:: The Park Paradigm ::

Markets for the Digital Generation

It’s not like they exactly need my validation. But if you want to glimpse into the future of what would generically be called “investment banking” a good place to start would be at Citadel:

Since its founding in 1990, Citadel has grown into one of the world’s most sophisticated alternative investment institutions. Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class. Through a combination of world-class talent and the use of advanced technology to suppoer them, we relentlessly seek to initiate and capitalize on change in the global financial markets with the goal of remaining at the forefront of the industry.

I must confess to a very limited knowledge of the firm, based almost entirely on what I have read in the press and taking note of the deals they have done and how they have approached the business of investing. (So please accept that my opinions on Citadel are based on conjecture and are accordingly quite possibly off the mark.) What has always resonated with me is their emphasis on building a robust, scalable infrastructure based on viewing technology strategically as a core component of their approach to investing and financial markets more generally. (For those unfamiliar with Citadel, here is a Bloomberg Magazine article that gives a good overview.) Citadel Solutions formed earlier this year to leverage their leading edge infrastructure is a case in point:

The Citadel Solutions team is at the forefront of shaping processes within the capital markets, taking leadership positions in industry working groups and continuously driving improved workflow. This passion for process is a cornerstone of our culture and represents the close partnership between our people, our technology and our clients. As a result, our technology is continuously updated to support best practices and we believe in perpetually strengthening our team with the best talent available to deliver the highest levels of service.

This combination of People, Process and Technology has been central to our success and is now available through our administrative service offering. By partnering with us, our clients can focus on their core business of investing, while leveraging the unique and advantaged position of Citadel Solutions to support their middle and back office service requirements across nearly every asset class, market and geography.

With this in mind, let’s say I wasn’t surprised when I heard that Citadel was injecting a large amount of capital into E*Trade. I won’t pretend to know whether or not (or even how) the numbers stack up - I don’t have the resources at my disposal to undertake that kind of analysis but I suspect it will be a great deal for Citadel and one of those deals where frankly I wish I had the financial and human resources to have done.

Most of the commentary on the deal has been focused on the purchase of E*Trade’s distressed sub-prime assets at what would seem to be an attractive price. Indeed this would seem to be a major part of the financial risk Citadel is taking and is interesting in the context of establishing clearing prices on these types of securities and (hopefully) encourage the return of liquidity to these markets around a new pricing equilibrium. I have no idea as to whether or not Citadel will make money on this (I suspect they will) but I see this as the less interesting part of the trade, at least from a strategic point of view. Assuming that you ring-fence that part of the trade - which after all is ‘just’ buying a portfolio of assets and so is ‘just’ a question of price (as to whether it was a good or bad trade) - it would seem to me that you are left with Citadel taking a large (and cheap) position in E*Trade’s core operating business: a (relatively) modern, electronic agency retail securities trading and distribution business. This type of business is potentially very valuable (one only has to look at the valuations of their erstwhile peers - TD Ameritrade, Schwab - or the recent purchase by Goldman Sachs of 10% of CMC Markets in the UK valuing it at c. $2.5 to $3bn), and notwithstanding the fact that the E*Trade franchise is somewhat tarnished by their recent troubles, could prove to be a very cheap option if they can now isolate their core operating business from the mess because of the Citadel deal.

Furthermore - and this is pure speculation on my part - I imagine there are additional benefits to Citadel from having such a strong position in this kind of distribution and trading platform: it is a great place for Citadel to originate and distribute risk. Indeed it is my understanding that E*Trade historically was a big customer of Citadel’s options market-making business; the potential to grow this kind of relationship would be beneficial to both firms.

