:: The Park Paradigm ::

Markets for the Digital Generation

Yesterday I spent the day at the first (of what will probably become annual) Fintech M&A conference, sponsored by Finextra and Deutsche Bank. There were some very interesting speakers and the quality of the discussion on the panels I saw was good, however the most valuable aspect of the day - like for most good conferences - was the fact that the organizers managed to assemble a fantastic group of 200 or so of the key players and decision makers in this market in one place at the same time. It was great to catch up with many people I haven’t seen since leaving investment banking last year and also to meet a number of people I’ve often crossed paths with but never before had the opportunity to meet in person.

Hermann-Josef Lamberti, the Deutsche Bank COO and Board Member, kicked off the day with a very good keynote, which more than anything set the stage for many of the discussions and conversations that followed throughout the day. (It would be great if he made his presentation available on the web to link to, I wonder if he has a blog?…) In particular, he highlighted how technology was “binding innovation and globalisation together in a single process” with complete virtualization of compute power driving a fundamental transformation of how one needs to think about the business, and highlighting that technology has been the key driver in reducing cost-income ratios in banking by 15-30% over the past 5-10 years. He forecasted a doubling in trading volumes over the next 24 months (continuing the strong growth in volumes over the past decades) and pointed out that they use peak levels of trading (ie during exceptionally high volume periods) as a good tool to forecast average trading volumes expected 1-2 years forward. He also made the point that mastering complexity (in IT) is key to sustained successful growth in banking.

Just before lunch, Tim Frost moderated a panel discussing the future of exchange consolidation with participants from the CME Group, Nasdaq, the Bombay SE, the Dubai Financial Center and TradeWeb. There was an interesting mix of agreement and dissent as to how the panelists viewed the likely future landscape for financial exchanges but what I found particularly interesting - and encouraging - was the relatively pragmatic view that change would likely continue apace and that innovation (possibly driven by new entrants) was likely to play a key role in sorting out the winners from the losers over the next decade. (Perhaps AmazonBay is having its intended effect, it just took time to sink in… ) There was a general consensus that volumes traded on exchanges will continue to grow strongly (secular growth, new products, new geographies all contributing) which is a thesis I certainly subscribe to, however I can’t help but wonder if at some point in the next couple years we won’t see exchange valuations disconnect (perhaps violently) from the heretofore correlated rise with volumes. I keep coming back to the many parallels I see between the large financial exchanges (today) and the giant telecom network operators (c. 1997)… The analogy is not perfect of course but probably closer than most senior executives of exchanges would want to admit. While the volume of voice and data (now the same thing basically) has continued to grow exponentially pretty much without a hitch, the valuations of the operators - after rising spectacularly in the first phase of this growth when they were able to perpetuate ‘old paradigm’ (high) transaction-based pricing on an essentially fixed-cost infrastructure that had massive operating leverage as volumes exploded - then crashed as the business model collapsed with the shift to a ‘new paradigm’ (low) network-access-based pricing model more in line with the new operating economics of the business. In other words, while exchanges are currently in a ‘golden age’, ultimately don’t the forces of competition re-align pricing to reflect the ‘cost-of-goods-sold’? In other words, what is to stop someone from building a state-of-the-art exchange and completely rewriting the revenue model of the industry by going to a flat rate capacity based model (or even free for some customers.) What happens when the trading equivalent of VoIP (call it SToIP - securities trading over internet protocol) hits the market? I don’t think the big exchanges go away, but neither then did the big telecoms…however their valuations were - how do you say… re-rated. (And I think if you asked them, they would say the business transformation they went through from 2002-2005 wasn’t a barrel of laughs…)

Just after lunch, I had the pleasure of moderating a panel on the future of the inter-dealer (ie wholesale) broking business, and was blessed with a fantastic group of CEO/COO panelists: Lee Amaitis (BCG Partners), Grant Biggar (Creditex), Patrick Combes (Tradition), Chip Carver (Swapswire) and Mark Yallop (ICAP). As in the morning there was a strong consensus that the strong growth in trading volumes of the last decade was set to continue for some years to come and competition would continue to be fierce. There was a feeling that you might see some further consolidation, however much of this had already happened. The development of new markets - both geographic and new asset classes - was seen as a key driver of future growth. We also had a thoughtful discussion of the potential for mergers between exchanges and OTC brokers, with some seeing this more likely to happen than others. Both Mark and Lee pointed out that the “all-to-all” trading service provided by an exchange was significantly different than the bilateral trading model of the IDB business and would pose significant challenges (in terms of integration, customer expectations, etc.) to anyone looking to marry these two types of trading platforms. (Relative) valuation issues were also highlighted as likely to preclude an of the IDBs from looking at these types of deals in the near term. Finally, there was an interesting discussion around the pros & cons of vertical integration through the entire trade cycle (execution, clearing, settlement, etc.) and my take was a cautious consensus emerged that this was unlikely to emerge as the winning model for a variety of reasons but most notably because customers (the traders) valued choice in execution venues very highly and were unlikely to be happy if they felt constrained.

