Busy investing in a whole bunch of super exciting and interesting new businesses. Busy working on the sale of ODL Group (where I was the lead independent non-executive director) to FXCM to create a true global leader in FX trading. Busy working with my partner Uday and FT Advisors on a number of interesting strategic advisory projects, in particular focused on the electronic and algorithmic trading space. Busy helping two of our portfolio companies raise follow-on financing. Busy working on our own corporate structure and capital raising where I hope to be able to communicate some exciting news in the not too distant future. Busy.

So what have we been investing in? Here is a quick rundown (in alphabetical order):

• Babuki – 2008 seedcamp winner, launching soon (will update) with an innovative platform for social gaming
• BankSimple – “an easy, intuitive, and social bank for people who appreciate simple online services. Unlike other banks, we don’t trap you with confusing products nor do we charge any hidden fees. No overdraft fees. We use sophisticated analytics to help you better manage your finances by providing you a individualized service, catered to your needs and goals.” Recently got some attention when they announced that Alex Payne of Twitter fame has joined as CTO. They also got a great write-up from @maxableson in the NY Observer.
• Blueleaf – investment information management and planning software “to help people like you see all their savings and investment accounts in one place; understand their financial information more completely, more quickly; securely share information and collaborate with spouses, family or advisors; save their data, even if they change financial institutions; and maybe most importantly, help them stay financially safe and secure.”
• Timetric – builds services to make sense of time-series statistics, based on the Timetric Platform: a proprietary service for publishing, analysing, and performing calculations on very large quantities of time-varying statistical data. Have a look at this neat little demo website they have built for tracking equity portfolios.
• Metamarkets – provides global, real-time media price discovery by aggregating billions of electronic media transactions in order to deliver dynamic price data, proprietary price and volume aggregations, and comprehensive analytic media market views to sell-side media principals.
• [not yet closed - will update soon]

Over the next few weeks or so, I plan to do a proper write-up on each of these businesses and the reasons we think they have bright prospects. So watch this space.

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But why am I explaining this here? And no, it is not to generate an outpouring of sympathy (which however I must acknowledge as very nice as I have been fortunate enough to have been reminded of over the past week.) No, there are effectively two distinct reasons I thought it would be worth telling this story.

The first is from a strictly practical standpoint: to get the word out to all the people I “work with” on a day-to-day basis without needing to write dozens or hundreds of emails (never much fun at the best of times but even less appealing with one-hand…) I suspect not all the people that I’d like to have this information are readers, and clearly for many of you this is probably unnecessary information, but while clearly not perfect, the broadcast mechanism of a blog I felt was the best option available to me. So for those of you waiting for an email or call to be returned, or an appointment to be confirmed, now you know what has happened and I would ask your indulgence and patience. If you have heard nothing back from me in the next few days or so, or if it is more urgent than that, please follow-up with a nudge. Otherwise, give me a couple weeks and I’m sure I can get back on top of things (at least as much as I ever do!)

The second reason is hopefully more interesting to a wider audience and is about addressing one of the risks that seems to me to be less discussed in the vibrant “start-up commons” that many other issues venture entrepreneurs and investors face. This is the risk to founders health from exogenous, unanticipated events.

In particular, I’m interested in risks not readily addressable by traditional key-man life insurance. This of course is a standard requirement when raising outside investment and insofar as it protects investor capital (if not their opportunity cost) from the worst-case result of a catastrophic injury or death of one or more of the founders (ie winding up of company), it probably doesn’t help in the more probable situation of a significant productivity loss due to severe illness or accidental injury. Thinking through our portfolio of early stage companies, I dare say none of them has thought much about this except for one, and if I am honest, this was only because we had to manage just such a risk in the early days of the company (which I’m happy to report was successfully done, helped of course by the individual’s recovery proceeding as expected.) If you are a start-up founder or investor, have you given this much thought? If so what sort of solutions or contingencies have you put in place to mitigate this risk? Are any insurance companies writing policies that pay out (to companies, quickly) in the case of non-critical short term health issues with key personnel? If so is the pricing reasonable?

