Sean Park Portrait
Quote of The Day Title
The Web will own every bit.
- Kevin Kelly

Articles filed under 'Banking'

The end. And the beginning.

Re-inventing industries is hard. There is no getting around this. The days are long. There are many uncertainties. There are many challenges to overcome. And yet. Just at those moments when you begin to question yourself, the industry you are trying to disrupt does something so incredibly stupid that your batteries are instantly recharged. Better, if the industry is banking or finance, the incumbent players do this over and over (and over) again. They’re lovely like that.

At the risk of wasting even more time (I’ll try to keep it short), I’d like to give you a wonderful example of this amazing ability these institutions have to shoot themselves in the foot. Not with a pellet gun but with a powerful automatic rifle. This is a story about NatWest, but if you work for one of their traditional competitors, I’m sure your institution is equally dysfunctional. Hubris is a dangerous thing.

We all know that governments and regulators everywhere are focused on tightening up KYC and money laundering rules. Whether to “combat terrorism” or “tax avoidance” or simply in a manic attempt to hold on to sovereignty in a post-sovereign digital world, it matters little. Fair enough. But the big banks, despite having spent billions on technology, have historically been pretty slipshod in ensuring compliance and so are now feeling the heat all the more and – queue giant pendulum – have been panicked into “cracking down” like there is no tomorrow. (Funny that…”no tomorrow”, but I digress…)

So now they increasingly not only make it nearly impossible to open a new account but are starting to do their level best to alienate their existing customers too. I can only imagine that, based on the rearview mirror that seems to be their primary management tool, they figure they have nothing to lose: market shares are static and customers never leave. This paradigm is especially acute in the oligopolistic UK banking industry but is present to some degree in all (developed country) banking markets. Ah but inertia is a powerful thing and they are forgetting the second part: things at rest tend to stay a rest BUT things in motion tend to stay in motion. And they themselves – through hubris? blindness? stupidity? – are ironically the ones now putting in motion the tectonic plates of customer behaviour. The wonderful thing – at least for a disruptor (or true “challenger” as they like to say in the UK) – is that the initial movement is slow, possibly imperceptible from the towering heights of the executive suite, and so gives plenty of time for these newcomers to sneak up and eat the incumbents lunch. (cf. Christensen)

NatWest Business Banking

So here’s the story. After having banked with them for 4 years, NatWest decides that it will refuse to allow our company to continue to instruct transactions unless they have a completely new set of certified documents with regard to the company directors (including me) and just to make it interesting – not sure if this is related – rejects some inbound payments coming from a sister group company (that by the way has been making similar inbound payments for over two years) causing all sorts of pain and anguish.

Just to make it even more stupid, I have been a personal customer of NatWest for well over a decade and they have all my address, identity etc. details. Nevertheless, I had to spend an hour this morning (not to mention the hours spent by our finance team dealing with this mess) going to a notaire to get a certified copy of my passport and 3 copies of 2 different bank or utility statements, in order to comply with their new, rigid, damn-the-consequences KYC policy.

Wait. It gets better. The notaire refuses to certify the statements as they are not “original” – ie they are printed out. Of course this is because banks (and utility companies) – intelligently for once – have spent the best part of the last few years getting rid of “paper” statements and so I don’t have any “original”, printed-by-some-printer-that’s-not-mine-and-put-in-the-post statements that can be notarised! And just to complete the surrealism, one of these statements comes from NatWest who politely, but firmly, “asked” me to stop receiving paper statements a couple years ago. Folks you can’t make this shit up. Hell, Kafka couldn’t make this shit up.

Anyhow I now have some certified, notarised paperwork – at a cost of CHF65 – that I hope NatWest will accept and that will allow our company to continue to be a customer. Oh goody. A customer that only runs positive balances, pays them fees and unless their policies force us otherwise, only uses online banking. A customer they would laugh at if we asked for a working capital line. Basically a one-way relationship in their favour. We can’t change our corporate bank account in a day. We have to suck it up and play their game. But, if it isn’t already obvious, we are shopping for a new bank in the UK. It’s just unfortunate timing as Fidor Bank isn’t in the UK. (Yet…) We’re looking at Silicon Valley Bank and Metro Bank. If others have suggestions, we’re open to considering them. We’re realistic. We know NatWest won’t give a damn if we leave. Even if we grow into a giant, they won’t have any institutional memory and so won’t even have any regrets. And of course maybe we don’t grow into a giant. But their risk isn’t losing one smallish corporate client. Especially one who is knowledgeable enough to push back when they act like muppets. In fact they might be saying “good riddance.”

If you don’t have customers, you don’t have a business.

But if you work in the world of startups, this approach, this cavalier attitude to customer acquisition and retention is nothing short of shocking. Beggaring disbelief. And this is not because startups are special, it’s just because they are closer to the hard reality that if you don’t have customers, you don’t have a business. Yes, Virginia this fundamental truth is lost in the jobworth-ian bureaucracies of too many big, fat, happy incumbents. And that is your opportunity.