I must admit to being slightly confused as to why E*Trade ever thought it was a good idea to get into the business of taking principle risk. I mean they were outside the historical (and sub-optimal) banking/securities firm paradigm, and yet like a moth to a flame used their success to migrate their business model into the conformist Wall Street main stream. Marrying agency intermediation, distribution and origination businesses with principal risk taking in the same capital structure just doesn’t make sense: the incentives are all wrong and the risk/return/capital equations for each type of business are entirely different. With toxic results - it’s not just theory. Principal risk taking is intensive in financial and infrastructural capital needs, and light in human capital. The agency businesses are intensive in human and (in some cases) infrastructural capital needs, and light in financial capital. However the human and organizational dynamics of corporations do not allow these distinctions to be applied, or at best only at the margins. So what? Well let’s just say the best job in a modern universal bank is running the loan portfolio; in good times you have no losses and so good returns and usually the agency side of the business does well too. This is important because your compensation is anchored in the firm. If your star salesperson is paid $5 million for generating $50 million of revenues, well ‘your’ revenues of $200mn should get you paid at least as much right? Only the salesperson used a few hundred thousand or maybe millions of capital (needed from a regulatory point of view) while you used a few tens (or even hundreds) of millions. The capital made the money. Not you. Of course that’s obvious, no way that the compensation policy doesn’t take this into account you say. Trust me, it’s not completely ignored of course, but the arb works. And then in bad times everyone is screwed but since it’s not a partnership, the portfolio guy isn’t giving anything back even if he’s down $400mn. The worst the agency guy can do is a goose-egg, so at least compensation is (broadly, ignoring fixed operating costs) symmetrical.

But even ignoring the distortions engendered by the internal compensation arbitrage, as an investor you are buying a bucket of gray paint which is unnecessarily hard to price - you’d be much better off buying the individual colors and mixing them yourself. The portfolio effect within the firm is good for management - they reap the benefits of diversification, while for investors they only see a dulling of returns and a dilution of accountability. The optimal capital structure for an agency business is very different than that of a principal investment business.

I’m not sure this is all very eloquently articulated. It’s probably an essay not a blog post…but perhaps it will help clarify slightly if I tell you where I think this inevitably will lead us to (but it could take 20 years): a world where you have regulated pools of capital (banks), unregulated pools of capitals (hedge funds), originators/distributors (customer-facing) and exchanges. Each with an optimized capital structure aligned to the nature of their underlying financial and/or operational risk. Now it’s not to say there won’t be any loose coupling of all of these, but for example - and coming full circle I hope - Citadel owning 20% of (a pure agency) E*Trade might be the kind of thing we see more of not less in 2020.

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Almost as if on cue, imagine my surprise (and delight) to find this month’s Prospect magazine (quickly becoming a must read for me, as a wonderful complement to my weekly Economist fix) feature an essay by David Goldblatt “Taking Sport Seriously” on its cover:

Sport has never been more important, but its meaning and appeal are still not taken seriously, at least in Britain. It is time for sport to enjoy the same cultural weight as the performing arts, and to be judged by the normal standards of public life.

The focus of the essay is on the lack of political and cultural respect accorded to sport in our - with particular focus on British - society and how this is incongruous with the role it actually plays in our culture, our economy and our society. The author spends some time explaining the historical context and does a good job of framing how this bias against sports (being accorded the legitimacy it is due) came to be; in politics, culture and - yes, finance - sport is trivialized and not seen as worthy of “serious” attention - after all, they are “just games”…

Yet serious organised play cannot be purely spontaneous. If we wish to watch the spectacular, to participate in its grand narratives, we need rules and rule-making institutions; we need facilities, stadiums and professional athletes. Spectaculars require backers; the circus must be paid for. Sport needs, attracts, and must deal with money and power, and the backers will always be looking to buy or take their share of glory. How are we to police the line between the realms of power and play, economic space and social space? The production and consumption of modern sport clearly is political, albeit with a small “p.”

The author goes on to propose his view of a more appropriate positioning of sport in our society:

What would a healthier sporting culture look like? It would start from two ideas. First, sport should be treated with the same seriousness that is accorded to the performing arts. Second, it should be judged by the same standards of transparency, sustainability and democracy that we expect elsewhere in public life.

While finding much to agree with in his framing of the current state of affairs and the broad lines of his call to acknowledge and even embrace the reality of the key role it plays in our culture and our economies, my opinions diverge quite strongly with respect to his take on the role of markets in buttressing or even leading this realignment. His logic breaks down when he states that private capital and market forces are inimical to the emotional and ethereal value that lies at the heart of sports cultural value:

In sport, as in so many other areas, we seem to have accepted the triumph of private capital and global markets as irreversible. The private ownership of British football clubs, often by foreign billionaires, may appear to be a fait accompli, but it remains a flawed model. After all, what is a club? Stadiums, players, coaches and directors can and do change, and yet Arsenal is still Arsenal. What gives Arsenal continuity is the accumulated social capital amassed by generations who have attached significance to the narratives generated by the team’s performances. This network of memories, meanings, identities and rituals constitute a precious form of value which cannot be owned by anyone and should not have its fortunes exclusively linked to the vagaries of private capital—just ask people in Brooklyn how they feel about the Dodgers’ flight to Los Angeles in 1958.