I’ve obviously had a few days and a good reason to think about this, and just to be clear, have been considering the question in the first instance from the point of view of a founder. (For while we are also investors, my company is in fact a start-up and I am reliant upon it for my livelihood.) And in terms of protecting my family, I have life insurance, but this accident underlined that in the event I were temporarily incapacitated and unable to work, mitigating the financial risk arising is potentially much more problematic, and that this is a problem (most acutely) faced by start-ups and small businesses. Indeed, were I still working for an established (big) company or organization, I have a very nice letter from my doctor stating I cannot work for the next 4 weeks and so I would sit at home collecting my salary and healing. But even more importantly, the business of the company would go on (even if I were Steve Jobs); and while (one would hope that!) some opportunity cost would be incurred, the larger and more established the company or organization, the more marginal it would be. ie The problem (for founders and their investors) isn’t insuring the loss of a month’s salary/revenues/burn per se (which is I’m sure a tractable actuarial problem.) Rather, it is insuring the opportunity loss of a month of foregone productivity or progress. And because the “value” of this lost opportunity is subject to so many internal, external and temporal/situational variables unique to each founder/company pair, I suspect this is probably an uninsurable risk, at least in the sense of financial insurance. Indeed, I think the solution to mitigating this risk if one exists lies more in ‘operational engineering” admitting that in some cases even this will be impossible.

And so my (highly tentative) conclusions are that:

• founders should probably think about a “Plan B” to manage their personal risk (eg this could be cash savings, support from family, returning to traditional employment, etc.)
• investors need to consider the value of portfolio diversification in this context and perhaps, insofar as possible, think about what critical skills may be replaceable on a temporary basis should a founder be incapacitated for a few weeks or months and ideally build a network of people who have or have access to these skill sets; my thinking here is not to suggest that founders are replaceable but that it may in some cases be possible to soften the impact should the unexpected happen.

I would be very interested in the community’s thoughts on this and in particular whether they think it is a risk that can and should be acknowledged and managed in early-stage (and/or later-stage) companies, or if on the contrary they believe this is an intractable risk and so just needs to be “accepted” without wasting any time, energy or money trying to manage it.

So having spent 90 minutes on this post (sooo slow…) I better get down to work, and so while I’ve a dozen posts up my sling, I probably won’t be back here for a week or so as I work my way through a daunting (but mostly exciting) to do list. Oh, and for the next few weeks at least, you can just call me Lefty.

Two trading firms, one of them an established Wall Street player and the other a Midwest upstart, are each about to premiere a sophisticated new financial tool: a box-office futures exchange that would allow Hollywood studios and others to hedge against the box-office performance of movies, similar to the way farmers swap corn or wheat futures to protect themselves from crop failures.

The Cantor Exchange, formed by New York firm Cantor Fitzgerald and set to launch in April, last week demonstrated its system to 90 Hollywood executives in a packed Century City hotel conference room….

…On Wednesday, Indiana company Veriana Networks, which says its management includes “veterans of the Chicago exchange community,” unveiled the Trend Exchange, its own rival futures exchange for box-office receipts.

These are exactly the kind of novel risk management marketplaces that will continue to emerge over the next 5 to 10 years as technology enables robust, easy and cost-effective trading and settlement mechanisms and data (which is the raw material of any exchange or risk management toolkit) continues to grow in size, richness and availability across every sector of the economy. Indeed the greatest impediment to the development of such markets is cultural: there is still an irrational, sometime hysterical, aversion to any risk management tool that is non-traditional and can be characterized as gambling. Of course gambling, trading and hedging are indistinguishable in practice and can only be differentiated in context, and really only represent differences in intent. As such, it is very difficult to proscribe one while allowing the other(s). There are however reasonably good, tried and tested regulatory frameworks that have been developed over decades to manage unhealthy practices (insider trading, market abuse, etc.) in traded markets for outcomes and commodities. Using these, regulators should be happy to quickly approve as many new marketplaces or exchanges as creative entrepreneurs and traders invent and let a thousand flowers bloom. I don’t think it is for the regulators to second-guess who might be interested in trading such markets and why, as long as the market rules and framework are robust, transparent and participants are swiftly held accountable for any abusive behavior.

