that today the relative prices of the ’sponsors’ vs their ‘peers’ is appropriate, and that the share price will indeed be positively correlated with the amount of ‘exposure’ the company gets during the World Cup, then surely the sponsor companies (and the investors in these notes) are exposed to what I will call the ‘eyeball value’ of the tournament. I don’t have a formula by which to calculate this factor to hand but I know that it is a positive function of who - the favorites, the home team and most populous countries - does well and how, - how many goals are scored and one (not more!) cinderella team in the pools - the tournament plays out.

So the arbitrageur, or hedging sponsor should be able to trade the basis between the basket note described in the article and a basket of bets on the tournament outcome. ie Someone long of the note (or one of the sponsors) would want to lay Germany (ideally at short odds) and the total number of goals. That way if Germany is knocked out before the play-offs and every game is 0-0 or 1-0 - a real snoozefest - they mitigate the lowered effectiveness (’eyeball value’) of their note (or advertising spend) through their wins on their layer positions.

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Algorithmic trading is a hot topic in financial circles these days. Despite it already being a very important and visible phenomenon on Wall Street and the world’s financial markets, in my opinion we are only at the very beginning of what will be a transformational shift in how trading (in all types of markets) is conducted. The market research firm Celent last year predicted a five year compound growth rate of 13% (between 2003 and 2008):

Celent predicts that algorithmic-based equity trading will increase from approximately 14 percent of overall trade volumes to almost 25 percent by 2008, representing a compound growth rate of 13 percent. Traditional buy-side firms, who have thus far been slow to embrace algorithmic trading, represent the industry’s largest growth segment, with a five year compound growth rate of 30 percent.

I think they are low. I think growth in machine or algorithmic trading has entered a period of geometric growth and will see sustained and significant innovation for the next 5 to 10 years. Advances and ideas from areas such as econophysics and artificial intelligence will lead the way:

(From MoneyScience:) Econophysics was started in the late 1990’s by several physicists working in the subfield of statistical mechanics. They spontaneously decided to tackle the complex problems posed by economics, especially by financial markets. Unsatisfied with the traditional explanations of economists (many of which lacked empirical justification) they applied tools and methods from physics - first to try to match financial data sets, and then to explain more general economic phenomena.

(other sites on the subject include Econophysics Forum, Focus Session on Econophysics, American Physical Society, and Didier Sornette, UCLA)

(Thanks to the very interesting Vanilla Put blog for the post on econophysics.)

This rise of algorithmic trading will go hand in hand with the increasing sophistication and scale of electronic exchanges, ECNs and other computerized trading venues.

This is one area however where I would have to admit that the street is not standing still. For instance, just today Bank of America announced its purchase of (selected assets of) Financial Labs:

Financial Labs, LLC was founded in 2003 by a team of Harvard University-educated physicists and astrophysicists with extensive training in computational mathematics, and the managing partners of FX Solutions, one of the major firms in the global retail foreign exchange trading industry. The skills acquired by a scientist in analyzing large data sets and building quantitative models are similar to those needed to identify profitable trading opportunities and fleeting inefficiencies in financial markets; thus, a symbiotic combination of trained scientists with seasoned, professional Wall Street foreign currency traders paved the way for the formation of Financial Labs, LLC.

In a simlar vein, Citigroup acquired Lava Trading in the summer of 2004:

Lava Trading Inc. is an innovative technology firm that develops unique, high-performance trading solutions for the financial services industry. Our products are created as true ASP solutions built to withstand maximum volumes in the most volatile conditions. As a cost effective and neutral provider, our OTC, Listed and Foreign Exchange solutions are used by leading broker/dealers, including most of the top 20 U.S. investment banks, market makers, hedge funds and institutional investors.

The transition to more and more computerised electronic trading will fundamentally alter the financial ecosystem. Like with any significant environmental change, some species will not survive while others - including entirely new ones - will thrive. It creates a great opportunity for both firms and people, but for those unwilling or unable to adapt, the future is bleak.

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I would imagine many people in the financial services industry think a mashup is something you do with potatoes or maybe involves bourbon… to be fair however most people actively involved in developing mashups don’t seem to have much interest in banking or securities trading if this site is representative…

(I suppose you’ll be surprised - not! - to find out that) I think this will change. Again the thread connecting finance to the current center of mash attention (media, travel, mapping, etc.) is the fact that it is essentially about data and value is added by organising and representing this data more effectively for the end user. When the “Mashup ecosystem explodes” (David Berlind) (via Doc Searls), I think there is something to be said for being a leader in the financial services space in terms of making your api’s available for mashing.

As an example, this idea (or something similar) over at Vanilla Put is something that would lend itself to a mashup approach.

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