Finally Lloyd Dorfman, the founder and Chairman of Travelex, finished the day by telling the wonderful story of how he built Travelex (in particular with respect to how it was financed and his experience of private capital) over the last 30+ years. Looking forward to next year, maybe they’ll have wi-fi next time so I’ll be able to write this in real time…

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In the August 2007 issue of Prospect, the economist John Kay writes a wonderful essay entitled “The Failure of Market Failure” in which he deconstructs the all-too-often conventional wisdom of how ‘market failure’ means many goods and services are better delivered via central (state) planning rather than via free market mechanisms. (Unfortunately the article is behind a paywall on the web, but I highly recommend you buy the issue and read the entire essay; furthermore their are great articles on the future of the music industry (pre-Radiohead/Madonna I might add) and taxing the super rich in the same issue.) Here is a taste:

Yet the most serious weakness of the market failure doctrine is that its model provides not just an inadequate account of how markets fail, but also of how they succeed. …But the endemic deficits and surpluses of a planned economy which is unable to co-ordinate large quantities of information in a rapidly changing environment are only part of the explanation for the failure of central planning…The main failing of planned economies was that they could not accommodate the flexibility needed to cope with an uncertain future. This issue is not one the market failure doctrine can easily recognise, since the underlying model does not recognise innovation and uncertainty, except in trivial ways.

If the partial genius of market economies lies in their capacity to achieve co-ordination without a co-ordinator, the greater genius lies in their ability to innovate and adapt in an environment of uncertainty and change. The sustained achievement of market economies comes from their pace of innovation - in products, technology and organisation - derived from the ability of market systems to undertake small-scale experiment, to watch the results, to mimic what works and discard what doesn’t.

…The trick that disciplined pluralism - decentralised choices with accountability - achieves is to replicate that combination of free choice and co-ordinated outcome throughout the economic system.

…The reason for promoting competition between providers is not that conflict is better than co-operation, but that recognising success and failure is indispensable to innovation and imitation. Incentives matter; but it is not only individual incentives which matter, and the failure to recognise this has given us both corrupt corporate bosses and demoralised public sector workers. So long as market organisation is equated with individual greed and jingling cash registers, the limits to markets will in practise be set by the determination of the public to keep them away from those areas of human activity - like health and education - that matter most to them. And that would, indeed, be a market failure.

I’ve put his book - The Truth About Markets - on my wishlist.

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I asked last week whether or not Mr. Greenspan might have the Park Paradigm RSS feed streaming into his blackberry; now - according to the FT - it seems Warren might be a fan too -

The US banks creating a $75bn-plus “superfund” to buy the assets of troubled investment vehicles should sell 10 per cent of the fund into the open market to ensure it is properly priced, the renowned investor Warren Buffett said on Thursday.

The billionaire is the latest leading figure – including Alan Greenspan, former chairman of the Federal Reserve – to pour scorn on the fund promoted by Citigroup, Bank of America and JPMorgan Chase with the US Treasury’s encouragement.

Thanks for picking up on this point I raised when the fund was announced:

I would also raise a second point which is to highlight the potential (inherent?) conflict of interest in such a fund as it would seem that it will be buying securities from its owners and is structurally engaged in a form of self-dealing.

Well if you are reading Mr. Buffet, please feel free to comment on my MSFT post from yesterday (I understand that you might want to discuss this privately and not on my comment stream so just leave your details and I’ll send you an email, or add you to my Facebook friends, whatever is easiest for you.)

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Someone close to Bill Gates - someone he trusts, but also someone who can be objective (Warren???) - needs to have a heart to heart with him and make him see that his baby is grown up now. It’s time to let go. The alternative is to keep pissing money down rat holes: damned if you do, damned if you don’t.

I’ve been meaning to write this post for about a year now, just never had the time; I had planned to pull out the old spreadsheets and do some good old fashioned financial modeling (ie from the days I was an indentured analyst, not a coddled managing director) but I’ll probably never get around to that and yesterday’s announcement of Microsoft’s new investment in Facebook has prodded me to just get on with it (at the risk - please I encourage it - of some smart private equity number cruncher telling me my numbers are all wrong, and my trade doesn’t work.)

Now Facebook is an exciting opportunity, and I won’t pretend to know whether $15bn is too high (although I’m pretty sure it’s not a screaming bargain) but Microsoft’s problem isn’t that they have bought bad companies with bad technologies at bad prices. Mostly just the opposite. There are a lot of very smart people at Microsoft, starting at the top. They have bought many really interesting companies with really neat technologies and incredibly smart people. And then they kill them. They don’t mean to. But it is unavoidable. The corporate antibodies in a giant like Microsoft inevitably end up overwhelming the acquisitions (which especially given that by the nature of the industry, most are very young and very fast growing, innovation-driven companies that have not had time to evolve any defenses against mature mega-corporation antibodies. Don’t feel bad Bill, it’s not a Microsoft thing, it’s a Fortune 100 thing. The nature of your business (technology) just exposes you more is all.