But that certainly isn’t the way the establishment sees things and even those that are developing new markets often see their market as an exceptional addition to the risk management landscape rather than a specific example of a more general case. (Although to be fair this may be simply a tactic to curry favor with the forces defending the status quo in order not to appear to be too heretical and so smooth approval for their specific new initiative.)

“The day that a widow or orphan bets against ‘Finding Nemo 3′ — that’s not a good day,” said Rob Swagger, Veriana’s chief executive.

Why? Why shouldn’t anyone be able to put their knowledge and insights to work to make a return. Why is it ok for a ‘widow or orphan’ to bet on GE’s future performance (by buying or selling their shares) but not to bet on the potential return of a film? It simply doesn’t make sense. Or the view that certain risks or outcomes are worthy of being traded and managed but not others?

Government authorities have generally approved only those futures exchanges that allow for the redistribution of a preexisting risk. Sports betting is not approved because, unlike a farmer selling a futures contract to offset losses from crop failure, neither party involved in the wager has an economic interest in the underlying event.

This statement is of course patently ridiculous. Many, many agricultural risk contracts are traded amongst principals who are neither producers nor end consumers, and to say that there is no ‘real world’ economic risks that could be managed via sports trading is just silly given that sports is an enormous, global business with hundreds of billions of dollars of capital at risk. And if that weren’t enough, it is happening anyways, with admittedly high risks of fraud and abuse. Wouldn’t it make more sense (in the context of protecting vulnerable market participants) to encourage regulated, robust, well monitored marketplaces rather than cling to the current Potemkin-esque prohibition? (Disclosure: I am a shareholder in Betfair.)

In any event, I can only endorse Cantor’s vision of creating a new, more vibrant and useful market for managing risk and structuring finance in the entertainment industry:

Now Cantor hopes for its exchange to be the first of many complex financing products for the entertainment industry. In one of the more ambitious plans, Jaycobs wants to team with filmmakers to create something like an initial public offering of stock in a specific film, staking out a potential new way to finance production.

And I hope they (and Trend Exchange,) working along side the CFTC are able to quickly illustrate that well-built and well-regulated marketplaces can mitigate the potential dangers while at the same time providing a powerful and useful set of tools for managing risk and generating returns. Perhaps this will help pry open the door to seeing more and more outcome markets develop of the course of the next several years.

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In order to have the discussion, an investor needs to keep a record of all of this. How many do? We are trying to – or at least have plans to do so – but I’ll admit it’s harder than it sounds. It’s not something that generally gets anywhere near the top of a priority list, when the days are filled with making and managing the investments you do make. (And when you are trying to raise capital and/or keep existing investors happy or informed if you are a professional.) Don’t get me wrong, it’s not rocket science and I think it probably comes down to spending a bit of time and energy upfront to put a workflow in place to be able to capture and manage this information efficiently. And to be truly useful, this record needs to be ‘timestamped’ and auditable: we all suffer from hindsight bias. ie We definitely would have invested in Google given the chance, and obviously we passed on Webvan….

OK, fair enough, but why is this important? It’s because I think knowing which investments (and why) an investor didn’t make, and comparing these to the ones they did make, is a much better way to analyze their skills and approach. I think this is true in any asset class, only in most (all?) others it is practically impossible to do the kind of analysis I describe above if they are a long only investor (private equity perhaps being the exception.) Of course for long/short hedge funds this type of thinking is embedded in their performance.

Nauiokas Park is too new for this kind of analysis to be relevant but I was thinking about it in the context of my prior angel investing experience. I didn’t keep a complete record but there are a few deals that come to mind, two of which I was fortunate enough to blog about before the outcome was known, one after (discount appropriately) and so are public record. Hopefully you’ll trust me on the other two.

The first example is a company called SpiralFrog which is now the poster child for the second wave of bad ‘internet’ investments. I was approached in early 2006, through my Wall Street/City network to look at this, as people new I was interested/knowledgeable about “tech” start-ups and had had some success as an angel investor. When I saw the prospectus (and yes it was a prospectus) and looked at who else was involved as investors, I was immediately suspicious: this wasn’t a nimble start-up, it was packaged like a Wall Street deal – the scale and approach were way too heavy. Looking into the plan and the projected financials it just got worse. I passed and when they launched to considerable fanfare, I wrote this in September 2006 and followed up with this a year later.