Now some of the devil’s advocates out there might be saying: “that’s well and good but rules are rules and big or small, incumbent or startup, all banks need to comply with robust KYC and anti-money laundering regulations.” Indeed. I agree. Only – and especially in the digital age – there are dozens (if not hundreds) of more robust, intelligent, customer-friendly ways of being compliant. Compliant in actually knowing your customer. Compliant in actually combatting money laundering. Not compliant in the six sigma application of an obsolete set of procedures that were designed in a different age to facilitate compliance to the actual rules. Subtle but crucial distinction, completely lost on NatWest and other banks of their ilk.

So goodbye NatWest and thank you for giving me (for the low, low price of just CHF65) a renewed energy and determination to keep working with the amazing people who will build the institutions that nibble by nibble will eat your lunch. Q.E.D.

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Why is capital still chasing (bank) branches?

Anyone who is at all interested in innovation and disruption in banking and financial services will have noticed that the world is seeing a Cambrian explosion of startups targeting this industry. It’s an exciting time for us at Anthemis Group, as we have been working to position ourselves for this wave of change for many years. “Skating to where the puck will be” as they say…

The explosive growth of new entrants in financial services – both of individual companies and the universe of such companies – is of course exciting for us, but does pose some challenges, most of which arise from resource constraints, notably time/bandwidth and capital. We are working hard to address and overcome these challenges as we grow our unique “meta-company” model, however it continues to puzzle me how much new capital continues to be ploughed into “industrial age” business models, particularly in banking. Two (unrelated) articles that surfaced in my news stream this weekend inspired me to ask the question out loud.

The first highlighted the huge investment that has so far been required to get Metro Bank in the UK up and running – over £100mn (!) The second talks about a couple different investor consortia vying to spend anywhere from £500mn-£1bn to buy a portfolio of branches from RBS (Project Rainbow.)

While I think that Metro Bank has a (much) better approach to traditional branch banking than most incumbents, and I can believe that it is plausible that the Rainbow branches could be better managed as a “clean”, independent entity, I fail to see how either of these strategies will lead to long-term, sustainable success and strong investment returns for their backers. Neither is natively adapted to transition to the business models that will emerge as Information Age leaders. Their economics are fundamentally flawed; being more efficient/better managed will give them an advantage over the incumbents, perhaps sufficient for some short term (2-5 year) wins. But in the longer term, they are just as exposed to disruptive new models as today’s incumbents (perhaps moreso given their lack of TBTF inertia.) (On the other hand, if they are able to take advantage of their challenger status, access to capital and more nimble management to partner with or acquire some of the new Banking 3.0 leaders, perhaps they can emerge as winners in the longer term…)

The economics of truly new entrants like Fidor Bank, Simple, Moven and dozens of others are not just marginally better, but in some cases an order of magnitude (or more) better. Clearly as new entrants they face many (often different) risks in gaining adoption and scaling. And while the success of any individual company amongst these “digitally native” new entrants is not assured, I would suggest that the big winners of 21st century banking will almost certainly be found amongst these types of businesses (and not from the ranks of traditional, branch-centric models.) As such I find it ironic that much more investment capital (seemingly an order of magnitude or more) is chasing these old models.

Having worked in capital markets and the investment world for a couple decades now, I actually do understand the dynamic at work – people (especially those working for large institutions) typically feel more comfortable investing in “more of the same”: better, faster, smarter versions, sure but… Of course it is easier to make linear projections of the past into the future. Investing in new models requires people to acknowledge discontinuities and exponentials, which is admittedly hard. The thing is, if you are in the middle of an epochal change in economic and societal frameworks (which I believe to be the case), this is the only rational choice.

For anyone thinking of investing in the future of banking, I’d invite them to compare the metrics (customers, assets, volumes, unit economics, etc.) of these digital newcomers with companies like Metro or Rainbow per dollar or pound of invested capital. Now think of what any of these companies could do with £100mn, let alone a £1bn… The puck may be in the corner for now, but I’d rather be in front of the net.

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Welcome to the stack: the end of mainframe banking

Many years ago, enterprise software was written to run on mainframe computers. This was the best (only?) solution at that time that had the requisite memory and processing power to run these applications and so – despite their cost, inflexibility and operational complexity – mainframes represented the optimal computing model for enterprise applications. Until a new computing model emerged. Based on powerful, plentiful and inexpensive blade servers and a number of new, standard software components, this “technology stack” became the new optimal computing model for running more and more of the enterprise. LAMP was the new 700/7000.

Not only was this new model less expensive, more robust and more resilient, it was much more adaptable. Further, the open standards encouraged a tremendous amount of innovation and experimentation which in turn fostered the development of a vast array of specialist but compatible variations. This enabled bespoke solutions for different applications and environments to be easily developed without the need to build a new platform each time. And as each component in the stack had a very specific role or purpose, its design could be optimised without compromise.

The traditional banking business model mirrors the mainframe: a vertically integrated, all-in-one solution with all the resources and tools needed to deliver banking products and services in one big (black) box. In the context of the 20th century competitive and technological landscape this worked fine. It was the optimal solution. But like the mainframe of the computing world, the all-in-one “big iron” approach to banking is no longer the optimal business model with which to efficiently and profitably serve the banking customers of today. A new approach, predicated on assembling specialist providers of the component elements required to deliver end products and services will prove to be the new optimal business model for banking. Welcome to the (banking) stack.

