A couple of months ago, I had the privilege to have been invited to speak at eComm 09 in Amsterdam. I have posted on this previously but recently the video of my talk was posted and perhaps will make it easier to understand my accompanying presentation. If you can spare 20 minutes (there is an additional 10 minutes of q&a at the end) and are interested in understanding how Nauiokas Park defines our opportunity space, please have a look as it is probably the most succinct expression of the worldview we bring to investing and analyzing potential investment opportunities.
And here is the presentation again, in case you would like to follow along as you listen to the video:
Well-built developer platforms are the future of every industry. (-ReadWriteWeb)
Note: Their is a small glitch around 7:40 where the video skips over a few seconds; funnily enough (for the conspiracy theorists out there) this is exactly where I say that had ZSIN’s existed, the extent of the disasters that occurred in the mortgage securitization markets would have been at least an order of magnitude smaller…)
I was very kindly invited by Paul and Lee to attend my first ever eComm conference, which will be in Amsterdam from October 28th to 30th.
The Emerging Communications (eComm) Conference & Awards was created to promote and accelerate communications innovation. Telecom, mobile and to a lesser extent, Internet based communications, had been innovation stagnant for far too long. Yet the opportunities for innovation had never been greater. Those opportunities are only going to grow as drastic changes further impact the multi-trillion dollar a year telecom industry.
The speaker line up looks fantastic and I’m the spare tire on an otherwise star-studded panel Thursday afternoon, that is if they still want me after my plenary talk that morning at 9:30:
Platforms, markets & bytes: the economic landscape of the 6th paradigm(?)
In a world where everything can be expressed as 0s and 1s, are the traditional ways of defining sectors and industries (as verticals) still relevant? If not what new business models and industry structures are likely to emerge? Oh and what’s the difference between a bank and a telecom company really?
Now at the risk that tumbleweeds blow through the comment section, proving once and for all that all my dear readers are in fact spambots (but in which case no one will see this and no embarrassment suffered), I thought I’d take a page out of the legendary Fred Wilson‘s book and ask you all for thoughts and comments on this theme that I might incorporate them into my presentation. (Or not!) So fire away!
I was cleaning up my office a bit this afternoon and came across my copy of Andy Haldane‘s brilliant paper “Rethinking the Financial Network (April 2009). People (including me) like to complain about the lack of leadership and insight at the commanding heights of the financial system, but based on this paper alone, I’m not sure the UK could ask for a better Head of Financial Stability at the Bank of England. (He was appointed to that position in late 2008, once the horse had not only left the stable but the country…)
If you are interested in the workings and health of the financial system, you simply must read this paper if you haven’t already. I won’t attempt to summarize it here, it is worth reading in its entirety but will excerpt his conclusion:
Through history, there are many examples of human flight on an enormous scale to
avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th
century to polio and influenza in the 20th. In these cases, human flight fed contagion
and contagion fed human catastrophe. The 21st century offered a different model.
During the SARS epidemic, human flight was prohibited and contagion contained.
In the present financial crisis the flight is of capital, not humans. Yet the scale and
contagious consequences may be no less damaging. This financial epidemic may
endure in the memories long after SARS has been forgotten. But in halting the spread
of future financial epidemics, it is important that the lessons from SARS and from
other non-financial networks are not forgotten.
I’m fairly certain he is not a reader so I can take no credit, but it is very rewarding to see someone in his position with such a firm grasp on the concepts I’ve been trying to articulate (much less completely and articulately) for some time now. (see The science of Financial Regulation (June 2009) and Averting (financial) ecological disasters (August 2008)) I hope his voice is listened to and his insight and intellect used to help us build a better, more resilient financial system for the future.
