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Quote of The Day Title
First they ignore you, then they laugh at you, then they fight you, then you win.
- Ghandi

Articles tagged 'Risk Management'

More competition beats more regulation

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

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

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

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

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

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

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

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

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

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

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

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

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

The case for investing in new companies.

Buttonwood has posted an excellent analysis of why financial markets are unlike other markets for goods and services:

This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.

Which explains why bubbles develop and burst and why ‘market fundamentalism’ does not generally serve us well when thinking about financial markets (as opposed to other markets.)  Buttonwood also alludes to the fact that bubbles often develop at times of great change (has he read Perez???):

Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society “gained” some empty condos in Miami and holiday homes in Spain.

His conclusion is that because of these structural characteristics of financial markets, central banks (and possibly regulators and/or governments) have a natural, pro-active role to play in trying to mitigate or counter these problems.

Of course a few investors – the most high profile being Warren Buffet – have successfully arbitraged this weakness in capital markets buy being countercyclical, being “greedy when others are fearful, and fearful when others are greedy”; but as most people know this is bloody hard to pull off and exposes the investor to significant liquidity/solvency risks if they get the timing wrong.   As Keynes said, “the markets can stay irrational, longer than you can stay solvent…”  If you have an edge, even a small one, doubling down will usually work as long as you have an infinite bankroll. Ooops, small fly in the ointment.  (Besides, if you have an infinite bankroll, what the hell do you need to bother about worrying about returns!)

Well I have neither an infinite bankroll nor the skills (and/or luck) to adopt a Buffet-esque investment strategy.  But I do have some skills.  And some experience.  And I can recognise patterns reasonably well.  And I have conviction.  And a reasonable track record for building new markets and adopting and executing novel business models.  So a few years ago I figured out that by focusing these modest talents and skills on investing in and helping to build new businesses, with a lot of hard work and days and months of research and reading I could generate pretty decent financial returns that were (almost) completely uncorrelated with the massive tides that buffet the world’s financial markets.  And most importantly, this lack of correlation is structural – ie it doesn’t disappear in violent bear markets when almost all mainstream asset classes discontinuously jump to near perfect correlation (much to the chagrin of the VaR boys.)

It’s not hard to understand why.  In fact it’s pretty obvious.  For a new business, the ups and downs of the market, GDP, etc. have at best a second or third order effect on the company’s value.  These factors are overwhelmed by the single most important factor driving value creation which is of course, can the company successfully sell it’s products or services to paying customers (or be more and more clearly on that path.)  As someone wise once said:  a “start-up is not GM”  ie They are not correlated to GDP.

Now don’t get me wrong, I’m not suggesting that investing in new companies is without risk.  In fact as most people would glibly observe, investing in start-ups is ‘very risky’.  Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces.  And just because the risks are easier to identify and name, doesn’t mean it is easy to manage them, just that they are potentially (more) manageable.

So if this is true, why have venture capital returns generally been so poor (at least in the last decade or so) and why don’t more smart people try their hand at this (rather than trading/managing other types of assets)?  Answering the second question first, I suspect this is because failing together is much nicer than failing alone, and so if the global financial crisis wipes out your hedge fund or investment bank or savings, well that sucks but, you know, shit happens.  If however you pour your own (or worse your investors’) capital into a couple of dozen new companies that crash and burn, well that’s just a very lonely place to be.  The answer to the first is not simple and you could probably write a book on this (perhaps Paul Kedrosky will?) but with the disclaimer that I don’t pretend to really know, my short and dirty take would be that there are two related factors at the heart of this failure.  First, investing in new companies is hard to scale – at least compared to many/most other asset classes and secondly, the traditional structure of the industry is poorly adapted to this reality.  Private equity legal and economic structures (which is how most venture partnerships are structured) doesn’t really fit the risk/reward/resource profile needed to invest successfully in new companies.  Of course their are exceptions – both temporal and human – but just because their are some investors clever and/or lucky enough to make it work doesn’t make it right.

I could of course be wrong.  And I could fairly be accused of hubris, especially as at this point I don’t have a long enough track record and/or enough exits to prove without doubt that my approach is correct.  And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”,  I am even more confident in my larger analysis that while the venture capital industry might be broken / poorly organized, the risk-adjusted returns available to those who chose to invest – methodically and with a well-calibrated capital and incentive structure  - in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes.  The challenge is of course to find these investors and not to swamp them with too much capital.  This problem isn’t solved but it looks a hell of a lot like the problem facing hedge fund investors (in most strategies that also do not scale beyond certain amounts of capital) and the asset allocation community would do well to try some of their more successful solution there on finding and seeding managers in this asset class.