Take for example the process of making a loan. This actually breaks down into a “process stack” that at a high level looks something like this:

  • origination
  • underwriting
  • processing
  • funding
  • payments
  • servicing

Each layer of this stack requires different skills and resources. The value drivers for each activity are different. Each requires a different mix of technology, design and talent and the application of fundamentally different business models and capital resources. As such, trying to house them all in the same organisation means that some or indeed each of these activities are operated in a sub-optimal fashion. Indeed, the stronger the culture, the better managed the bank is (in the context of traditional, hierarchical models), the more acute is this problem.

That said, so long as margins remained high and competition muted, with competitors operating more or less efficient and skillfully executed versions of the same business model, sticking with the “mainframe” model was just about tenable. However this is no longer the case. New entrants – unburdened by legacy technologies and mindsets – are emerging across the stack with business models that are natively adapted not only to leverage the technologies of today but that also address the changing expectations of customers in terms of pricing, design and user experience. In many parts of the stack, incumbent institutions will find it hard to compete as the best of these new entrants gain traction.

The best managed of today’s leading institutions will adapt to this changing landscape. How? By letting go of their traditional business models, opening up their value chain and making an honest assessment of where in the stack they have a sustainable competitive advantage and where indeed they do not. This is not a trivial change for most traditional banks and aside from the adjustments in technology and business model it will entail, perhaps the most challenging aspect in this transition will be to change the culture and mindset of these institutions for whom open architectures and collaboration is often anathema.

But for those institutions that are able to make these changes, the rewards will be significant. By focusing their resources and talents on the areas of the stack where they have a true competitive advantage, exiting other areas where they are structurally uncompetitive and collaborating with (and investing in) companies with disruptive new and powerful value propositions in these areas, they will successfully navigate the transition to becoming an information age bank.

Taking the example above, already it is becoming clear that the traditional models for originating, underwriting and processing loans are no longer competitive. New models from companies like FundingOptions, Zopa, OnDeck Capital, Kabbage and many others are proving to be much more effective and economical. Traditional banks should be lining up to partner with companies like these and in particular become lenders and provide core transaction banking services, areas where they do have a real competitive advantage. They should also be leveraging their strong distribution channels to drive customers to these platforms in exchange for lead generation fees. Of course for the managers and employees responsible for these functions within traditional banks, the transition will be painful, ultimately their jobs will disappear. However, in any case, this outcome is inevitable as their value proposition and competitive position becomes ever more compromised.

By embracing change and working within the grain of this new paradigm, incumbent banks can do much to ensure their future success and survival and will find it much easier to rebuild trust – with customers, regulators and their communities – mitigating the short term pain and setting themselves on a path to sustainable profitability. The alternative is to keep doing the same thing and slowly but surely rust away. The best banking executives of tomorrow will need to be as familiar with APIs and SDKs as they are with APRs and RAROC.

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This is no way to run a financial system

The micro-cracks are turning into fissures, soon to be gaping crevasses as (finally) the obsolescence of our industrial age banking system plays itself out in spectacular front page headlines. Meanwhile it would seem that our society and our leaders are (mostly) frozen in some kind of macabre trance – eating popcorn and mesmerized by the inevitable Crash.

If you look at the LIBOR scandal in the context of the technology of the fast emerging information economy, it is absolutely mind-boggling that such an anachronistic process even exists in the world of 2012. In a world where every financial flow is digitized and only really exists as an entry in a database. In a world where truly enormous real-time data sets (ones that make the underlying data required for a true LIBOR look puny) are routinely captured and analyzed in the time it takes to read this sentence. In a world where millions (soon billions) of people have enough processing power in their pocket to compute complex algorithms. In a world where a high school hacker can store terabytes of data in the cloud.  In this world, we continue to produce one of the most important inputs into global financial markets using the equivalent of a notebook and a biro… WTF???

You think I’m joking? Libor is defined as:

The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.

For each (of 10) currencies, a panel of 7-18 contributing banks is asked to submit their opinion (yes, you read right) each morning on what each rate (by maturity) should be. The published rated is then the “trimmed arithmetic mean”; basically they throw out the highest and lowest submissions and average the rest. No account is taken of the size or creditworthiness or funding position of each bank and the sample size after the “trimming” for each calculation is between 4-10 banks. However, the BBA assures us that this calculation method means that:

…it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.

You don’t need to be a banker or a quantitative or statistical genius, or an expert in sociology, or even particularly clever to figure out that this is a pretty sub-optimal way to calculate any sort of index, let alone one that has an impact on the pricing and outcomes of trillions of dollars worth of contracts…

In the 1980s when LIBOR was invented – and (lest the angry mob now try to throw the baby out) it should be said an important and good invention – this methodology just might have been acceptable then, as the “best practical solution available given the market and technological context.” Banks used to have to physically run their bids in Gilt auctions to the Bank of England (thus why historically banks were located in the City, tough to compete on that basis from the West End or Canary Wharf, at least without employees a few Kenyan middle distance Olympians…) But you know what?  And this is shocking I know… They don’t do it that way anymore!!!