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 always interesting Bill St. Arnaud pointed me in the direction of this interesting speech by Jeremy Rifkin who talks about the convergence of a quantum advance in communication and energy technologies leading to a “third industrial revolution”. Clearly talk of the “smart grid” is not new and we may actually be well on our way to the “peak of inflated expectations” but this does not take away from the much much bigger picture that this convergence will be fundamentally transformational:
The same design principles and smart technologies that made possible the internet, and vast distributed global communication networks, will be used to reconfigure the world’s power grids so that people can produce renewable energy and share it peer-to-peer, just like they now produce and share information, creating a new, decentralized form of energy use. We need to envision a future in which millions of individual players can collect, produce and store locally generated renewable energy in their homes, offices, factories, and vehicles, and share their power generation with each other across a Europe-wide intelligent intergri
And although it is probably too early for us, I am extremely optimistic about the very exciting investment opportunities I see coming down the pipe because of this revolution. No we aren’t planning to add to or change the investment focus of Nauiokas Park to green tech or clean energy. What I am alluding to is the opportunities that will emerge to create new markets, market structures and participants when the world’s energy becomes a truly networked, digital commodity. Imagine a world (not so many years away) where tools like Google PowerMeter are as widely adopted as Google Search or Skype. And distributed micro-generation (solar, wind, micro-generators, etc.) and micro-storage. All connected, all digitized. Generating vast amounts of data and transactions. And you’ve got yourself a market. Sure, I here you say, energy markets already exist and by the way are pretty big. No big deal here, move along. Well, it’s not perfect but I would suggest comparing the financial markets of the 1970s to the financial markets of today, to get a sense of the quanta of change we should expect in energy markets – with the concomitant risks and opportunities this will present. And I suspect it will all happen a bit more quickly: one decade instead of three(?)
I know it’s not the done thing, but despite all the doom and gloom I can’t help but to get more optimistic every day about all the truly exciting opportunities that are bubbling up in harmony with the new industrial and economic paradigm that is dawning. (Which is not to disagree with the doom and gloom – for those people, companies and industries stuck in the old paradigm there isn’t much to cheer about, and it must be especially galling for those who were leaders in this old world order.)
We can make our world smarter.
Intelligence can be infused into how we manufacture and sell… move goods, people and money…
The world is ready for a smarter planet.
Find out how to build it together.
If you would rather avoid wading through the inevitable corporate speak on IBM’s website, a good place to find out about what they are doing and how they are thinking is this recent article “IBM’s Grand Plan to Save the Planet” from Fortune:
In the parlance of the information technology industry, these situations all represent “dumb network” problems. The term sounds pejorative, but it simply means that we don’t truly understand commuter traffic or electricity flow or the inner workings of the cacao genome, and as a result our highways, utility grids, and cash crops are not managed as effectively as they could be.
The good news is that we now have the technology to convert these analog distribution systems into multidirectional “smart” networks. Readily available sensor technologies like RFID chips and digital video can track movements in granular detail. Cheap data storage, powerful analytics software, and abundant computing capacity give us the ability to warehouse and make sense of all that information. With the knowledge we’re gaining, we can remake our world in a more efficient way…
…So Palmisano is encouraging his employees to think even bigger, to scout out any dumb network that can be made smarter. Because, as any self-respecting capitalist knows, in great pain lies dormant profit. “We are looking at huge problems that couldn’t be solved before. We can solve congestion and pollution. We can make the grids more efficient,” he says. “And quite honestly, it creates a big business opportunity.”
By now, you probably understand why this resonated with me; there is significant congruence with the themes explored here and that underpin the foundations of out investment thesis at Nauiokas Park. In particular applying the amazingly powerful computing technologies that exist today to make sense of highly complex systems and networks, and of course to analyze and extract meaning from enormous and growing data sets. (Of course it’s also nice that they seem to have been inspired by our logo when designing their icon for ‘Smarter Money’!) On their website, IBM describes the opportunity they see for Smarter Money for a Smarter Planet:
Money, in other words, has been reduced to zeros and ones. It’s intangible, invisible. It’s information. Which is central both to the problem we face and to its solution.