Worse still - given that acquisitions are doomed to failure - is the glaring inability to (profitably) innovate in-house. Now to be fair, this again is not surprising. Microsoft is too big and worse - too rich - to have much chance of driving bottom-line boosting innovation from within. They face the traditional bugbear of big firms, which is no one ever got fired for not putting their neck out; no matter how smart and visionary the people at the top, the vast armies of the middle see (personal) risk, not opportunity, in change and innovation. And so (as rational economic beings) they resist. Usually passively, but given their sheer numbers, that is more than enough to suffocate even the most promising new products or services. Additionally, Microsoft has the problem of having too much money (burning a hole in their pockets…) and so even when they do come up with something interesting (say Xbox for example), they spend too much money and time building it which ultimately leads to financial failure accompanying these rare commercial successes.

So what should be done? This is after all a $300bn company with tens of thousands of employees and hundreds of millions of customers. In my opinion, it’s pretty obvious: you take it private and restructure the hell out of it, give it an appropriate capital structure and in so doing release significant amounts of human and financial capital to redeploy in creating and growing the next generation of innovative technology companies. Microsoft is a quintessential fifth paradigm company, founded at the dawn of the information and telecommunications revolution ushered in by the microchip. It’s time to take the enormous wealth created by Bill and his colleagues and turn it towards the opportunities that will arise out of the sixth paradigm.

The current market cap is just under $300bn, I figure you’d need to pay a 20% premium to get a deal which in any event would be less about price and more about convincing Bill it was the right thing to do. So that would mean $360bn (or just €250mn or £175bn…) Sounds like a lot - especially in these post-credit-bubble-bursting times. But forget for a moment about the headline number and look at the underlying numbers (any help from a good MSFT analyst in correcting / debugging these back-of-the-envelope thoughts is welcomed!) In 2007, Microsoft had revenues of $51bn and an EBITD of c. $20bn. They have c. $30bn of cash/investments on their balance sheet and generated c. $18bn of free operating cash flow, another $5bn from investments, and spent $24bn buying back stock. They spend around $7bn a year in R&D (not sure what their depreciation policy is on this.) These are big numbers. Now, most of the bottom line comes from Windows and Office. Split these off and run them like the cash cows that they are: cut R&D, cut operating expenses - good old fashioned private equity pruning. Microsoft has no debt. How dumb is that?!? Give Windows/Office an efficient capital structure: you can probably even securitize a lot of their blue chip corporate licence revenues. In any event, you should be able to finance at least 6x EBITD. I don’t have the divisional breakdowns (the Annual report download from Microsoft’s site doesn’t work! I’m not making this up…maybe it only works with IE?!) but I wouldn’t be surprised if the lion’s share of FCF comes from these products. I figure - post restructuring - you should be able to get at least $22bn out of these alone, and so probably justify an enterprise value of $250mn+, with $125-140bn of debt (which could easily be serviced with the cash generated.) All of Microsoft’s other businesses would need to be sold (either back to their founders, trade sales or IPOs) or shut down. So are they worth $100bn or so? I don’t know. However it seems entirely plausible. Especially, unshackled from Microsoft, they would have much more chance of being successful.

So who could buy it? Who has c. $70-100bn of equity capital available (and the credibility to get the debt financing and spin-offs underwritten?) Clearly there are the usual suspects - the giant private equity players: Blackstone, KKR, Goldman Sachs, Silver Lake, TPG, etc. and the enormous sovereign wealth funds. (You want China to get serious about protecting software licences - give them a stake in Windows/Office…) And what about Cascade (Bill’s private investment management firm)? They might be interested (both financially and emotionally) in recycling $10 or $20bn of the proceeds back into the deal. (Not to mention all the other MSFT billionaires.) Also you have to think alot of the big institutional holders of MSFT would much rather hold a lean and efficient Windows/Office company and so might well be interested in recycling their payouts into a sidecar or 144a structure to participate in the deal. And then of course there is Warren. A lean, run-for-cash Windows/Office is a company that would be right down Berkshire Hathaway’s alley, no? Basically - and even if my maths/numbers above are a bit shaky, my gut feeling is that it would stack up. It’s fundable. And the banks will fall over themselves to get it done. Think of the fees!!! (In this instance, the ‘absolute’ numbers matter more than the ratios!)

So coming back to the start, the key is convincing Bill it is in the best interests of the company, his foundation (he can really focus), the employees, and the economy. It’s a win/win/win/win so to speak. And instead of punting a quarter of a billion dollars on a tiny stake in Facebook - you engineer a more robust and interesting trade like having Facebook buy MS Live (with stock) as part of the buyout. I don’t know, but I’m sure there are smarter things to do with their cash than the corporate equivalent of chasing rainbows (which seems to be the governing framework of Microsoft’s acquisition policy.)

If somebody does want to take a run at this, I hope they’ll think of giving me a small finders fee, and get me on the tombstone for bringing the idea. I wouldn’t expect alot. One basis point would be just fine.