A second is Monitor110 – great post-mortem here by Roger. This one I didn’t have a chance to invest in but I would have passed. I admit I hedged my bets a bit with this post, but was skeptical of the business model (and unsure of the product.)

The third is Powerset. What attracted me was the great team they pulled together and my conviction that semantic technologies were going to become increasingly important and valuable. I didn’t directly have the opportunity to invest but was one degree away and think I could have if I had agressively pursued.

Zopa is the fourth. I was approached by a friend when they were raising their initial outside round. I loved the idea but didn’t think it could get traction – at least not enough, fast enough to disrupt the market it was targeting, especially given how free and easy it was to get credit (something I new about…) I think I was right then. But I still love the concept and would be open to taking a closer look again in the future should the opportunity present itself. My focus would again be on understanding whether or not they can scale and whether or not the business model is optimal.

The final example is Skype. I didn’t directly have the chance to invest, but again at one degree of separation I could have tried. That said, I’m pretty sure had I been given the opportunity I would have passed: I didn’t see (until everyone had figured it out) how it could be a good investment despite loving the product. I’ve changed my mind and if I were running a big private equity fund, I’d definitely be trying to run my slide rule over them to see if I could make eBay a better offer than the public market.

Good investing is about managing your failures, your losing trades. The best way I know of doing this – whatever the asset class – is working hard to figure out what could go wrong before putting on the trade. (I guess it’s the bond trader in me…) There is always something that can go wrong. If it is big or likely enough you should pass. If not, by having a clear understanding and focus on these risk factors, you give yourself the chance to adapt and/or mitigate before its too late. This is especially true in venture investing as many risk factors in these companies tend to be endogenous; obviously if your basic premise turns out to be wrong that’s tough (but not impossible) to mitigate and sometimes it doesn’t work out. But by actively knowing what is going wrong and why at least you can avoid throwing good money after bad while also knowing when the odds are in your favor and you should double down.

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Last summer I wrote a post highlighting the fact that the global financial system is a scale-free network. This in itself is not particularly insightful – although I wonder how many of the most senior executives, regulators and politicians understand this explicitly and more importantly use it as an intellectual framework on which to base their ideas on systemic risk management and regulation. This is important because understanding the mathematical underpinnings and topology of such networks is crucial if we ever hope to construct a system of monitoring and regulation that is robust and well adapted. I was reminded of this late last night as I was re-reading an article written in 2003 by Albert-Laszlo Barabasi and Eric Bonabeau published in Scientific American on scale-free networks where they (presciently) note that:

Understanding how companies, industries and economies are interlinked could help
researchers monitor and avoid cascading financial failures.

For anyone wanting an introduction to scale-free networks this paper is an excellent place to start but basically as a reminder (via John Robb):

A scale-free network is one that obeys a power law distribution in the number of connections between nodes on the network. Some few nodes exhibit extremely high connectivity (essentially scale-free) while the vast majority are relatively poorly connected. The reason that scale-free networks emerge, as opposed to evenly distributed random networks, is due to these factors: Rapid growth confers preference to early entrants. The longer a node has been in place the greater the number of links to it.

This in a nutshell is why some financial institutions are ‘too big to fail’, or (as we heard much chatter about when first Bear Stearns, then Lehman Brothers went down) more accurately, ‘too connected to fail’. Scale-free networks are extremely resilient to random failure but highly vulnerable to specific failure of the most important hubs (Barabasi and Bonabeau):

In general, scale-free networks display an amazing robustness against accidental failures, a property that is rooted in their inhomogeneous topology. The random removal of nodes will take out mainly the small ones because they are much more plentiful than hubs. And the elimination of small nodes will not disrupt the network topology significantly, because they contain few links compared with the hubs, which connect to nearly everything. But a reliance on hubs has a serious drawback: vulnerability to attacks.

…The Achilles’ heel of scale-free networks raises a compelling question: how many hubs are essential? Recent research suggests that, generally speaking, the simultaneous elimination of as few as 5-10% of all hubs can crash a system.