He goes onto demand that we “balance private capital’s opportunity to make profits from [sports] with its duties of care.” I don’t disagree but find nothing contradictory in the preservation of “this precious form of value” with ownership by private capital and market mechanisms generally. That is not to say that good regulation and governance is not needed - indeed regular readers will know that I consider that a sine qua non of robust and efficient markets - but it confuses the lack of these with private ownership. They are not linked. I would go further and say that market forces are the best guarantors of good stewardship in the medium term precisely because there is a direct (non-diffuse) interest in preserving the “magic” that drives so much of the value. Indeed, the greatest risk of amateurish, parochial and near-sighted governance is more often found in sports and countries where the sport is considered a “public good” and so risks being compromised by the corrupting and often opaque forces of undemocratic and politicize power that typically favors a privileged and incumbent elite.

(For example, if the IRB were “privatized”, the next rugby world cup would almost certainly have gone to Japan (and not New Zealand.) Furthermore, Argentina (and other emerging rugby nations) would have long ago been given the opportunity to regularly compete with rugby’s elite. Both these would be to the benefit of the game; creating more (and spreading more widely) the “precious value” that sport brings, and would make commercial sense. However the political appointees that run the IRB - and are not subject to the discipline of private capital, but answer to the powers of the incumbent (self-perpetuating) elite - are free to ignore this even at the risk of damaging the long-term value of the game.)

Market mechanisms - allowed to work - will indeed promote the cultivation of the grass roots and ensure a necessary level of competitive parity because it is in their self-interest (economically.) One only has to look at the professional leagues in the US to see that private capital understands this impeccably. The failure in the UK (and elsewhere) - and I am sympathetic to his view that there is a failure - comes from the muddying of the waters by according sport a “special” quasi-public status: it’s a variation of the tragedy of the commons - the capitalists only abdicate their responsibilities because they can. ie Someone else (the government, the community, etc.) pays for it. So (mainly correct) diagnosis, but wrong treatment.

In any event, I applaud Prospect for doing its part in engaging the debate and the author for framing the issues so eloquently and challenging our society to reassess our preconceptions on this subject.

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I don’t follow football (soccer), but if you live in the UK, you can’t have missed the headlines following England’s defeat a couple days ago knocking them out of the Euro 2008 championship. And I’m not talking about the sports pages.

Numerous reports flagged the probable negative economic impact of this loss on the country, with estimates ranging between £1.3 and £2 billion pounds (from BBC News):

“A successful run to the 2008 final would have led to a £2bn bonanza for the economy,” said Simon Chadwick, professor of sport business strategy and marketing at Coventry Business School.

Professor Chadwick also explained that the impact of England not playing in Euro 2008 could even go deeper than just lower retail sales.

“Evidence from previous tournaments also shows that, at another level, worker productivity normally increases as the England national team progresses through major tournaments and the ‘feel good factor’ takes hold,” he said.

It’s not just diffuse, hard to isolate, losses across various sectors, the equity markets reacted strongly by marking down shares in companies most obviously affected, with Sports Direct for example being the biggest loser on the London market on the day, down 15% wiping over £100mn off its market capitalization.

If I were a market-maker in this stock, I would certainly want to be allowed to manage this kind of event risk by having access to the sports risk exchanges like Betfair. Now I don’t know that they don’t but all my experience of the City would suggest that it is unlikely:

Head of Trading: “I would like risk limits to trade on Betfair to help hedge our positions in sports sensitive stocks.”

Risk Management: “So you want to bet on football and horses and such? I think somebody must have spiked your coffee this morning.”

Head of Trading: “No. I want to hedge my book. Furthermore it would allow us to be more aggressive in making prices to our customers, making them happy and reducing our risk.”

Risk Management: “But that is crazy. You’re asking us to include gambling in our VaR models? I would get laughed out of the bank if I proposed that to the regulators. We deal with real, measurable financial risks, not fanciful punts on footy.”

Head of Trading: “Oh yes I understand - you only deal with risks that you understand completely and can manage precisely. Like exotic credit correlation and the like…”

Risk Management: “Yes, precisely! Errr…wait a second…”

So Trading goes up to Management,

Senior Management: “Son, we are a serious and reputable City institution. We do not gamble. If you want to punt on sports please do it on your own time and with your own capital. We are not a betting shop.”

