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.
When speaking to start-up investors about their track record most of the time the conversation revolves entirely around the investments they have made in the past. The winners, the losers and why. More rarely do people talk about the investments they didn’t make. This is understandable for a number of reasons, one of the most important being there is usually no obvious record to fall back on and there is no way to short bad start-ups. So one relies on the investor keeping track of the investment opportunities they looked at and passed on, and further keeping tabs on how these companies did. Not many investors do this – at least not publicly, one (great) exception being Bessemer who with great humor points out their heroic misses – opportunities they declined that turned out to be home runs – in what they term their ‘anti-portfolio.’ But it would also be interesting to see a record of the deals an investor didn’t do that failed. But this is even harder (if one is to avoid noise) – even a small, relatively new investor like us sees hundreds of proposals and even this depends on what one considers as having ’seen’. Is it an email in passing saying XYZ is raising money, would you like to look? Is it spending a few hours going through an executive summary / pitch book / website finding out more? And it is also important (if this information is to be meaningful) to qualify why the investment wasn’t made. Is it because it didn’t fit a certain sectoral or geographic investment criterea? ie Good prospect but not for us. Is it because of a conflict with an existing portfolio company? ie Good idea but we like these guys better or they were first in the door and now we’re stuck. Is it because of apathy or lack of resources (time, money)? ie Good idea but just can’t focus and isn’t top of the list? Or is it because, well it’s just not a very good opportunity? ie Mediocre or downright bad idea.
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.
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.
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.
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:
Last September I was asked to give a presentation at the DerivaTech conference in London on the merits of derivative markets. My basic premise was that derivatives are (just) tools: they can be incredibly useful and are not intrinsically ‘good’ or ‘bad’ but rather their utility (or danger to society) depends on how they are used. You can use a hammer to build a house. Or you can use it to bash someone’s head in. Getting rid of hammers because of this undesirable use case obviously wouldn’t make too much sense.
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.
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.
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.
Normally this is the sort of thing I would post to my ‘tumble blog’ Everything you can imagine is real. (This is where I now post links to articles and items I find interesting but don’t have the time or inclination or need to add any comment of value.) But since many of you may not subscribe / read that blog, and because I think this is such a well written – concise, insightful, eloquent – essay, I wanted to post a link to John Kay’s latest editorial here.
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.
You see it was those nasty short-sellers and journalists and well we’re not entirely sure who else was in on the conspiracy but a lot of bad people. A lot.
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.
Information technology, more specifically the development of parallel processing, “gigabit-terabit-petabit” bandwidth and networking logic, is changing the way we conduct our lives today. While jet-setting executives (or policymakers) of this decade can be present in more places in less time than any predecessor, corporate information, corporate processes and corporate controls can now be shared around the world in real time via information superhighways. These advances in information technology are catalyzing the globalization of business and finance in ways far more important to global central banks than something as basic as physical transportation. These advances are driving the age of financial networking, and what has been described by some as leading to the vastly narrowing ecologies of finance.
Basically what I’ve been thinking for coming on a decade and evangelizing for the past 5 years or so, and now a defining part of the thesis underlying my new business.
The first phase of this “age of financial networking” has unsurprisingly driven the creation of a very tightly coupled system, with a relatively small number of very large, very important nodes or hubs (the global financial services mega-fauna*), in effect create a “scale-free network”, which has a number of advantages (played out nicely from 1987-2007 in financial services) but also some key – potentially fatal – vulnerabilities. John Robb (someone everyone involved in senior policy and management decisions should read) describes it better than anyone:
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. First mover advantage is very important.
In an environment of too much information people link to nodes that are easier to find. This preferential linking reinforces itself by making the easier to find nodes even more easy to find.
The greater the capacity of the hub (bandwidth, work ethic, etc.) the faster its growth.
The Strength and Weaknesses of Scale-Free Networks
The proliferation of scale-free networks and our increasing dependence on them (particularly given their prevalence in energy, transportation, and communications systems) begs the question: how reliable are these networks? Here’s some insight into this:
Scale-free networks are extremely tolerant of random failures. In a random network, a small number of random failures can collapse the network. A scale-free network can absorb random failures up to 80% of its nodes before it collapses. The reason for this is the inhomogeneity of the nodes on the network — failures are much more likely to occur on relatively small nodes.
Scale-free networks are extremely vulnerable to intentional attacks on their hubs. Attacks that simultaneously eliminate as few as 5-15% of a scale-free network’s hubs can collapse the network. Simultaneity of an attack on hubs is important. Scale-free networks can heal themselves rapidly if an insufficient number of hubs necessary for a systemic collapse are removed.
Scale-free networks are extremely vulnerable to epidemics. In random networks, epidemics need to surpass a critical threshold (a number of nodes infected) before it propogates system-wide. Below the threshold, the epidemic dies out. Above the threshold, the epidemic spreads exponentially. Recent evidence indicates that the threshold for epidemics on scale-free networks is zero.
…the networks of our global superinfrastructure are tightly “coupled”—so tightly interconnected, that is, that any change in one has a nearly instantaneous effect on the others. Attacking one network is like knocking over the first domino in a series: it leads to cascades of failure through a variety of connected networks, faster than human managers can respond.
“Recent evidence indicates that the threshold for epidemics on scale-free networks is zero.” “…leads to cascades of failure through a variety of connected networks, faster than human managers can respond.”