Without question, the replacement of physical money with electronic money — and the spectrum of financial innovations that have accompanied it — have helped the world’s economy grow and prosper. But our technical and management systems haven’t kept pace. They couldn’t provide warning signals of risk concentrations, over-leveraging or underpricing. Banks could repackage risk and sell it, but they couldn’t value an individual loan in order to unwind the debt when needed. However, the same digitisation that has helped create this challenge is starting to provide the means to solve it. Intelligence is being infused into the way the world works, including our financial systems.
We’re all aware of advances like online banking, but the transformation happening underneath is far more profound.
Unprecedented computing power and advanced analytics can turn oceans of ones and zeros into insights, in realtime. Which means we could potentially have a more transparent, predictable and intelligent financial system for a smarter planet.
While it is very exciting to see a giant like IBM get behind such an intelligent and forward thinking strategy, I must admit I was a little disappointed not to find more substance on the Smarter Planet websites. It’s not that I suspect this is just a nice marketing campaign, rather that the communications department needs to work a bit harder to plug in to the projects and ideas IBM is working on in the trenches so to speak to make this vision a reality. And I think they could do more to engage a wider community through their Smarter Planet Blog and/or other social communication tools. Again as it is now it seems a bit sterile and very much a one-way broadcast, as opposed to a two-way dialog. Indeed one of the things I’ve tried to do – both through this blog and with our company – is to help to build a community of people interested in debating and shaping the future of financial services and markets. I think we have had some success, however I have nothing like the reach or resources of a giant like IBM and so it would be fantastic if they were to join the conversation and amplify it far beyond our modest community.
The Fortune article concludes:
Leadership positions, as the company knows all too well, come and go. But with luck, the tone of “Smarter planet” will remain. The message – that technology can be deployed to greater ends than creating the next fetishized cellphone – is bigger than any single company. And so, too, is Palmisano’s epiphany. He deftly led IBM out of the dotcom doldrums. Perhaps more important, he has revealed a model for monetizing scientific research in a way that benefits humanity.
Sure, not everyone can afford $6 billion a year for R&D. But real innovation rarely comes from big, rich companies. With luck, IBM’s ad campaign, coupled with its blowout 2008, will call scientists and entrepreneurs to arms. They’ll see our archaic global shipping infrastructure, a dilapidated educational system, disappearing honeybees, the fraud on Wall Street, and think, I know how to fix that. And I can make a killing doing it.
It will come as no shock to most readers that I think one of the key opportunities of the next decade or so is to harness the possibilities unlocked by the advances in ICT – most notably the continuing march towards a ubiquitous, high-speed internet – to vastly lower transaction costs and enable robust, distributed marketplaces to emerge in sectors and activities where heretofore the (informational and transactional) costs of organizing such a market would have been prohibitive. While it is certainly an oversimplification, I think such opportunities can be broadly categorized into two groups:
those that make the transactional mechanisms of existing markets more efficient – either incrementally or by a quantum shift to a new market structure – by reducing informational friction and arbitrage and eliminating parasitic intermediaries while at the same time massively improving the productivity of ‘intelligent’ intermediaries; and
those that enable markets to emerge where previously none existed at all (or only in the broadest economic sense, but where transactions were previously ad hoc and opaque), often (but not always) these are markets for services (rather than goods or financial instruments) where the nature of the service is highly heterogeneous and in data terms is “unstructured” rather than “structured”*
Putting my money where my mouth is, I’ve taken the opportunity to invest in two exciting start-ups that fall into this second group: last year in seedcamp ’07 winner MyBuilder.com and just now in (seedcamp ’07 finalist) School of Everything. Both have passionate, energetic and visionary founders that have been able to translate their ideas into robust and well-executed platforms for organizing and ‘trading’ specialist services. As for any pioneering start-up, neither can be sure of success, however the combination of a fundamentally sound idea, in harmony with the inevitable secular change in how economic activity will be organized in a networked world, married to a strong committed team is as good a place as any to start.