But inertia and close-mindedness is just a petri dish for opportunity. And opportunity is always seized in the end. Five years from now, this conversation will be the historical anachronism it deserves to be.

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In a leader this week on banking in Africa, the Economist asks the question “A bank in every pocket?” making the point that “banking on mobile phones holds promise, provided regulators are willing to be flexible”:

Leonard Waverman of the London Business School has estimated that an extra ten mobile phones per 100 people in a typical developing country leads to an extra half a percentage point of growth in GDP per person. To realise the economic benefits of mobile phones, governments in such countries need to do away with state monopolies, issue new licences to allow rival operators to enter the market and slash taxes on handsets. With few exceptions (hallo, Ethiopia), they have done so, and mobile phones are now spreading fast, even in the poorest parts of the world.

I wholeheartedly agree with their point - indeed my post a year ago (!) A Trinity: Finance, Mobile Phones & Africa (from November 11, 2006) made many of the same observations:

It seems clear that mobile phones (as opposed to personal computers) will be the most important device for access and connectivity in the developing world, and probably everywhere eventually. But access to the internet and computing will become more and more common everywhere, with many different initiatives - both technological and financial - focused on bringing down the cost and expanding the market for computing in the developing world.

As has been written many many times before, mobile phones are changing everything. From politics to business to culture. The digital generation is but a subset of the connected generation, a worldwide phenomenon. Again, this is probably being felt more strongly in developing countries - not so much because the effect is greater or different - but because the contrast with what came before is that much more marked. This extension of connectedness enabled by mobile telephony taps into something that is inate in humans; it extends our ability to form communities unbounded by geographical or even political constraints.

The Economist goes on to highlight the flexible, adaptive regulatory approach to mobile banking being taken in the Philippines (something I was not aware of) as a model to emulate:

Rather than trying to work out the best rules in advance, which could hamper innovation, the regulator is working closely with the banks and operators behind the country’s two m-banking schemes. That way the regulator can see what is going on, so the schemes’ operators get more flexibility. The experience will feed into new banking regulations. Rules that are too tight will hinder adoption; rules that are too lax could allow fraudsters to bring the whole idea of branchless banking into disrepute. But if regulators strike the right balance, m-banking may provide the next example of the mobile phone’s transformational power.

In the same edition, “On the frontier of finance” gives a good overview of the state of the banking industry on the African continent, highlight that while recent growth and investment is encouraging, the opportunity remains vast with most of African’s - even in the richest countries like South Africa - remaining unbanked and having no or poor access to even basic financial services.

A couple weeks ago, in a special report in the FT on Tanzania, Tom Burgis wrote a very good article “Crops are starved of lending” on how the lack of access to basic financial services, working capital and markets hold back improvements in agricultural productivity and essentially trap much of Tanzania’s population in a vicious cycle of poverty:

Four in every five Tanzanians live in rural areas; most are subsistence farmers. Eighty-five per cent of cultivated land is still worked with hand-held tools, 10% with animals and just 5% with machines. For a decade, the sector’s growth has failed to match the overall expansion of the economy. Without a transformation in agriculture, Edward Lowassa, prime minister, admitted in a recent speech, there will be no escape from poverty.

…[in a village dependent upon cashew farming] The 1,006 vilagers are unable to bypass what officials say are illegal cartels of traders who keep prices cripplingly low, depriving farmers of capital to reinvest in raising quality and productivity. Their predicament is worsened by the near impossibility of borrowing.

I know that solving problems like these is not easy; that there are many social, cultural, institutional hurdles to overcome (on top of the operational and technological challenges) but it would seem to me that in the next decade or so, there really is a chance to ‘leapfrog’ using cheap, ubiquitous mobile communications and devices as a substrate and deliver the power of modern financial services and markets to every corner of the planet. Even the poorest. Especially the poorest. Indeed the maxim “go where the pain is highest (with respect to introducing new products and services)” means that it is not ridiculous to think that some of the earliest adopters of sixth paradigm markets and techology may well be found in some of the poorest and challenging regions on the globe.

Imagine these villagers armed with mobile phones giving them access to markets, risk management tools (weather, commodity risk), payment systems, and ultimately capital - breaking free from the bottlenecks and information barriers currently trapping them in a vicious circle of poverty. How is that for a big idea? We’re (I’m!) not quite there yet (in terms of being at the inflection point) but we are getting very close. Hey maybe this is worthy of a TED Prize wish in 2 or 3 years from now!