Hopefully readers will recognize in this why the failure of ‘hubs’ like Bear Stearns or Lehman Brothers was potentially so damaging, setting off a cascading epidemic throughout the financial system. It is also why the Madoff failure in and of itself was not at all systemically threatening, whereas LTCM was – the key difference being ‘connectedness’ not size per se. A further consideration – based on the application of diffusion theories used to predict the propagation of a contagion throughout a population – is that the critical threshold (for propagation of an ‘infection’) is effectively zero for a scale-free network. That is all ‘viruses’ no matter how weakly contagious, will spread and persist in the system. In other words it is mathematically impossible to eradicate such sources of failure from a scale-free network. More bluntly, any attempt to eradicate or prevent financial viruses, say for instance poorly conceived sub-prime mortgages, is an act of futility.

Why is this important? Because most financial regulation, is conceived and implemented with this objective as a founding principle and worse ignores the topology and structure of the network it is trying to protect. Not only does this vastly increase the probability that the regulatory framework will ultimately fail to achieve it’s goal, but it imposes severe additional costs on the system for no greater gain in stability or robustness. Current financial regulation distinguishes far too little between the different nodes in the network, the vast majority of which are of no consequence to the overall robustness of the system. Fifty percent of financial firms could probably fail without any risk of catastrophic systemic failure as long as none of those firms were important hubs. I’m exaggerating of course (but not as much as you think.) That is why for instance the EU’s recent draft legislation on alternative investment funds – with rules uniquely predicated on size and leverage – is so wrong-headed: it misses the point. Not completely, but this is mainly due to the fact that correlation between size and connectedness is not zero (all other things being equal, bigger firms are likely to be more connected.)

However wouldn’t it make much more sense if the regulatory framework focused explicitly on the root cause of systemic vulnerability rather than accidentally or obliquely? Before any agitated readers get too excited, I realize that what I have outlined has been grasped (belatedly) to some extent by the regulators, bankers and politicians and has started to shape the discussion on the reformation of financial regulation, especially in the US where it seems increasingly likely that the new regulatory proposals will be much more concerned with the effective systemic impact of a market participant rather than their legal or organizational structure. The recognition that the fact that an organization is a bank or insurance company or hedge fund or whatever is less important than the exact types of activities it undertakes and its connectedness to the rest of the system is obviously a welcome development but it doesn’t go far enough.

Wouldn’t it make much more sense to build a set of rules that explicitly addresses the vulnerabilities of a scale free network and as such focuses disproportion attention and resources on protecting the hubs from attack or failure. The beauty is that the digital global financial system of the 21st century and advances in the science of networks actually now allows us to do this: we can empirically and quantitatively observe, measure and manage the ‘connectedness’ of institutions. Forget the rating agencies, companies like Bonabeau’s IcoSystems and others could help the regulators create, maintain and monitor network ‘maps’ and score each market participant in terms of their connectivity. This should be the defining core metric of financial regulation and mirroring the power law distribution of the underlying network, financial regulation should focus its attention and resources in geometrically increasing fashion.

This would have a number of (self-reinforcing) beneficial effects:

• It would impose (geometrically) increasing costs on institutions as they grow in complexity and systemic connectedness creating a natural optimal equilibrium that balances the benefits (to the institution) of such growth against the external costs it imposes on the system. It effectively puts a price on the negative externalities and avoids the tragedy of the commons without needing to dictate to firms how big or complex they are allowed to become (which is doomed to failure due to the law of unintended consequences and the problems of quantum thresholds (ie clustering just below the threshold.) I doubt very much that a firm like Citigroup would have come into being under such a regime.
• The size of a financial institution would not be a driver and so simple, relatively unconnected firms could operate with a very light regulatory touch. This would allow the system to naturally exploit economies of scale that don’t give rise to incremental systemic risk.
• Innovation would be allowed to flourish without anyone – regulators, executives, politicians, super-intelligent alien forces – needing to decide which innovations were toxic and which were beneficial. As long as the key players in the system were vaccinated against these viruses and protected against mutations, you could let Darwinian evolution progress more or less unimpeded in the long tail of systemically unimportant firms. Indeed by allowing an increased rate of failure in the overall network, you would be able to more quickly and less painfully identify dangerous risks as they emerge in the network.
• Resource allocation for regulators becomes much easier and more transparent. The amount of regulation and regulatory attention each firm would receive would become directly proportional to their systemic importance.