I must admit in the case of SoE, part of my motivation to invest was driven by a more emotional and/or intellectual interest in what they have set out to do:
Our current education system was designed in the industrial revolution to prepare people for factory work. The world has changed a lot since then – and the time has come to rethink education from the bottom to the top.
At School of Everything, we believe that learning is personal, and starts not with what you ‘should’ learn but with what you’re interested in. So we’re building a tool to help anyone in the world learn everything, and teach anything, how and when suits them – by putting people in touch with each other, not with institutions.
Not only is education and learning the lifeblood of our modern economy and an important social good, but by creating a marketplace for people to ‘distribute’ and acquire skills and knowledge, SoE is providing another very useful output for harnessing what Clay Shirky has identified as society’s “cognitive surplus.”
Now, the interesting thing about a surplus like that is that society doesn’t know what to do with it at first–hence the gin, hence the sitcoms. Because if people knew what to do with a surplus with reference to the existing social institutions, then it wouldn’t be a surplus, would it? It’s precisely when no one has any idea how to deploy something that people have to start experimenting with it, in order for the surplus to get integrated, and the course of that integration can transform society.
The early phase for taking advantage of this cognitive surplus, the phase I think we’re still in, is all special cases. The physics of participation is much more like the physics of weather than it is like the physics of gravity. We know all the forces that combine to make these kinds of things work: there’s an interesting community over here, there’s an interesting sharing model over there, those people are collaborating on open source software. But despite knowing the inputs, we can’t predict the outputs yet because there’s so much complexity.
The way you explore complex ecosystems is you just try lots and lots and lots of things, and you hope that everybody who fails fails informatively so that you can at least find a skull on a pikestaff near where you’re going. That’s the phase we’re in now.
So if there is something you’ve always wanted to learn, or something you’d love to teach to others, School of Everything is a pretty good place to start. I wonder if anyone is giving courses on how to run a bank…you’d think demand for that might be pretty high these days… Given these tough economic times I suspect that SoE is even more useful, whether it’s to learn a new skill to keep an existing job (or find a new one) or to earn a bit of money and/or social capital by teaching if you’ve suffered the misfortune of losing your job or are working reduced hours.
In any event, I’m very excited to become a small part of this and congratulate Paul and his team on this follow-on funding and wish them great success in building SoE into a wonderful global marketplace for learning.
If I had a billion dollars. (If I had a billion dollars.)
Well I would buy you a Skype. (I would buy you a Skype.)
I would buy a Twitter for your Skype (so you could tweet and chat and call all your friends.)
The news has left many in the industry wondering if eBay will put Skype, which it paid a hefty $2.6 billion to buy in 2005, on the auction block. Donahoe had said last year that eBay would consider selling the business unit if it couldn’t be integrated with its auction or PayPal payment system.
And according to statements made during the conference call, it looks like Donahoe doesn’t think there is much the Skype technology can do to help eBay’s other businesses. When asked what eBay was doing to add shareholder value to Skype, Donahoe admitted that “the synergies between Skype and the other parts of our portfolio are minimal,” the paper said.
Well if it were up to me, I’d sell eBay – maybe Ken Lewis at BoA might be interested, would look innovative and might distract the federales from the Afghanistan that is the Merrill acquisition – and keep Skype. eBay could have been the Betfair of consumer goods, instead it became the Microsoft of marketplaces…
Anyhow, I’d buy Skype. Maybe not for $2 billion, but I think it is potentially a very valuable asset and I’m convinced that it is not even scratching the surface of its potential. The problem is that they seem to be trapped in linear thinking with respect to their business model. Selling minutes and add-value telco services. A telco. An alternative and innovative telco. But a telco. Nothing wrong (well you know what I mean…) with telcos but if you want to buy a telco, buy BT – its a lot cheaper. And its not just management (that can’t think out of the box) – it’s the press, analysts etc:
So an acquirer would likely be buying Skype for its 370 million registered users, which is nothing to sneeze at. But the big question is how much money can be made from these users? Sure, people love using Skype’s free services, but most of its revenue is made from a small portion of its users. Skype generates most of its revenue from its SkypeOut service, which charges users to make calls from the Skype service to regular landline phones and cell phones.