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Like JP, I am privileged to have one foot in “the City” (Wall Street for North American readers) and one foot in “the Valley” (and am probably perceived as a bit of a black sheep in both.) I am also privileged to be Generation X, with one foot in the Baby Boomers’ world and one in the Digital Generation’s. And so I immediately saw the truth in his recent observation on how the rules of (social) engagement are so different in each. Which all too often leads to missed opportunities on both sides:

An aside. One way to understand the difference between the audience of yesterday and the audience of tomorrow is by looking at how Blackberries and Macs get used in the enterprise, at meetings and conferences. Yesterday’s generation look surreptitiously at their BlackBerries, pretending to pay attention to what is being said. For some strange reason, they think that no one will notice. Tomorrow’s generation, on the other hand, put their Macs on the table and use them to take notes, to look up references, to stay connected. And they pay attention to what is being said. While everyone else thinks they aren’t listening. So one generation pretends to listen, actually does something else, and goes around in the benighted belief that no one will notice. And the other generation pretends not to listen, knows how to multitask, and does all this in the open. Hmmmm.

I guess bridging this divide is really what I have been trying to do for the last few years and is a cornerstone of my new venture. I guess it comes down to seeing the lack of a public wi-fi network (and more importantly nobody except me even noticing let alone caring) at a major conference on financial technology as a glass half full…

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In 1971 Intel unveiled the world’s first commercial microprocessor, a technological revolution that heralded the Age of Information and Telecommunications - the fifth techno-economic paradigm since the dawn of the industrial revolution in the 18th century.* Although it is almost impossible to identify the core elements of each successive technological revolution without the distance of historical perspective, I wonder if Betfair’s recently announced Flywheel trading engine might be an analogous revolution at the dawn of the sixth paradigm - the Age of Markets. Will Moore’s Law be joined by Yu’s Law? (or Devine’s Law?):

“The number of transactions per second per $1000 of hardware increases by X every Y months…(!)”

(Remember future wikipedia contributors, you read it here first! )

To put this into context, and using Carlota Perez’ framework, let me outline some of the elements I believe will characterize the Age of Markets. Firstly, new technologies and new or redefined industries will emerge:

• truly global financial markets (including ‘developing’ countries)
• entirely new concept of risk management and insurance: “outcome” markets
• convergence of retail and wholesale risk markets
• ubiquitous worldwide realtime trading in “digital goods and services”

These will be supported by new or redefined infrastructures:

• cheap electronic exchange software
• digital transaction costs converging on free
• abundant (almost free) computing power and communication bandwidth
• worldwide dissemination of mobile networked computers (phones)
• vast social networks (breaking institutional monopoly on trust)

Indeed, unleashing the potential for ubiquitous traded markets in heretofore “inaccessible” products, services and outcomes depends on a number of foundation elements: essentially free transaction mechanisms (allowing high frequency, low value transactions), vast distributed digital communication platforms, robust and secure trust frameworks, and intuitive (ideally invisible, at least in the conscious sense) and painless trade capture and risk management interfaces. It would seem that Flywheel has the potential to meet at least the first of these requirements (from BusinessWeek):

Betfair CEO David Yu set the company’s R&D team the task of increasing throughput by 100 times for free. Project 100X took two years to develop and was run both internally and with three other partners, in what Carter calls a “bake out” - whichever team came up with the best prototype would get the investment for the rollout.

The budget for the entire project was less than £1m over two years.

In the end, the R&D team came up with a betting engine, called Flywheel, that could demonstrate a throughput of almost 100,000 transactions per second, while also reducing the cost per transaction by 200 times.

Even with a traditional betting engine, Betfair processes five million transactions per day - much more than the London Stock Exchange’s transaction processing system is capable of.

The R&D team expects one million trades per second to be possible through Flywheel, which it estimates is the equivalent of the entire combined annual global equity trading volume being processed in a matter of hours.

However, for Carter, the key achievement is the cost levels. He explained the whole system runs on two servers with an approximate cost of £25,000. This, he said, is in comparison to a high street bank with a similar throughput load that will typically use a mainframe costing many millions of pounds.

Ok, just in case you skimmed over that last bit, it probably bears repeating:

ONE MILLION TRADES PER SECOND. ON £25,ooo OF HARDWARE.