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In Part 1, I contended that:

…efficient organized markets in tickets for events have not been allowed to develop despite the fact that: (a) the existing market structure is horribly inefficient to the detriment of both buyers and sellers and (b) a vastly more efficient, tried and tested, robust market structure which could very easily be applied to ticket markets already exists and furthermore, especially given modern web technology would be easily adaptable to ticket markets.

As I also noted, I’ve been thinking about this for some time, but was catalyzed to comment by reading two articles. The first (behind the FT’s ridiculous paywall, yet another industry to be deconstructed and rebuilt!) was an editorial by Joe Cohen on secondary ticket markets sparked by the massively over-subscribed Led Zepplin reunion concert. The second was a post by John Wilson also on the subject of secondary ticket markets.

Basically they both point to the fact that secondary markets for tickets exist (despite laws and restrictions against them; these only serve to make them work badly…) and that this is a contributing factor to unnecessarily disfunctional primary markets:

(Joe Cohen on the sale of Led Zepplin tickets, FT Sep 21, 2007)
The circus that has ensued would dent anyone’s confidence in promoters. A crashed website, a ballot with a window of less than a week to enter and no guarantee of a ticket at the end of it. Add to this, of course, the blood-spitting opposition of such promoters to reselling your ticket if you turn out to be unable to attend. “Be patient,” was the concert spokesperson’s answer to the debacle. Be realistic, is my response, and look to the US for a healthier way of ticket allocation.

(John Wilson on getting tickets to the Police concert)
Where to get tickets at this late stage? Well, at this point I did some digging around and was astonished by the results.

- Ticketmaster still had tickets at £90 face value plus booking fee of over £10.
- Seatwave and Viagago, as well as similar ticket trading exchanges had an abundance of tickets. These were trading at an average price of £112 on top of which had to be added Seatwave charge on the buyer of £15 or so. This was for tickets and not hospitality packages
- ebay also had lots of ticket on buy it now and auction. All were evidently looking for a premium.
- Gumtree also had an abundance of tickets, but these were mostly at a discount to face value eg £90 tickets for £45

Why such a wide variety of prices for a relatively homogeneous item? Moreover, if there were still tickets in the primary market (Ticketmaster), why would anyone pay a premium in the secondary market?

Well, there are several factors to consider
- I bothered to search; some people don’t bother to scan the many “trading venues”
- trust; I trust that Ticketmaster has the genuine article. Seatwave & Co have refund policies (assuming you believe that they can honour them) and assurance re delivery. ebay has a ratings system. Gumtree is dealing in the wild west with persons unknown as is the case with other websites advertising tickets.
- time to “expiry”. As the event approach, people become more desperate to sell which can quickly drive down prices if there is an abundance of tickets evident. But even if scarce, you still want rid of them in time. Some people “blink” sooner than others.
- booking fees can add a considerable premium onto the price, so some tickets advertised above “face value” simply reflect attempts to recoup booking fees.

Much to the ticket industry’s annoyance, there is clearly an active secondary market, but despite their lobbying efforts, the UK Govt is loathe to outlaw such markets, questioning why live entertainment should receive special concessions and how is the consumer harmed by the current situation.

As I pointed out in Part 1, and is implicitly underlined by these two gentleman, a healthy - transparent, liquid, well-regulated - secondary market adds enormous value to the price discovery and distribution process of any (transferable) good or service. So why is their so much resistance to free and fair secondary markets in tickets? Well, last year at the futures industry’s annual Burgenstock conference I was speaking on a panel - discussing the future potential of markets in sports risk - and the conversation gravitated towards the question of why so many people seemed to have such a hard time seeing the potential for new types of markets and, worse, why they should not stand actively in the way of these developing. A gentleman in the audience reminded everyone (I for one had not been previously aware of this historical gem) that in the early 20th century - and then especially from the period starting with the “Great Crash” and lasting until the early 1960s, secondary markets in equities were seen by much disdain by many in the establishment and were at best tolerated and at worse actively argued against. In this context, the NYSE was seen as a second-class citizen in the financial firmament and traders and speculators in shares were considered an untouchable caste by the brahmin bankers. The moral of the story: that resistance to change and the dispersal of power engendered by transparency and access to information have been resisted by the “gatekeepers” since the beginning of time. (Just ask Martin Luther!) Equally, this resistance has always proved futile and those that embraced transparency and change, usually not only survived but prospered in the new paradigm. (The mystery is why the strategy of active immobilism continues to find disciples given its horrendous historical track record of inevitable failure…I’ll leave that one to the sociologists amongst you!) Perez would frame this situation as a disconnection of the techno-economic paradigm (what is possible) from the socio-institutional paradigm (what people in power can stomach.)