We can’t prevent dangerous risks from developing in the financial system but we can work with the grain of the underlying structure to mitigate the systemic danger instead of against it, or at best ignoring it. The robustness of scale-free networks to accidental failure has many advantages in that it allows our financial system to operate very efficiently and robustly most of the time. And by explicitly recognizing the mechanisms by which catastrophic failure can occur in our approach to regulation we will be much less likely to suffer such failures in the future and the costs of regulation will be appropriately borne within the system creating a virtuous circle that drives the system to self-organize into the optimal configuration of complexity and connectedness.

If you know Tim Geithner or Charlie McCreevy or Lord Turner, please send them this link. Hopefully it’s not too late!

And if you are looking for the perfect Father’s Day gift for the financial regulator or Senate Banking Committee member in the family, you could do worse than Bonabeau’s book Swarm Intelligence: From Natural to Artificial Systems.

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(via netimperative.com:)

The collapse of major businesses and the failure of governments to stem the tide of bad news around the economy has created an environment rich in opportunity for entrepreneurs, according to business leaders meeting held in London this week.

Speaking ahead of the event, keynote speaker Ed Wray, chairman of Betfair, said: “2009 is going to be a turbulent year but it will provide an opportunity for entrepreneurs to come forward and help take the UK out of recession and into the next period of economic growth.

“The US will be the first out of recession because it has an economy built around mass entrepreneurship – the UK now needs a large slice of that same kind of creativity, innovation and entrepreneurial flair.

“Every great business must be able to survive a downturn and successful businesses forged in the current conditions will be fundamentally far stronger by nature. The pressure cooker conditions of the current economic climate will undoubtedly create some new household names of tomorrow.”

In a nutshell, when we are talking to investors, our number one message is that these tough economic times are exactly the right times to invest in the next generation of businesses and business models. That in times of falling multiples, de-leveraging, uncertain cash-flows and/or discount rates in mature companies and markets, building new businesses is a fundamentally uncorrelated risk. Furthermore, the risks and challenges for new companies and new approaches is almost always on balance lower than it is when the economy is booming: first and foremost, talented people are more available – financially and psychologically – and since this is the most important ingredient for 99% of young companies, this is incredibly important. Secondly, inertia is much easier to overcome, you don’t have the ‘if it’s not broke, don’t fix it’ apathy that can be very difficult (and extremely frustrating) to overcome; if you have a better mouse-trap, people will actually notice and act. Finally, the prevailing sentiment of caution and skepticism means that – and of course this is a generalization but a valid one I believe – everyone, including entrepreneurs, investors, customers, employees – tends to be more focused and realistic. This means that fewer flimsy or “me-too” start-ups are floating around and innovation and disruption are considered in a more sober and analytical context. Less froth.

So I can hear you saying, Sean, c’mon…stop talking your book – really now, start-ups? (private) growth-stage companies? No risk? No way! Some – many? – of these businesses won’t end up working, even if they have clever ideas and people. You can lose most or all of your investment.

Well, of course you can and of course there is risk. There is always risk. I’m just not convinced that it is bigger or harder to navigate or understand than some of the alternatives. Large cap public stocks for instance…had you bought say shares in RBS, just two years ago you would have lost 96% of your money.* Barclays – 86%. HBOS – 94%. Citigroup – 94%. Not to mention the 100%-ers. Blue chips. Yes well, the poker analogy does seem to hold! (* all are approximate numbers, not including dividends, etc.) Equally, not even the most bullish of analyst or executive at any of these firms would have suggested that there was the remotest possibility of a 10x, or even 5x return over the next few years at the prices then prevailing…and understanding the dynamics of what will drive the returns is enormously (exceedingly?) complex. Of course to be fair, you could have changed your mind and sold your shares in any of these companies on any day which is something you are unlikely to be able to do in a small private company. So clearly you can’t have all your eggs in this (illiquid) basket but on the plus side, the illiquidity focuses the mind wonderfully and helps avoid getting caught up in market “noise”.