I’m talking my own book sure, but honestly who’s stock would you rather own? The NYSE Euronext? Nasdaq? how about Deutsche Borse? or OMX? or the LSE? …or Betfair???

In Amazonbay, I suggested that someone like eBay might move into financial markets, leveraging their technology and associated low transaction costs by buying a financial exchange, leading electronic agency brokers and ultimately Betfair (in the summer of 2010!) With a market capitalization of c. $44bn eBay could probably afford NYSE Euronext (at c. $21bn plus a takeover premium) but the real prize would be Betfair. By 2010 they should still be able to afford it but it’s far from clear it will be for sale and one imagines it will be a far sight more expensive than the £1.5bn valuation Softbank acheived when it took a private stake in April 2006. Speculating about big brand name corporate deals is obviously fun but risks confusing the real point.

Any business predicated on charging a significant ‘metered’ transaction fee for matching or facilitating a (digital) trade is likely to see it’s business model washed away like a sand castle at high tide and needs to be ready to compete in a world where marginal transaction costs are zero and value is derived ‘because of’ the trade, not ‘with’ the trade.

Oh, and one more thing… ONE MILLION TRADES PER SECOND. MILLION.

…this is not your father’s oldsmobile…

(* see Technological Revolutions and Financial Capital, p. 11)

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Jed Christiansen at Mercury Research & Consulting has just posted an excellent and comprehensive listing of the many and varied prediction market companies and software solutions available today - a great resource and jumping off point for anyone wanting to research this emerging phenomenon. Although I think I understand why, I was surprised not to see Betfair listed: clearly for anyone in the UK interested in this space they will have already heard of it and it is perhaps not exactly a “prediction market” at least not in the same genre as many of the companies listed, nonetheless in other ways it is the shining success among outcome exchanges and especially in the US (due to Betfair’s strict adherence to US law) is not necessarily known or understood by everyone.

In any event, well done Jed for making this mini-survey available to all.

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A couple great posts from the always interesting Sports Economist recently asked the question “why study sports economics?” adding to a (not quite top ten) list written by Justin Wolfers:

1. Sports provide unique opportunities to test economic theories.
2. Sports shapes broader national debates.
3. Professional sports are an important part of the economy.
4. Sports participation is an important activity.
5. Sports provides a useful teaching metaphor.
6. Doing research on sports is fun.

Earlier they highlight the relevance of the 2007 Nobel Economist’s work for sports markets:

OK, not quite, but the work of Leonid Hurwicz, Eric Maskin and Roger Myerson has much relevance to sports economics and the design of sporting contests such as leagues, championships and so on. Their key insights relate to the design of mechanisms when agents have private information. The economic framework for analysing these problems (e.g. ensuring that rules are “incentive compatible”, i.e. the payoff to breaking them is not greater than obeying them) was laid down by these guys, and insights into the regulation of monopolies and so on were important consequences of their work. It’s not hard to think of a whole host of current sports issues to which their work is relevant: incentives and revenue sharing; creating mechanisms to prevent match fixing; doping. Moreover, the notion of a sports competition itself can be thought of as a mechanism designed to elicit maximum effort from contestants.

I’m looking forward to learning more about Mechanism Design Theory as it would seem to have particular relevance in an emerging “age of markets”.

Serendipity of course took me to these posts (I check Sports Economist every few weeks to catch up) on the same day I first learned about Lewis Hamilton’s plan to list himself on the stock exchange (from the Independent):

The innovative move could see the racing driver list a minority stake in a company in which he would be the main asset and remain the major shareholder. Several US sports stars are considering similar proposals, including Derek Jeter, the star batsman at the New York Yankees baseball team.

Hamilton’s multimillion pound salary from McLaren, his F1 team, is set to be dwarfed by the sums earned from endorsing and promoting products. If he chose to pursue a listing on the AIM market in London, he could, for example, sell a 10 per cent stake in Lewis Hamilton plc, for $100m. Investors in the company would be paid a dividend equivalent to 10 per cent of Hamilton’s total future earnings. The company would be structured like any other listed vehicle with a board of executive and non-executive directors.

By pursuing a listing, the driver would be able to safeguard his financial future at the start of his career by pocketing a large lump sum. The plan could be attractive to Hamilton because it would reduce the financial downside of any injury that might prematurely end his racing.