And so Bear Stearns (and others) are caught out. But they could not fail. Nor can Fannie and Freddie. Given this understanding of the current global financial system as a tightly-coupled, scale-free network, the effects of stupid and fraudulent mortgage lending in Las Vegas mushrooming into generalized system-wide distress is easier to understand…
Loose coupling describes a resilient relationship between two or more systems or organizations with some kind of exchange relationship. Each end of the transaction makes its requirements explicit and makes few assumptions about the other end.
The risks inherent in this mode of organization are clearly unsustainable. The world’s financial network will need to adapt. (The same is true of many other critical infrastructures: telecoms, utilities, transportation…where progress in this direction is already starting, to emerge.) We need to (and I believe we will inevitably do so) move towards a more robust, loosely coupled financial system: and the beauty is by adopting and adapting lessons computing and networking technology (which ironically underpinned and drove the creation of today’s brittle financial system) we already have a roadmap (and some of the tools) to do so.
Furthermore, these ideas aren’t new. John Hagel (another person anyone running a large corporation needs to have read**) wrote about this in 2002 (!):
A good working definition: loosely coupled is an attribute of systems, referring to an approach to designing interfaces across modules to reduce the interdependencies across modules or components – in particular, reducing the risk that changes within one module will create unanticipated changes within other modules. This approach specifically seeks to increase flexibility in adding modules, replacing modules and changing operations within individual modules. (Note: if any of you have come across a better definition of loosely coupled, please let me know – I’d like to follow up on this in a future blog.)
Three things stand out from this definition. First, it assumes a modular approach to design. Second, it values flexibility. Third, it seeks to increase flexibility by focusing on design of interface.
…The desire for flexibility is a powerful force driving the move towards loosely coupled systems, but there’s an even more powerful reason to adopt loosely coupled systems. It has to do with experimentation, learning and performance improvement. Within well-designed, loosely coupled systems, there’s a lot more room for experimentation…
He goes on to make the point that this move towards loosely coupled systems in business will fundamentally change the way we manage and organize our corporations:
Rather than traditional hierarchies driven by command and control management styles, we are likely to see relatively independent organizational modules brought together to perform one set of processes and then different arrangements of modules to perform other processes. Some of these modules will belong to the same enterprise, but modules from other enterprises may be brought in to perform specific tasks on an as needed basis…Conventional business strategy approaches emphasize the need to develop a detailed strategic blueprint and then tightly couple operational initiatives to execute the blueprint. As uncertainty grows in business environments, these hard-wired approaches to business strategies are becoming less and less viable.
Reading Robb and Hagel, I hope it is as obvious to you as it is to me that: (a) the global financial system clearly not loosely coupled, and (b) would be infinitely more resiliant if it were. I don’t expect these changes to happen overnight. Given the human factor, I suspect it will occur alongside the generational shift over the next 10-20 years. That said, the opportunities for those that ‘get it’ and adapt sooner rather than later are enormous: this sort of discontinuity is one of the only occasions where it is possible to completely alter the competitive landscape, and is particularly perilous for ‘incumbents’ (everything to lose.) Furthermore, given the critical importance of the financial system to our globel economy and societies, and its manifest vulnerability in the current regime, some of this change needs to happen quickly (more quickly than is comfortable) if we are to avoid a potentially very bad outcome. I guess you could say that one of the good things about having swung to the fear side of the fear/greed pendulum is that change – albeit painfully and begrudgingly – is seen as unavoidable.
We are deliberately going to build our new business to align with this new paradigm, so no matter how successful we may be, expect our ‘ecosystem’ to grow exponentially in size and complexity in comparison to our actual firm. For better or worse, we will never be ‘too big to fail’…
* spent 15 minutes searching the web for a list of the world’s largest financial institutions by assets with no joy…a bit surprised, something for freebase?
** I often wonder about the paradox that our most powerful and important corporate and political leaders – the very people who need to be the most widely read and open to new ideas – are by the inevitable constraints and conventions of their position, are probably unable to do so. Think about it, how likely is it that the CEO of a giant corporation will be allowed to block out 4 hours in his diary on Wednesday afternoon to read and think? For the good ones this must be incredibly frustrating. As for the others, well let’s just say I would question the robustness of the process that got them there in the first place…
As you may recall, a couple months ago Weatherbill announced a partnership with Priceline, underwriting a promotion they ran that would reimburse the cost of your holiday package if it rained more than half the days during your stay.
In June, 12% of Priceline’s site traffic clicked on a promotion. While the Sunshine Guarantee promotion may attract only a niche audience (0.2% of Priceline shoppers), those who do click on this promotion are highly likely to convert – an impressive 24% of Sunshine clickers will complete a booking. Despite attracting relatively few clickers, it resonated with its audience and led to strong conversion rates, showing just how effective a smaller, targeted promotion can be.
I’m sure we’ll see more and more of these sorts of embedded derivatives in weather-sensitive consumer products. While you may go to the time and effort of directly hedging your wedding, the average person – even if they were aware of an easy-to-use product like Weatherbill – probably will be too busy/apathetic/forgetful to hedge something smaller – like a day out golfing. But embed the coverage into the product (or at least make it as easy as ticking a box) and I think demand will be very high. The days of “NO RAIN CHECKS” are surely soon behind us…
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