So how does one mitigate the risks in new, entrepreneurial ventures? Well there are a number of approaches that can work and like anything it’s generally a combination of experience, analysis and hard work. Not very enlightening I know. Our particular approach puts a lot of focus on using our domain knowledge and focusing on one – albeit vast – component of the economy: financial services and markets. Also, we have developed a series of investment themes, built on a number of what we believe to be fundamental medium to long term secular trends that will drive the growth and shape of the industry and the economy in the decade to come. Indeed, these trends and themes are the basis for much of the material here on my blog since I started publishing three years ago. We then look for ideas and companies within these themes that are instrinsically aligned with these trends. Where relevant, using our knowledge of the structure and business models of the mainstream participants, we also look for ideas, companies and technologies that have the potential to fundamentally disrupt an existing market or business model by providing the same product or service in a vastly cheaper and/or improved way. Easy.

Finally the event referred to in the opening quotes is a great new (to me) website / community – entrepreneurcountry.net – developed by Julie Meyer at Ariadne Capital; and for any prospective / budding entrepreneurs out there, here is a great 10 minute video with a few tips on raising capital from Julie herself:

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Further, I made the case that the industry had done itself an enormous disservice by “using the hammer” in the “wrong” way – by (deliberately) exploiting the ability of derivatives to obfuscate, the industry had not only ended up losing hundreds of billions but had done a great job in destroying perhaps its single most important core value creator. That of course would be trust. And in the bargain all the beneficial uses of derivatives risked being thrown out with the proverbial bath water.

Basically, as their traditional businesses and cash cows – agency trading, underwriting, etc. – had their margins melt and their business models / compensation structures made obsolete by the rise of the networked information economy (destroying information scarcity which lay at the core of the traditional banking business model), the banks turned more and more to principal risk taking – prop trading, derivatives ‘arbitrage’, etc. – to make up the difference. Putting aside the moral hazard (too big to fail, insured deposits etc.) issues this raised and ignoring for a moment whether or not it is an intrinsically good business model for a bank, it got worse as this shift coincided with a long period of low volatility and benign economic growth… This meant that the (real) opportunities disappeared quickly and – still needing to shore up the bottom line, to feed the blue line – what had started out as science slowly but surely slid into alchemy…

Of course this didn’t happen overnight, but slowly and therein lay the heightened danger: like the apocryphal frog boiling in a slowly heating pot, what started out as useful and reasonable ended up dangerous and irresponsible.

It strikes me that the whole Madoff affair was in fact a particularly acute and egregious manifestation of this phenomenon. I was reminded of this by Andy Kessler’s excellent analysis in Forbes:

My guess is that this is what went down. Even though Madoff Securities was on the leading edge of automated trading, the business itself was becoming less and less lucrative. Everyone had the same computers. Spreads, the difference between the bid price and the ask price that became Wall Street trading profits, began shrinking. And the move to list stocks in penny increments instead of eighths (12.5 cents) whacked trading desks all over Wall Street.

So you make it up in volume. Beyond cocktail parties, Madoff really created the money management business to feed himself trades. But his strategy was garbage. He absolutely bombed as a money manager, but he desperately needed the assets under management to feed his trading operations, so he started to make the numbers up. As is usually the case, most don’t set out to be crooks, but Madoff became one when his talents proved lacking. There is your “why.”

It’s not new. This was the Enron story: They lost tons in water ventures and Indian power plants, so concocted fraudulent entities to cover up their losses. Same for Sam Israel and his Bayou hedge fund. And even (without the fraud) the Citigroup/Wall Street story, too. They tried to be investors to make up the difference of their bread-and-butter business deteriorating and were awful at it, so they levered up in off-balance-sheet vehicles.

So why are smart people seduced into these kind of strategies (ie bloody-mindedly pursuing disappearing returns to the point of destruction)? Obviously any trite answer on a blog post will fail miserably to do justice to this question, but if I had to venture a pithy hypothesis, it would be that – like it or not – most people are wired to prefer risking conventional failure over embracing unconventional success. Just ask the behavioral finance guys…I think it has something to do with continuing to dance.