So if LIBOR is important (and it is), how should we be calculating this in the 21st century? Here’s a few ideas:

  • include all banks participating in the market – and not necessarily just those in London – how about G(lobal)IBOR??
  • collect and maintain (in quasi-real time) important meta-data for each contributing bank (balance sheet size and currency breakdown of same by both deposits and loans, credit rating, historical interbank lending positions, volatility/consistency of submissions, derivative exposure to LIBOR rates, etc.)
  • collect rates and volumes for all realized interbank trades and live (executable) bids and offers (from say 9-11am GMT each day)
    build robust, complex (but completely transparent and auditable) algorithms for computing a sensible LIBOR fixing arising from this data; consider open-sourcing this using the Linux model (you might even get core LIBOR and then forks that consenting counterparties might choose to use for their transactions, which is ok as long as the calculation inputs and algorithms are totally transparent and subject to audit upon request1)

This is not only possible, but in fact relatively trivial today. Indeed companies like the Climate Corporation*, Zoopla*, Metamarkets*, Palantir, Splunk (and dozens and dozens more, including newcomers like Indix* and Premise Data Corp) regularly digest, analyze and publish analogous datasets that are at least (almost certainly far more) as big and complex as the newLIBOR I’m suggesting.

Indeed, the management of this process could easily be outsourced to one – or better many – big data companies, with a central regulatory authority playing the role of guardian of standards (the heavy lifting of which could actually be outsourced to other smart data processing auditors…) In theory this “standards guardian” could continue to be the BBA (the “voice of banking and financial services”) but the political and practical reality is that it should almost certainly be replaced in this role, perhaps by the Bank of England, but given the global importance of this benchmark, I think it is also worth thinking creatively about what institution could best play this role. Perhaps the BIS? Or ISO? Or a new agency along the lines of ICANN or the ITU - call it the International Financial Benchmarks Standards Insitute (IFBSI)? The role of this entity would be to set the standards for data collection, storage and computation and vet and safekeep the calculation models and the minimum standards (including power to subsequently audit at any time) required to be a calculation agent (kitemark.) Under this model, you could have multiple organizations – both private and public – publishing the calculation and in principle if done correctly they should all get the same answer (same data in + same model = same benchmark rate.) Pretty basic “many eyes” principal to improve robustness, quickly identify corrupt data or models.

As my friend (and co-founder of Metamarkets and now Premise Data Corporation) David Soloff points out:

TRUST ONLY THE MACHINES.

And it’s not just LIBOR as Gillian Tett highlights in the FT:

If nothing else, this week’s revelations show why it is right for British political figures, such as Alistair Darling, to call for a radical overhaul of the Libor system. They also show why British policy makers, and others, should not stop there. For the tale of Libor is not some rarity; on the contrary, there are plenty of other parts of the debt and derivatives world that remain opaque and clubby, and continue to breach those basic Smith principles – even as bank chief executives present themselves as champions of free markets. It is perhaps one of the great ironies and hypocrisies of our age; and a source of popular disgust that chief executives would now ignore at their peril.

Rather than join the wailing crowd of doomsayers, I remain optimistic. The solution to this – and other similar issues in global finance – either exist or are emerging at a tremendous pace. I know this because this is what we do here at Anthemis. But I’m clear-headed enough to know that we only have a tiny voice. Clearly it would seem that our long predicted Financial Reformation is starting to climb up the J-curve. I just hope that if Mr. Cameron does launch some sort of parliamentary commission that voices that understand both finance and technology are heard and listened to. Excellent, robust, technology-enabled solutions are entirely within our means, I’m just not confident that the existing players have the willingness to bring these new ideas to the table.

* Disclosure: I have an equity interest, either directly or indirectly in these companies.


1 There may exist some good reasons for keeping some of the underlying data anonymous, but I think it would be perfectly possible to find a good solution whereby the data was made available to all for calculation purposes but the actual contributor names and associated price, volume and metadata were kept anonymous and only known to the central systemic guardian. Of course you’d have to do more than just replace the bank name by some static code, it would need to be dynamically changing, different keys for different calculation agents etc. but all very doable I’m sure. You’d be amazed what smart kids can do with computers these days.

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A Damascene Conversion?

Though your towers were tall
and your powers were grand
you could not understand
how you fell from great heights
and you burrowed with speed
a kingdom you did lead
from heaven to hell
- A Fistful of Swoon, Vandaveer

Excuse me if I seem a bit sarcastic but I can’t help but smile. Slowly but surely the masters of the universe seem to finally be waking up to the inevitability of the eventual obsolescence of the archetypal business model of 20th century banking. I’ve been talking about this for a decade and the fact that it only took, let’s see…a gigantic global financial crisis and several years of messy aftershocks for these great and good to even start thinking about switching horses? Well, you just have to laugh because the alternative is simply too depressing.

I happened to be traveling a fair bit this past week, which for me means I actually have a few minutes of downtime to read the Financial Times (thanks to British Airways and the rules forcing everyone to turn off all electronic devices upon take-off and landing…) and stumbled upon three articles that caught my attention. First up on Tuesday was Hugo Banzinger – Deutsche Bank’s Chief Risk Officer – highlighting the fact that “Banks must regain investors’ trust” on the op-ed pages. Really?? You think?