The SkypeOut revenue stream is sufficient to sustain Skype’s business model today, but as IP networks are deployed throughout the world and all communications becomes IP-enabled, there will be fewer opportunities to make money from connecting Skype calls to the regular phone network. What’s more, as Skype adds more subscribers, those users are more likely to talk to one another over the free Skype-to-Skype network rather than paying to call these friends and family on regular phones. Of course, it will likely take years for this scenario to play out, but this fact could color a potential acquirer’s willingness to pay a premium for the service.
“As more people adopt Skype, there’s potential for the asset to peak in value,” Friedland said. “It won’t likely happen for another five to eight years. And unless Skype comes up with a new meaningful revenue driver, it could start to decline.”
370 million registered users. Three hundred and freakin’ seventy million. And growing. Fast. And more people joining is a bad thing?!?
Let’s just pause here for a moment. So Mr. Friedland, if Skype ended up having say one or two billion – BILLION – registered users and so like became the de facto communications substrate for the vast majority of the connected citizens of the planet, that would be…ummmm…bad?
There are a hundred and one ways to bootstrap amazing, profitable, cash generative businesses off of Skype’s brilliant platform and installed base, and they are all in my new book: Managing Skype for Dummies. Actually, I didn’t write it. And it’s usual title is the Cluetrain Manifesto but still…
1. Markets are conversations.
I don’t know what Meg was thinking (those of you who listened to the eBay analyst webcast and pored over the accompanying presentation the day eBay announced it was buying Skype will surely remember that at the end of both you were even more confused than at the beginning…) But even if it was by accident, she was on to something (admittedly she did get a bit punchy with the pricing, although if she had paid in paper instead of cash…) It’s just that that something wasn’t being able to call EvilRabbit467 and haggle over the price of an iPod nano to ‘close the deal’…
Seriously if I was the captain of some vast private investment capital pool, I would be sitting around with my partners and a handful of clever young associates and putting together a plan for Skype. But if I were Donahoe, I’d spin Skype out to my shareholders as a separate listing, this would create value and possibly more importantly, especially in these interesting times, give Skype an explicit valuation and an acquisition currency. Then it gets interesting.
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…
My desert island business tool would have to be my netvibes homepage: by allowing my to efficiently follow and ingest over a hundred different feeds covering the entire breadth of my varied (and some would say eclectic) interests it has become the substrate upon which much of my work is done. It’s my deck.* Themes emerge and disappear, are reinforced, modified, diverted, consolidated. And sometimes enough interesting pieces of the puzzle emerge, pushing me to anchor them in my thoughts by writing a post here.
I’ve written a number of times on the potential for mobile telephony to shift the paradigm in Africa, but post the SafaricomIPO this is perhaps more of a mainstream view today and needs less repeating.
What is perhaps less talked about is the potential to combine increasing mobile and broadband penetration with robust and inexpensive local networks to transform outcomes even in the most remote environments. One of the major challenges facing the African continent is building out mobile coverage outside of urban areas and increasing access to broadband internet pretty much everywhere. White African frames the problem eloquently here:
While it’s good to talk about mobile phone penetration, I was a lot more interested in seeing the discussion going on around mobile broadband internet and how that is the next big move in Africa for the operators. Passing data, not just voice, is the battleground of the future in Africa – and all the carriers are fighting to position themselves to win.