But I’m an optimist. So whereas I know the road will be bumpy and resistance will not melt away with a whimper, I’m convinced that the market for tickets - both primary and secondary - will undergo a transformation that take months and years, not decades. The foundation of my conviction is that the market model (and many if not all the mechanisms and processes) exists already (in the shape of the capital markets, see Part 1) and needs only minor adaptations to serve the needs of all the participants (’wholesale’ and ‘retail’) in the markets for tickets for entertainment events. And indeed, the entrepreneurs and innovators are moving forward at this very moment: a number of ticket brokers and/or exchanges exist such as StubHub, viagogo, seatwave and of course eBay (amongst many others); major primary resellers like Ticketmaster; and aggregators such as Tickex (who in a highly fragmented market such as tickets have a great business model in my opinion.)

I’m in no way anything close to being an expert on these firms and their business models, however my impression is that in general they have focussed on the fulfillment process (super important of course) rather than the risk management process. Of course you need both, but in my opinion, the potential (financial) opportunity arising from intelligently revolutionizing the risk management (underwriting and distribution) process is even greater than the exciting rewards available for these companies that are optimizing the matching and fulfillment process. This is certainly an opportunity I will have my eye on going forward. (Indeed, I look forward to learning more about John’s portfolio company he alludes to at the end of his post linked to above.) Rather than delve deep into the myriad opportunities that exist to transpose the capital markets paradigm on to ticket markets, let me leave you with a fragment of a possible future:

The year is 2021 and Oasis has announced they will be doing a reunion concert at Wembley Stadium to celebrate the first year-on-year drop in CO2 emissions in the history of the modern world. The $7 billion Live Entertainment Fund - a leading hedge fund focused on underwriting and investing in live sporting and entertainment events - has underwritten the entire ticket offering at a price of £20 million and will work with a number of ticket distributors to syndicate and distribute the tickets over a week, one month prior to the concert, using the online bookbuilding capabilities of Tickex Group. The fund would not comment, but analysts expect the proceeds from the sale to exceed £25mn, which will likely give LEF a return on equity of more than 30% for their 6 month investment (depending on the cost of various insurance and weather hedges: the tickets are expected to include the now standard 50% rebate for rain for outdoor concerts and sporting events.) Since its inception in 2010, the flagship LEF Music Fund has returned an average of 43% annually.

(Oh and by the way I had my pension fund invest £50,000 in LEF in 2011…making it a lot easier for me to afford to bid for a box for my friends and family to go see Oasis at Wembley!)

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Why is it that the market for (event) tickets is so dysfunctional? It’s not the first time I’ve written on this subject, and I had promised to revisit it… Over the last couple months a number of (notionally unconnected) events has catalyzed me in to making good that promise. As way of introduction, let me elaborate on my question: efficient organized markets in tickets for events have not been allowed to develop despite the fact that: (a) the existing market structure is horribly inefficient to the detriment of both buyers and sellers and (b) a vastly more efficient, tried and tested, robust market structure which could very easily be applied to ticket markets already exists and furthermore, especially given modern web technology would be easily adaptable to ticket markets.

Let me take each of these points in turn.

For any event, there are a number of roles that need to be fulfilled: the end product (the entertainer(s), sports teams, etc.), the producers (those who contract the end product and organize the production), the venue (real physical property but also broadcasters), the risk takers (those who underwrite the cost of the production and take the financial risk), the distributors and brokers (those who sell the tickets) and the audience (those that purchase the rights to see the event.) For some events these roles are fulfilled independently, for others the roles are sometimes combined (for example a promoter might both produce and underwrite an event) and most often, especially with respect to distribution, there are multiple participants for the same event. If you were to illustrate this process in a flow chart it would look something like this:

And this is typically how tickets are sold and distributed for the first time, in other words the primary market. And strangely enough it looks amazingly similar to how securities (bonds, shares) are sold and distributed in financial markets:

Trillions of pounds (euros, dollars, etc.) of securities have been (mostly) successfully underwriten and distributed over the years using this basic arrangement (or a variety of variations thereon); and the key reasons this framework has developed to help issuers sell securities to investors are basically twofold: (1) to arrive at a price that best achieves the goals of all parties and (2) to optimally allocate risk during the sales process to those best able and willing to accept and manage it.

Price discovery is at the heart of this process, and is driven by the goals of the issuer which almost always include getting the highest price but often qualified by meeting certain other - sometimes competing - objectives such as ensuring a certain distribution profile - perhaps encouraging new investors, or repeat investors, or certain types of investors; or seeking to engender a certain trading performance in the aftermarket - usually a gentle rise but sometimes a more explosive rise to attract publicity for instance; etc. In investment banks charged with underwriting securities, the job of advising the issuer on what price will best achieve their objectives falls to the syndication desk and the syndicate managers who are responsible for collecting, analyzing and synthesizing all the relevant information that goes into determining the optimal price. This includes such things as: investor demand or indications of interest, the size of the proposed offering, potential competing offerings concurrently in the market, general market conditions and prevailing secondary market prices for similar securities.