Banks have also remained remarkably silent on how they plan to adjust their business models. Lenders will have to demonstrate that their future business models are beneficial to society, that they can be run safely and that they are able to restore profitability to make them attractive investments again.

He continues:

Many investors shy from investing in bank equity. Business models and future profitability are too uncertain. Restoring bank profitability is of utmost importance, requiring drastic actions. The standardisation of products and automation of process has to replace the tailor-made approach of many trading desks. IT investment costing billions will be necessary. The number of people on trading floors will have to drop to levels seen at exchanges. Salaries will have to normalise to levels comparable to other services industries. Capital intensive inventory for securitisation will have to return to its originators. Market making will have to be networked and back offices will have to adopt lean production methods as seen in modern manufacturing.

These changes will eventually lead to a process revolution of the kind we experienced in retail banking in the early 1990s.

All good stuff. I concur. Indeed in April 2002 I wrote1:

The industrial revolution in investment banking is all about creating a new paradigm for the execution of capital markets business. It is about reinventing the organisational mindset, replacing the traditional front, mid- dle and back office with a highly flexible and efficient product factory attached to a profes- sional cadre of relationship managers and solution providers who work with customers and clients to tailor products and solutions to be produced and executed by the factory. It is about viewing the services we provide as two distinct value propositions, one resting on the creativity and knowledge base of the bank and its bankers, and the other resting on the efficiency and accuracy of production and execution.

And followed up in June 2003 with2:

Much is promised by banks in terms of ‘putting the customer first’ and ‘delivering solutions not products’ however the reality is that, even if this is the good faith intent, the current structure of the banks is still aligned to the delivery of financial products as a holistic package with all the ancillary bits (settlement, research, payments, etc.) thrown in to a greater or lesser extent. An essentially analogue model for an emerging digital world. The ‘digital’ model breaks down all aspects of the business into dis- crete component parts and allows for each to be optimised (either in-house or out- sourced) and then packaged and delivered to the client according to their needs.

Through this industrialization of the process, the skills and functions of the bankers must equally realign, with expert designers, engineers and manufacturers on the production side, and state of the art customer service representatives on the other.

I guess I just must have been saying’ it wrong…

Next, a bit later in the week, the infamous Sallie Krawcheck – yes the former Citigroup CFO & Head of Strategy, former CEO Citigroup Wealth Management, former President of the Bank of America Global Wealth & Investment Management division – was also given a slot by the Financial Times editors to explain to us that “JPMorgan shows fighting complexity is futile”. Gee, is this complexity stuff a recent development??

But despite coming a bit late to the game, she nails it:

It is complexity that in good part defines Wall Street and forms some of finance’s highest barriers to entry…In the main, the response from regulators to the perceived causes of the downturn has been to fight complexity with complexity.

Of course I agree. Too much complexity (June 2008):

I’m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these ‘integrated’ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model – while possibly intellectually robust on paper – are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.

Indeed – sticking with the chemical analogy and without writing a book about it – it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etc…) should naturally “decay” to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants.

And too little competition (in the form of disruptive new entrants in particular):

Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspan’s take on US payment regulations http://www.moneyscience.com/pg/bookmarks/Admin/read/77403/held-hostage-how-the-banking-sector-has-distorted-financial-regulation-and-destroyed-technological-progress-pdf. And similar examples exist across the spectrum of financial services and across the globe.

The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly it’s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.

But of course if you are reading this, you already know we’re working hard and investing big to help change this. And despite my slight snarkiness above, I am actually excited to see views I’ve held dearly for many years starting to be adopted by (some of) the leaders and personalities of the financial services establishment. (Indeed, Sallie if you’re reading this, I’d love to have the opportunity to tell you about Anthemis and compare notes on the future of finance. And good to see you on twitter. Welcome to the (financial) reformation!)

The third article was about Senator Sherrod Brown trying to revive new legislation is the US which would mandate a break-up of the megabanks. He states:

“I am confident that we will see the government over time requiring some divesting of assets because if [big banks] keep getting an advantage in the marketplace, and they keep growing and having a higher percentage of assets, it’s basically a government-endowed advantage. Thank you, US taxpayers.”

I wonder if we might eventually see something along the lines of the break-up of AT&T, a process that was initiated in 1974 but took ten years and lots of litigation before taking effect in 1984. However ultimately, the problem with banking is not just about size. In this respect, I have some sympathy for the banking lobby: creating 5 or 10 mini-JPMorgans or BoAs is not really the solution (although it could be an intermediate step.) Sheila Bair has also been making the case for smaller, less complex banks:

Yet instead of waiting for the government or shareholders to act, the leadership of these megabanks should take the lead in downsizing. The best way for Dimon to provide a better return to his investors is to recognize that his bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over. If, by downsizing, Dimon can achieve valuations comparable to the regional banks’, he will potentially release tens of billions of value to his shareholders.

More importantly, I think we will inextricably move towards a fundamental reconfiguration of the industry: away from vertically-integrated monoliths and towards an ecosystem or “stack” of firms focused on different components of the industry. The stack metaphor I think is particularly apt, not only because it is a useful conceit to describe the financial system but also because finance is essentially an information technology business and much useful inspiration can be taken from observing the evolution of the ICT industry as it moved from the mainframe to the internet to the cloud era. And it’s not entirely coincidental that I first presented these ideas at a telecommunications conference in 2009.