So I can get my head around a ‘Madoff’ happening. What is harder to understand is what on earth the fund-of-funds who invested so much money with him were thinking? I may be obtuse, but I thought the main (the only?) reason for these businesses to exist was in order to identify, understand and monitor good investment managers. On this I have to say I agree with Martin on this (that financial companies who made money selling Madoff products should return their commissions.) And it is worth pointing out that regulators haven’t exactly covered themselves in glory either (which should be a cautionary tale for those who suggest that regulation is a panacea…)

Perhaps the only good thing to come out of all of this is that the cult of secrecy that for too long permeated finance will disappear. Don’t misunderstand me, there is a time and place for confidentiality. But too often it is indiscriminately invoked like some sort of fantastical talisman – out of all proportion and context – to hide not skill but incompetence.

And to end on a more optimistic note, the problem is with the ‘traditional’ (ie 19th/20th) business models in finance, not finance itself. And here at the dawn of the 21st century there is an abundance of opportunity to discover, invent and build the financial services industry of the future. This hasn’t changed in 2008. It just became a bit more likely to happen sooner rather than later. Remember the wise words of William Gibson:

The future is already here – it is just unevenly distributed.

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Was cleaning up my inbox earlier today and this interesting promotional offer caught my eye:

Flybe’s website goes on:

This year we wanted to go one step further to give you extra peace of mind. We will give passengers who book flights, car hire and hotels direct* with Flybe in January 2009 free of charge travel cancellation cover in the event of redundancy prior to travel. Offer excludes the self employed and those who have had less than 2 years continuous employment and who do not qualify for statutory redundancy pay as per Statutory Redundancy legislation.

It seemed potentially interesting as yet another example of risk management tools being given to consumers. So I thought it would be interesting to look at the fine print…

Ignoring the irony that the policy backing up this offer is underwritten by AIG UK Limited…I was pretty disappointed (but not surprised) by what I found. Firstly, you are only paid if you cancel your trip. This is totally lame. If you lose your job, you’ll likely be more inclined to take the holiday/family visit/etc. you have booked. Further I’m not sure everyone will realize they only get reimbursed if they cancel, (even though to be fair to flybe they make it clear that it is cancellation coverage…)

On the other hand, I guess if it were true redundancy insurance, you might have a serious adverse selection problem (and AIG would charge more?) even though the terms state that “at the time of booking your trip, you had no reason to believe that you would be made redundant” (does that exclude then everyone who works for a bank? or for AIG UK?)

Anyhow while this particular offer is more gimmick than substance (as opposed to the iTravel Let it Snow promotion underwritten by Weatherbill for example), I think it is indicative of a growing trend to providing consumers with granular risk management tools.

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How could banks have persuaded themselves, their shareholders and the public that they were making so much money when in reality they were losing it? The history of financial deception and self-deception is as old as humanity, but a few themes recur. A Ponzi scheme offers a high return using the funds of newcomers to make payments to earlier subscribers, and collapses when the supply of suckers runs out. The New Economy was the greatest of Ponzi schemes. It has been different this time. But not so different.

Read the whole thing. Brilliant.

Now I know it is hard to believe but… true. True! It seems they snuck in at night – after New York closed and before Tokyo opened – and stuffed more and more assets on to our books. Mostly illiquid stuff – they knew what they were doing! The scoundrels… Night after night. Like clockwork. And at least to start, the income and mark-to-market gains from this stuff juiced our profits. Since we’re very good at what we do, we didn’t notice – didn’t think the doubling of our profits suspicious – and just adjusted our comp accordingly.

And then POW. They set off their nefarious trap. Told the world we were levered 60 to 1. Hell even I know on a bad day you can wipe yourself out trading 2-year notes with that kind of leverage… sheesh. Like, whatever dude. But you know what??? It was true… We dug deeper and found the leak – they’d hacked in from a little pension fund in New Zealand or something and bunged us so full of assets that we were like a turkey the day before Christmas. Bastards. I blame it on IT. Or operations. But mainly I blame it on these evil speculators who pushed our leverage through the stratosphere just to make a quick easy buck. But I feel horrible about it.

In other news Dick Fuld testified before Congress…