Let’s take this last point; I think you will find that if you as any banker or syndicate manager what they consider to be the most important factor when looking to start the price discovery process for a new security it will be the prevailing secondary market prices of similar issues. If their exist many true comparables, the market will hone in very quickly on the clearing price for the new issue; when the security being issued is relatively unique (no other issuers or securities in the market with comparable financial metrics and/or in a similar business for example), the early indicative pricing will most likely need to be tested with investors through an iterative feedback process, which in its most structured form is called ‘bookbuilding’. In this process, the underwriting syndicate solicits ‘indications of interest’ from investors, where they are asked how much they would be willing to buy and at what price. (In some instance, particularly in the bond markets, they might also be asked to give feedback on other parameters such as maturity and the size of the issue.) By building up a picture of demand, the underwriters can optimise the match between what investors are looking for and what the issuer wants to achieve.

Starting in 2001, just after I had joined DrKW, we invested heavily in building an online system to manage this process which until then had been managed (if it was at all) by the industry via manual collection and consolidation (in a spreadsheet) of email, (Bloomberg) electronic messages and yes - I’m not making this up - post-it notes brought to the syndicate desk by sales people. Indeed the term bookbuilding comes from the 19th/early 20th century practice of underwriters writing orders by hand into leather-bound ledger books that recorded the distribution of the new securities. So in over 100 years, the industry had only managed to replace the (aesthetically pleasing) leather books with Excel. Despite much resistance - and the fact that DrKW was a relatively modest player in the debt new issues market - within a few years, online bookbuilding became the norm in Europe. In my opinion this was a result of the higher level of competition amongst underwriters in Europe which gives issuers more leverage in the process and the incredible gains in efficiency and transparency enabled by online bookbuilding were quickly understood and appreciated by issuers. Of course anytime you introduce transparency to a process, those embedded in the system, at the heart of the process lose power, and the skills needed to succeed evolve. Historically the syndicate manager was alone in ‘knowing what was going on’ and was ‘indispensable’ and there were many banks and syndicate managers who were loathe to see this paradigm pass. Of course, the advent of e-bookbuilding opened up whole new avenues and possibilities for underwriters and their customers but not seeing the possibilities of change is not unique to investment banking… Interestingly - and perhaps this has evolved since I left the market a year ago - the US debt markets have not adopted these modern methods (and this despite their European businesses being amongst the largest players in European new issue markets, so they can’t say they aren’t familiar with the technologies and the possibilities), due in my opinion to the smaller number (of larger) players on Wall Street. (I didn’t say oligopoly!)

Typically in a bookbuilt issue, all the investors are sold the securities at the same price (a modified dutch auction process) and all distributors are engaged contractually (by their underwriting agreement) to adhere to this price during the primary selling period. In the fixed income markets this innovation (yes until 20 or so years ago this did not exist) is called a ‘fixed-price reoffer’. This gives buyers the incentive to show their best price, knowing that if the securities are sold more cheaply, they will not be paying over the odds. In so doing, the likelihood of achieving the highest clearing price (meeting all the issuers other objectives) is highest.

Thinking about the methodological continuum of issuing securites, if ‘bookbuilding is at one end of this spectrum, at the other extreme we find the ‘auction’ and in the middle the ‘bought deal’. Of course there are many different ways to conduct an auction (the most commonly used in securities markets is the ‘dutch auction’ and variations thereon) but in the context of this continuum I would simply describe an auction as a distribution mechanism where price is the only selection criterea (for buyers) and where the seller shoulders all the pricing risk. This is usually an optimal distribution strategy for an issuer who regularly accesses the market, has securities that are easily priced by the market (due to extensive secondary trading history in similar securities) and has no additional (to achieving the best clearing price) distribution goals. Nobel prizes in economics have been won discussing the different kinds of auctions and optimizing outcomes, so I’ll leave it to you to dive into the literature if you want to learn more. The bought deal on the other hand has the underwriter shoulder all the pricing risk; this is simply where the bank(s) ‘buy’ the deal from the issuer and then subsequently sell it on to investors. The advantage to the issuer is that they have certainty of pricing, but as in an auction give up control of the ultimate distribution of their securities. This form of issuance is generally used by frequent issuers with a well established (and unlikely to change) investor base.

One last element worth highlighting - to round out this whirlwind primer of how securities are priced and distributed in international capital markets - is the ‘grey market’. This is a (contigent) market in the new security traded on a “when and if issued” basis (between parties who are outside the underwriting arrangements.) Grey markets tend to appear and/or trade actively if investors and dealers believe that the likely issuance price is wrong (either too high or too low). When Stanley Ross first introduced the idea of grey markets in when-issued securities 30 years ago, he was met with massive resistance from the underwriting community: after having ruled the roost - “like it or lump it” - for so long, I guess the syndicate managers of the day didn’t like being told, very publicly, that their pricing was wrong. Of course there are times when good reasons exist for a discrepancy between the issue price and the grey market, and smart syndicate managers today know when the divergence is justified and when it signals a flaw in their pricing and distribution strategy. And so grey market trading has become just one more tool in the new issue market’s price discovery toolbox.