This is important and I think the tipping point has (or is about to be) passed, but for a variety of economic, political and regulatory reasons it is difficult to predict how and when a more robust and ubiquitous broadband access will be available to most Africans. In the mean time, it would seem to me that a great opportunity exists to build (tens of) thousands of small, local, ‘community’ networks using a combination of technologies such as wireless mesh and femtocells connecting mobile phones and sturdy “appliance computers”(via Emeka):
Aleutia’s currently working to integrate ZigBee into our desktops, a new wireless mesh-networking technology that doesn’t drain batteries like Wi-Fi does and has a range of up to 1km. In areas where connectivity is expensive and hard to obtain, this would allow one computer to share its Internet connection with hundreds of others, and, in areas without Internet connectivity, would enable free email, file transfer, and messaging over an enormous geographic area.
All powered by renewable (solar, wind, micro-hydro) local power sources, which besides being more robust and sustainable (in the economic sense), should also help underwrite the capital costs of building the network through sales of imputed carbon credits.
These networks would be valuable on their own – providing an information and communications backbone for education, health and markets for the local community – but also would serve as excellent platforms (in terms of building knowledge and acceptance of these tools) ahead of the local network being tied into the rest of the world via broadband internet when the infrastructure and pricing permits. In fact, by building up the network infrastructure in this way – ie by creating a network of networks – Africa has a chance to actually create a more robust infrastructure than currently exists in most of the developed world, without the need to re-engineer; another leapfrogging opportunity…As John Robb continues to powerfully argue, “smart local networks” are crucial to creating a more resilient societal infrastructure, tolerant to faults, accidents and attacks – black and white swans alike:
Most of the local loops (from telco fiber to cable company coaxial) currently in place and/or being installed in the US are dumb (I suspect it is the same globally). They simply route data from local customers to regionally clustered corporate server farms and then outwards/back. This means that any disconnection (physical or logical fault) between local customers and these remote systems will result in a complete cessation of service. To correct this deficiency, communities need to start to think more like a corporation: security of data services are considered central to a company’s survival. So, as part of future negotiations with cable/telcos, communities should request that companies allow them to piggyback on their “dumb” networks to create a smart local loops.
Just the sort of infrastructure that is needed in the all too often hostile (political and natural) environments in which these networks need to operate. And it ties in well with the idea of a resurgent localism, a theme that motivated Stowe to create a new blog, /Ground:
One of the most salient trends — one that I think trumps others — will be the rise of localism. As nation states increasingly falter, and lose relevance we will see people shifting their sense of belonging away from mass organizations and political constructs, like nationalism and global religions.
Layer on top (of these networks) the best that Web2.0 has to offer in terms of social software (wikis, twitter, blogs, freebase, etc .), along with solutions unique to Africa (FrontlineSMS, Ushahidi, etc.); mix in the strong culture of communal and family identity and… voila! You have a potentially very powerful and transformational piece of kit. Alpha this, beta this, build, iterate, build again… and I’m pretty sure that once you’ve industrialized the process, you will have a very exportable proposition: a turn-key solution for installing a smart (and green) local network.
In fact, I think this is a very real and interesting commercial opportunity. Maybe even a candidate for an X-prize in Global Entrepreneurship? I’d love to find a credible, motivated team that has the skills and the vision to make this happen and take us one step closer to the sixth paradigm. Looking forward to seeing the business plan!
*Cyberspace Deck: Also called a “deck” for short, it is used to access the virtual representation of the matrix. The deck is connected to a tiara-like device that operates by using electrodes to stimulate the user’s brain while drowning out other external stimulation. As Case describes them, decks are basically simplified simstim units. Another way to think about it might be like a lineman’s telephone—a tool used to actively maneuver through cyberspace rather than to passively perceive pre-recorded physical and emotional sensations (like a simstim unit).
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By now, you probably understand why this resonated with me; there is significant congruence with the themes explored here and that underpin the foundations of out investment thesis at ![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_c.png?x-id=854c3cc5-9621-4020-a308-66b6d1ecc635)
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