In such a world, it would not be inconsistent to have several megabanks with enormous balance sheets, but these would likely be very simple constructs – highly regulated and limited utilities, providing a basic deposit taking and liquidity providing function to the system. As I suggested in my AmazonBay video in 2005, the ultimate destiny of (the core) of the global megabanks might to simply become “giant regulated pools of capital.” Such banks would have relatively few employees, extremely robust but relatively limited infrastructure, and would make consistent but modest returns on their capital. They would sit towards the bottom of the financial stack, the financial equivalent of the massive (but usually faceless) data centers that run the internet…

As you might suspect, we have a number of ideas of how this reconfiguration might play out, and this thesis deeply informs our investment process and some aspects of it are already reflected in our portfolio, other aspects not yet but soon we hope. I was thinking of writing an article that would map out how we see banking services being organized in say 2022 but rather than give too many of our secrets away here and now, I think I’ll keep some of these in reserve for the moment. Especially since the industry seems finally to be starting to pay attention and I don’t want to lose our 10 year head-start on designing the future of finance as it makes my job so much easier! As William Gibson said, “the future is already here, it’s just unevenly distributed”.


1 Industrial Revolution (2002)

2 Minority Report (2003)

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More competition beats more regulation

As the “Occupy[anywhere bankers work]” movement gains momentum, renewed calls and support for more regulation of banks and other financial institutions grow. And yet.

Financial institutions are already highly regulated and one could argue that at best, this has not achieved the desired outcomes and at worst has actually contributed to some of the most egregious behaviors as the clever folks in financial institutions lost sight of the end game (ie the products and services and customers that lie at the heart of their raison d’etre) and focused increasing amount of energy and talent to working the system.

And not unlike Br’er Rabbit fighting with the Tar Baby, getting stuck and then pleading with Mr. Fox not to be thrown into the Briar Patch, the large incumbent banks pleading with the regulators not to write more rules may just be a brilliant case of misdirection.

but do please, Brer Fox, don’t fling me in dat brier-patch

Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspan’s take on US payment regulations. And similar examples exist across the spectrum of financial services and across the globe.

The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly it’s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.

I’d like to coin a new phrase, “regulatory theater” inspired of course by Bruce Schneier‘s “security theater“:

Security theater is a term that describes security countermeasures intended to provide the feeling of improved security while doing little or nothing to actually improve security…Security theater gains importance both by satisfying and exploiting the gap between perceived risk and actual risk.

Regulators (and politicians) sensing the need to be seen to be doing something about the risk, fall into a trap of creating more and more regulations hoping to protect all of us from ourselves, only to create new (almost always) more dangerous and costly risks higher up in the system. Rinse and repeat. Until these risks reach the top of the pyramid and can no longer be shuffled and redistributed. At which time, they come tumbling down on all. This regulatory theater can be comforting in the short term but actually takes us further and further away from a sustainable solution to managing financial risks in our economies.

These risks exist and cannot be regulated away. Call it the 1st law of Financial Dynamics: the of conservation of risk. And I would postulate that pushed down to the base of our economic system, these risks would be easier and less costly to manage. With a more competitive and open system, with continuous renewal through many new entrants, the end users of financial services would get better (higher quality, lower cost) products and services with much lower risk of catastrophic systemic failures. Certainly – statistically – some of these new entrants would be managed incompently. Some would be frauds. People, customers would lose money. But the costs of dealing with these failures would pale in comparison to the multi-trillion dollar, economy-crushing losses that the existing system has allowed, nay encouraged to build up.

I’ll finish with an example, take UK retail banking. Concentrated, uncompetitive, legacy. No new entrants, no competition. Metro Bank, NBNK, Virgin/Northern Rock in my opinion are just shuffling deck chairs; better than nothing I would grant but essentially no real innovation, run in the same way with (mostly) the same assets, same people and same business models that previously existed. A token nod for the industry and the government to be able to say their is new competition (much as a dictator allows a hapless opponent to run in an election…) – window dressing. And even here, look at the hoops Metro Bank (who claim to be the “first new UK bank in 100 years”, QED…) had to go through to get a new banking license… If I were Cameron/Osbourne/Cable, the first thing I would do to start fixing the problem would be to create a new “entry” banking charter. Light touch. Basically just vet the founders and investors for fitness. Perhaps make them put up a certain minimum amount of the equity and/or guarantees as a percentage of their net worth. 90 days from application to charter. Nothing more. But restrict these new banks to say £50mn of assets until they have a 2 year track record (at which point they could apply for an increase in permissible assets and/or a full license.) Then oblige the large banks to open up their core banking infrastructure via APIs – analogous to obliging BT to make available their core telecom network to other operators.