To wrap up Part 1, I suggest you draw two conclusions: (1) the international capital markets over the last 30 years or so have developed a very sophisticated and robust methodology and process for pricing and distributing new securites, and (2) many (if not most) of the innovations that led to this state of affairs were vigorously resisted by the existing establishment at the time of their introduction (and this continues today). It is worth noting however that the power of good ideas and the forces of competition allowed these innovations to ultimately prevail. (Moral of the story: you can either ride the wave or stand in front of it and get dashed against the rocks…)

In Part 2, I’ll try to illustrate how I think all this is relevant for markets in tickets for any kind of event.

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…now that he has time to kill in airport lounges waiting for his next book tour stop? It seems that he shares some of the concerns with respect to the Super Credit Rescue Fund that I raised last week…

Alan Greenspan on Friday raised serious doubts over the plan to create a $75bn-plus investment fund to buy the assets of troubled investment vehicles, warning that it could prevent the market from establishing true clearing prices for asset-backed securities.

“It is not clear to me that the benefits exceed the risks,” the former chairman of the Federal Reserve told Emerging Markets magazine. He added, “The experience I have had with that sort of intervention is very mixed.”

(Sean asked last Tuesday:)

Indeed the important medium term ‘$100 billion’ question is just how big are these real underlying losses and how much equity needs to be written off to clear the market. The banks in question are certainly in a good position to have a good understanding of what exactly this number is likely to be. If their management and motivation in setting up this fund is framed around accelerating the accurate repricing and acknowledgement of risk, than they can only be encouraged. If on the other hand, the real underlying driver is simply to reshuffle the deck and keep the dance going (not my metaphor!) then the credit prom might end up looking more like [a scene from Carrie.]

Alan, I’m still waiting for my 2030 innovation prediction to show up on Long Bets* so that you can take the other side.

(*submitted this a month ago, anyone know anyone at the Long Now Foundation? they seem to be taking a very long time to validate my prediction…)

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Well done to Bank of America for seizing the opportunity enabled by advancing mobile tele-computing appliances. Of course I’m talking about the iPhone, and when I predicted back in January that the possibilities created by such mobile and user friendly (at least for those who don’t have giant digits) hardware would lead to an opening up of a whole new frontier in mobile markets and commerce, I have to admit I was too cynical to think that a giant like Bank of America would be leading the way:

In a move sure to set a precedent, Bank of America is the first banking application featured on Apple’s iPhone App directory.

Here’s their intro:

Bank of America Mobile Banking is available to all Online Banking customers. With Mobile Banking you can use your iPhone or iPod touch to easily and securely check your balance, pay your bills, transfer funds, or find a nearby ATM or banking center. It’s easy, fast, and convenient — just use the Safari browser on your iPhone or iPod touch to go to www.bofa.mobi and you can get started.

Although other banks have mobile banking Websites that work equally well on the iPhone, they’re the first to proactively promote it as an iPhone app. It’s a smart move given that many sites still need to tweak their interface code to be optimized on the iPhone screen. As a result, iPhone users are often frustrated with their experience on sites that are not optimized.

In time I think any service - certainly any financial service - that is time sensitive (all trading services and many others) will need to be offered conveniently (!) on and optimized for mobile devices. This is certainly true of ‘retail’ services but I’ll go out on a limb and say that it will be equally important for institutional (wholesale) financial services as well. As people get a taste of not being tied to their desks or workstation, they will come to demand this functionality (just as once they got a taste of mobile email via the blackberry, they would no longer live without it.)

Secondly (and in my view much more important and interesting), the very existence of the possibility of easily ‘trading’ in any market anywhere is both a sine qua non and will be a driver of (in a virtuous circle) the development of traded markets in anything and everything (that is worth trading) - in particular anywhere there is a need to allocate a scarce resource or a need to assign a probability to any given outcome. The Age of Markets will be made possible by the very low barrier to market participation that comes as a result of: (1) the ability to trade electronically (either the informational goods themselves or derivatives of real physical goods and services), (2) massive and cheap computing power driving marginal transaction costs to zero, (3) abundant wireless data bandwidth, and (4) powerful and intuitive mobile computing devices (combining state-of-the-art hardware with innovative and easy-to-use user interfaces.) The ability for billions of people to express their preferences through a market as easily as they can state their opinions aloud will allow these thousands of markets to bloom.

I know I’m skating over a lot of the details, but I think many regular readers will be able to fill in the blanks and get my meaning. And for those that don’t, you’ll just have to trust me - check back in 20 years and we’ll see if I’m right.

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I’ve recently been doing some work for a client looking at the future of air transport, mainly from the point-of-view of how new information and communication technologies will permit - and drive - a complete transformation of the existing industry paradigm over the next 2-3 decades (given the existing ‘installed’ infrastructure - aircraft, navigation systems, airports, etc. - and the very high safety tolerances, ie the 80/20 rule doesn’t cut it, the timescales for change are necessarily longer than in many other industries or systems.) In a nutshell, managing the air transportation system is ultimately about managing (and optimising) a complex network, analogous to a communications network for example where rather than traffic in electronic bytes, it is aircraft (and even more fundamentally people and packages) that are travelling through the network.