Readers won’t be surprised to hear that I think this is an excellent and interesting idea worth pursuing and if he goes ahead, will be yet another step in legitimizing sporting risk as the real and relevant (non-correlated) asset class that it is; I certainly didn’t predict Lewis in AmazonBay but this is exactly the kind of possibility I wanted to draw attention to with my rather far-fetched metaphors in the film. Of course, if Lewis PLC goes ahead and floats, one should expect trading volumes on F1 markets at Betfair and other sports exchanges to pick up considerably, especially on race days (think Treasury futures when “the numbers” - non-farm payrolls, GDP, etc. - come out). If I were the bank underwriting (and subsequently making markets) in these shares, I would make damn sure that my management and risk limits allowed me to trade the underlying F1 markets on Betfair etc. Of course this is not completely new - many football teams have had public listings; however I suspect Lewis PLC would be a much cleaner test of the relationship between economic risk and the underlying sporting outcomes given the lower basis risk (fewer variables.) And there should be plenty of both “end-users” (shareholders, sponsors, broadcasters, etc.) and speculators to provide liquidity to both the shares and the outcome markets.

My only regret is that I’m not in a position (yet!) to pitch for Mr. Hamilton’s business as an underwriter or financial advisor. Although I would be happy to advise him strategically (if any readers are close to his management please forward this post to them!)

(More recent posts on sports risk management here.)

*Note: The Independent article above mentions that US baseball star Derek Jeter has contemplated a similar idea. Given that he plays a team sport, the basis risk between his performance is higher than for someone like Lewis Hamilton and depends to a large extent on where he plays - both in terms of “is the team good?” and “is the (media) market big?” Furthermore given the ridiculous criminalization of sports trading in the US, any market-maker in Jeter Inc. would be hard-pressed to legally hedge their book. Of course, if they had a UK office they could potentially get around this but without US retail participation, I doubt Betfair or any other exchange would have a liquid market in baseball risks. Then again, maybe this is just the ticket to plow through sensible legislation and regulation of sports trading through Congress; if Goldman Sachs and Merrill Lynch are doing the asking, maybe Senator/President-elect Clinton will put her name on the bill!

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While completion insurance for construction projects is not a new business, for certain high-profile projects I wonder if it wouldn’t make sense to open up the risk pricing to a wider audience…

The recently unveiled plans for the London 2012 Olympic stadium got me thinking about this (from London Metro:)

The £496m structure, which has jumped in price from the £280m estimated in 2004 when London was bidding for the Games, will stand at the heart of the Olympic Park. It is being billed as a design representing a new era for Olympic stadium design.

Building work on the stadium is set to begin up to three months ahead of schedule in April or May, with completion in 2011 to allow for test events, the Olympic Delivery Authority (ODA) said.

I suspect that if you had a market in construction cost and completion date, both would go bid very quickly at £496mn and May 2011…and it would be a good bet. As Mr Taleb drives home in Black Swans, the people responsible for making these forecasts at best include all the normal - ‘expected’ - factors that contribute to the cost and delivery date of the development. It is unlikely that they have accounted for things outside those which have historically contributed to delays and cost overruns. Indeed, there is no way of “scientifically” accounting for these possibilities, and I further suspect if they were to add an arbitrary 50% or more haircut to at least provision for some unknown eventuality, they would never be allowed to do so (by the customer, the accountants, the insurers, etc.) However if there was a traded market price any interested party would be able to hedge this risk. This is not to say “the crowd is wise” and can know the unknowable (as is the often mistaken cry of prediction market evangelists) but that with a traded market the risk is better syndicated (distributed) to those best able to bear it at any given price. And the price signals - while not omniscient - would be useful to both the customer (London 2012) and the construction companies. For unlike the Syndey Opera house, the deadline is hard. (Well there is always Wembley I guess if it all goes completely pear-shaped…)

So I guess I should send a request over to Betfair to get these markets up and running! Only problem is (and this is why the future lies is data - robust, clean, reproduceable data) you would need to have a clear and robust settlement mechanism. Probably easier for delivery date (esp. if market settles on a week, fortnight or month to avoid ribbon cutting date shenanigans - ie insider trading) than for cost. That said given that it is a public project there must be some government auditing department that could state the methodology and vouch for the accuracy of the final accounting.

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Working to bridge the disconnect between the socio-institutional paradigm and the techno-economic paradigm, which as Carlota Perez so eloquently writes will lead to a golden age for the emerging digital generation:

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