I wouldn’t be surprised if within a year or two you had 30 or 40 new banks competing in various different ways, with many different (and differentiated) value propositions. And some would go bust. And some would be frauds. But even making the (ridiculous in my opinion) assumption that they all lost all of their customer’s money, and all of this money was insured by the government, we are talking about £2bn. Compare that to the direct losses of c. £23bn on RBS and Lloyd’s alone, not even considering the contingent losses and indirect costs born by the UK economy as a result of their predicament. Of course, I believe that many of these new banks would succeed and grow and any losses would be substantially smaller than £2bn. But none of these new banks would be too big to fail for a very long time (hopefully never) and although failure of even just one of them would attract headlines and aggrieved customers giving interviews on BBC1, especially if the cause of failure were to be fraud – it would behove us to put this into perspective. To not forget the difference between perceived and actual risk. To remember that huge failure even if diffuse and “no one individual could credibly be blamed” even if more psychologically comfortable, is actually much much more damaging than smaller point failures where cause and effect are more brutally obvious.

The world’s incumbent financial institutions are deeply mired in Christensen’s Innovator’s Dilemma, protected by regulatory barriers to entry that while not fundamentally altering the long-term calculus, have pushed back the day of reckoning only to make that day seem ever scarier. It might seem counter-intuitive, but I think we should be calling not for more regulation but for de-regulation of financial services (the real, robust, playing-field-leveling type and not the let-us-do-what-we-want-but-keep-out-any-competitors type). Competition is a far more robust route to salvation than regulation. Let a thousand flowers bloom.

The Financial Reformation

Last week I spent the week in Amsterdam at Sibos 2010 where I had kindly been invited by Peter Van der Auwera to participate in the Innovation stream, and in particular in the Cloud Computing and Long Now streams within Innotribe.  On Monday, I gave a short “scene-setting” talk on cloud computing and app stores in finance called The New Financial Stack (more on this / link hopefully later this week) and also I agreed to produce a video aimed at provoking and/or inspiring some original and non-linear thinking about the future of finance. Called “The Financial Reformation”, it sets the scene for two decades of fundamental change in the financial services industry based on the amazing democratising power of information technologies. I hope you like the result:

But as you might suspect if you have watched the video, this is just a start… Indeed, this initial video could be considered as simply the trailer for a longer form video which will look at the period from 2008 to 2028 in more detail; similar in some ways to the AmazonBay video of several years ago. The first draft of the script for this story is already written but I am very keen to build on and enrich it, not only with the fascinating concepts and insights that I absorbed in the Innotribe sessions at Sibos last week, but also – insofar as anyone is interested – with comments and ideas from the wise crowd of Park Paradigm readers. I’ve got a few ideas as to how best to go about this, and plan to post these later this week or next, but in the mean time if you would like to share your thoughts, please feel free to comment below.


ps I’d like to give a special thanks to the amazing team at Motherlode who were instrumental in turning my ideas into reality and who worked tirelessly to deliver the video in time for the world premier at Sibos;  I’d also like to thank and congratulate Peter, Kosta and the rest of the Swift Innotribe team for what was simply an incredible four days.  I hope Swift gives you the recognition you deserve!

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We’ve been busy…

You may have noticed that I haven’t posted much in the last couple months and given all the interesting things going on in the world it certainly wasn’t for lack of material. Breaking my arm obviously didn’t help increase my productivity (or make typing very easy) but it wasn’t the main reason for the silence. It’s much simpler than that: I was busy!

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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Through the Looking Glass, Midterm Report

Five years ago I wrote a thought piece called ‘Through the Looking Glass’ to provoke non-linear thinking and foster debate on the possible future direction of the financial services industry and market structures. (I later turned it into a short video called AmazonBay.) It was a retrospective told from the point of view of an observer in 2015. It was never meant to be taken literally – in particular with respect to (most of) the specific corporate mergers – rather I used these as a concise and dramatic way of highlighting the possible or even probable consequence of the deep secular currents that I felt would inevitably work to reshape the landscape.

(December 2015:) …The global securities and investment banking groups that dominated the market in the last century are now extinct. In their place we have an intelligent galaxy of new specialist advisory, investment management, algorithmic software and consulting firms networked with a universe of powerful transaction facilitation exchanges. Banks now exist only as giant regulated pools of capital.

Following the sweeping banking reforms proposed last week by President Obama, and the fact that we are now halfway to this hypothetical future, I thought it might be worth doing a quick mark-to-market of how my ideas have lined up with reality.

Oracle

  • stock exchange consolidation and emergence of new exchange venues (A-) pretty close both in outcomes and timing – the major stock exchanges have been merging a-go-go while at the same time new trading venues have proliferated, and exchange (or quasi-exchange) trading of new asset classes continues to develop strongly.
  • sports/outcome trading in US legitimized (B-) my narrative had this happening in February 2010, not there yet but Congressman Frank’s bill might open the doors later this year and the trend seems to be on the right track and will probably be signed into law by Obama (!); as an aside was way early on a Betfair IPO…
  • giant bank mergers followed by break-up of vertically integrated universal banks, with Goldman Sachs leading the way (A) we have seen the big get mostly even bigger (RBS/ABN, BoA/ML, Barclays/Lehman…and while JPMorgan didn’t buy MS, they did get Bear Stearns and WaMu); GS hasn’t yet broken itself into three as predicted but I’m still confident it will lead the way when/if industry structure changes, and more generally the trend of regulatory thinking across the globe is definitely a trailing wind for the kind of change I envisioned. The 2010-2012 timeframe for the re-organization of global banks is probably a bit early but plausibility has certainly gone up (from near zero) significantly since I wrote this.
  • more (and more) algorithmic / automated intermediation of markets (A-) this was obliquely referenced in my article but was really at the heart of the idea that this fictional ‘AmazonBay’ platform would end up dominating this aspect of markets; clearly the market is heading this way – in fact it may seem obvious now but most people did not fully understand this even as little as five years ago.
  • Amazon anything (B+) The jury is probably still out on this one, but in my view it is looking increasingly likely that Amazon.com will become a giant of the next economic paradigm; whether or not they use their vast intellectual and technological resources to participate more directly in the financial services arena is not yet clear, but I can tell you the only ‘big company’ job I would not hesitate for two minutes to accept if it were offered would be CEO or CSO of Amazon Financial Services (AFS) Jeff are you listening? ;)