In this context, optimally allocating the scarce network resources (airspace, taxiways, gates, etc.) is the name of the game. Of course this being the Park Paradigm, you won’t be surprised that I believe that - building on the possibilities afforded by innovative and state-of-the-art technologies and algorithms - one of the best tools for allocating scarce resources (in any system) are markets. And so it was with great interest that (pointed there by the always eclectic Boing Boing feed on my netvibes page) I was excited to see Clifford Winston’s take on the question asked by the Freaknomics team:

(The question: The U.S. airline market is a mess right now, with unhappiness increasing among customers, employees, and executives. While certain companies have become profitable again, the future looks murky. What will the U.S. airline industry look like in 10 years in terms of prices? Customer service? Safety? Technology? The economics of the business itself?)

The U.S. airline industry is a victim of its own success — intense competition and low fares that have contributed to steady growth in air travel — and a victim of poor government policy toward airports and air traffic control that has prevented runway and airspace capacity from staying ahead of passenger demand. The results are mounting congestion and delays that raise airlines’ costs, infuriate passengers, and demoralize employees.

The solution requires the following: 1) to charge all aircraft for the delays caused by their takeoffs and landings, as well as the delays caused by their use of airspace near airports (my emphasis); to increase the number of runways at congested airports; 2) to introduce technological aids that would facilitate additional operations on parallel runways and reduce the separation between aircraft when they take off and when they land; and 3) to implement a satellite-based air traffic control system that, among other things, would give pilots the freedom to choose the most efficient routing, altitude, and speed of their flights.

By using the price mechanism to reduce peak-period demand for runway and airspace capacity, by expanding runway capacity at the most congested airports, and by adopting new technologies to enable more aircraft to use available runway and airspace capacity, air travel delays would be substantially reduced. In the process, competition would flourish, and the nation’s exceptional air safety record would get even better.

Unfortunately, congestion pricing is perceived by policymakers to be a political loser. And, based on experience, the time that it takes to build new runways and introduce new technologies is most accurately measured in decades.

Ideally (as opposed to than say London’s static and low-tech implementation of its congestion charge) you would have a real time risk exchange pricing congestion on-the-fly: aircraft operators could then trade their flight contracts in real-time and dependent on what they have sold to their passengers (or cargo) optimize along the price v. time continuum. (Clearly this is constrained by needing to land before the fuel runs out if the plane is already in the air.)

Think of it this way: “We are going to circle Heathrow for an additional 30min but will be refunding each passenger £25…” (ok a bit trite but hopefully helps to illustrate the possibilities…) Or “Buy a ticket on XYZ Airways from [Boston to Chicago] [today] for travel on [November 15th at 2pm] and we will rebate you < $2> for every minute the flight is late…” (with the [] variables determining the <> specific payout depending on the prevailing market conditions - congestion and weather pricing - and the expected load factor of the plane (which btw might also be traded: think of a more dynamic exchange version of Farecast…); very complex algorithms but simple conceptually. Or alternatively let the customer fix the rebate <> and set the upfront ticket price as a function of that, ie the customer can price his own time…the possibilities are endless.)

Furthermore, given that alongside congestion, weather is the most significant factor causing disruptions to flight schedules, you could combine this with dynamic weather markets to further optimize the risk pricing and network resource allocations. (Technology like this could provide real-time airborne weather data for such an underlying market.) The aircraft operator of the future would in fact have a dedicated team of traders/risk managers dynamically hedging their risk (the transportation contracts sold to their customers) against the market. I would imagine - like in other risk markets - there would be both long term hedging and spot/real-time markets.

If you think this is crazy stop and consider that another huge (though rarely seen by the general public) network industry basically operates along these same lines - the wholesale electric power network. (Which btw is set to undergo its own transformation with the introduction of ’smart metering’ over the coming decade; see here for an interesting take on this subject.) Clearly every major electric utility has a team of traders managing their long and short term risks in order to balance their generation and distribution capacities to the signals of constantly changing supply and demand; why should air transportation providers not have the same?

The falling cost of implementing market-based exchanges and pricing tools will in the future drive any resource allocation problem towards a market based solution and in so doing improve the efficiency of our economies by orders of magnitude. Think Moore’s law only applied to the productivity of the whole economy rather than a chip. Call it the coming “Age of Markets.” (The sixth paradigm.)

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WeatherBill had a couple of exciting announcements yesterday (see TechCrunch and Red Herring.) Firstly they raised a further $12.5 million of capital from a group of investors including Index Ventures, NEA, Atomico Investments and Allen & Co. I also participated, and have been an investor in the company from the start (and have previously written about the company a number of times.) Even more exciting is the news that they are now offering coverage of a number of European countries (the United Kingdom, Germany, The Netherlands, Spain, and Norway.) The opportunity in the UK is particularly exciting given the island nation’s changeable climate and its citizen’s well-documented obsession with the weather.