(Note: Remember I used real company names mainly to add vividness to the ideas underlying the narrative. The key concept I wanted to convey with this GS break-up vignette was that the vertically integrated model would decompose under the light of new technology and regulations into a (technology-centric) Sales & Trading component, a more focused, relationship driven Advisory component (cf. the emerging proliferation of pure advisory ’boutiques’) and independent, conflict-free Asset Management businesses (cf. the secular growth of hedge funds and Barclays sale of BGI, etc.))

(February 2009:) …Reacting to new competition, Goldman Sachs becomes the first major investment bank to break itself up. Securities and distribution are sold to Ebay Financial Markets, while the remaining activities are split into two new companies: GS Advisory Services and GS Capital management…

Charlatan

  • eBay anything (D) Despite the fact that the actual companies cited are more symbolic than literal, the choice of eBay to represent the cutting edge of online, data-driven, algorithmic marketplaces was simply awful. To the extent that it risks distracting the viewer from the key, underlying messages. It is now entirely implausible and so instead of bridging the cognitive gap, the inclusion of eBay simply extends it. Thank goodness this is somewhat mitigated by my inclusion of Amazon.com (see above) as the other new markets avatar but they come late to the narrative…
  • sports trading developing as an asset class (C+) this clearly hasn’t happened, although there are one or two small funds and firms offering managed accounts; and a vibrant ecosystem of professional traders and the associated software has emerged around the Betfair and other exchange platforms. In my defense, I picked sports as just a provocative and emotionally attractive example of the idea that – enabled by technology – a vast array of new tradable markets in goods but also outcomes, would emerge. Work in progress.
  • credit crunch and asset bubbles (D) although the overall purpose of the piece was to provoke thinking on the sustainability of existing business models in financial services in the face of radically shifting underlying technological, economic and demographic trends, I failed to include a thread touching on the possibility of catastrophic systemic discontinuities arising as a result of the prevailing market structure and business models. It’s a significant ommission, especially as at the time of writing this I was in the process of exiting my former responsibilities as a senior executive in the credit business due in part to my increasing discomfort with the sustainability and prudence of the risk pricing in that market.

All in all, I would give myself a mid-term grade of B+/A- with room both to improve and to slip back. Mostly on the right track, especially with respect to big themes but perhaps a bit optimistic in terms of some of the timelines. What do you think? Better? Worse? To be fair, the correct measuring stick is not so much whether or not I was right or wrong, even in terms of ‘macro’ predictions but whether or not this article and video helped catalyze serious discussion, debate and thought about the potential for disruptive and non-linear change in the financial services industry. Alas I have no idea how one could even attempt to measure that, but any thoughts or anecdotes you might have with respect to this would of course be appreciated.

Through the Looking Glass (2005)

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One day…

…we might see GigaOm write this:

Amazon JP Morgan, displaying a sense of urgency that is perhaps driven by the pending launch of Apple’s tablet-style computeranti-trust legislation which will end the US banking oligopoly, is turning its Kindle device banking and payments infrastructure into a platform. The Seattle New York-based company has announced that it will allow software developers to “build and upload active content applications” and distribute it through the Kindle Chase Store “later this year.” Amazon JP Morgan will be giving out a Kindle Chase Development Kit that will give “developers access to programming interfaces, tools and documentation to build active content innovative financial services and products for Kindle. Chase” The company will launch a limited beta effort next month. From the press release:

“We’ve heard from lots of developers over the past two years who are excited to build on top of Kindle Chase,” said Ian Freed, Vice President, Amazon Kindle Bo Nusmore, EVP, JP Morgan Chase. “The Kindle Chase Development Kit opens many possibilities–we look forward to being surprised by what developers invent.”

Vertically integrated black box? Or open platform? Which type of bank makes for a more robust system? Which type of a bank is more evolutionarily fit to compete on a level playing field? I know that their is an enormous moat protecting large financial institutions from competition but I would hope they would be using the super-profits that this affords them to prepare for the day the moat is breached. And perhaps behind the parapets they are. Because I pretty sure there are an increasing number of very clever, ambitious (and even angry) folks starting to congregate on the edge of that moat and while it might take some time and a dash of luck, it would seem certain that eventually they will be inside the castle. And then, it just might be too late.

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