And if you ask me, the rise of the ‘super-angel’ much talked about in venture circles these past months, is a step in the right direction and perhaps an indication that asset allocators are (finally) waking up to this opportunity.

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Markets in everything, Part 471: Hooray for Hollywood

The LA Times published an interesting article yesterday discussing the arrival of two new exchanges focused on helping hedge box office risk:

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

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

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

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

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

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

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

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

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

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

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

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

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Weather forecasting.

I’ve been avoiding putting together a list of predictions for 2010 (more on that later) but just couldn’t resist suggesting that 2010 could well be a breakout year for weather risk management. All of the conditions necessary have finally started to come together and with the worst of the 2008/2009 hysteria behind us (without passing judgement on the future direction of markets), companies (and hopefully individuals) will start to wake up and respond to the risks and opportunities inherent in weather variability. I wouldn’t be surprised if weather risk was one of the top three risks faced by the vast majority of (non-financial) corporations, perhaps even the most important risk in some cases, and of the same order of magnitude as liquidity, foreign exchange, commodity and interest rate risk – all risk categories for which massive global markets in risk pricing and transfer exist. Weather in this regard remains significantly underdeveloped:

(via Ben Smith, First Enercast Financial) For example the Department of Commerce estimates that more than $1 trillion of U.S. economic activity is exposed to weather. Even if a small fraction of new risk is hedged through derivative contracts, 2010 will be a very good year for these markets.

The massive costs incurred in much of the northern hemisphere over the last few weeks due to heavy snowfalls and cold temperatures are just one more example of how important a factor in economic outcomes weather risk can be. For example, just take the exceptional – and uninsured – costs incurred by local authorities and airport operators across the UK for snow removal, sanding, salting, loss of revenues, etc. Previously, a manager of a company (or government entity) who suffered an exceptional weather-related loss could shrug their shoulders and plausibly say “it was out of my hands.” In a way that would be impossible if for example their organization suffered a massive loss because their buildings or equipment perished in a fire and they were not insured. In that scenario, shareholders or taxpayers would be incandescent with rage at the incompetent risk management of the managers. Not managing weather risks is no different in substance (now that appropriate weather insurance and derivatives are increasingly widely available), only remaining so in perception as awareness lags.

Of course I am biased, having invested in Weatherbill, which is at the vanguard of transforming weather risk markets:

(via J. Scott Mathews, WeatherEX LLC) The weather market was built upside down, which is quite a feat, even for financial engineers. What we mean is that it started on the wholesale level without any retail underpinnings. It started out like a castle in the air…The changes coming in 2010 for the weather derivative market will be keyed “from the bottom up.” Solutions companies such as Guaranteed Weather and Weatherbill who bring management choices to “ground level” risk holders are helping to complete a strong base to keep that castle from crashing on us.


The difference between weather derivatives (Weatherbill.com) (or any other new risk management tool) and say books (Amazon.com) is that risk management tools need to be ‘sold’ – there is a learning curve, however shallow; and while most people instinctively understand and can conceptualize their weather risks, their survival instincts – honed by decades of doing business with rapacious financial services firms – and fear of ‘getting their eyes ripped out’ means that they are understandably cautious when considering using weather risk management instruments for the first time.

This is where Weatherbill’s business model I think is particularly well adapted to the opportunity: on the one hand, they have a very modern (open) approach to pricing: anyone can go to their website and play around in their pricing ‘sandbox’. Try doing that ten years ago when you wanted to price up a complex FX or interest rate option. Basically it was build your own model or keep sending pricing request to your favorite sales person (who would then have to go beg the trader for a price, and in addition to the regular parameters, the client’s identity, the salesperson and the trader’s mood would also be imputed into the price. That is of course if he felt like making one.) On the other hand, (and this is something that has evolved over the past couple years) Weatherbill has aggressively sought out distribution partners – insurance brokers, industry platforms (eg travel sites), etc. – as trusted providers to their respective customer bases, they are ideally positioned to help their customers manage their weather risks by leveraging Weatherbill’s platform. I first wrote about this a few months ago, and since then they have signed up a number of new and significant partners.


I love skiing and my family take a season pass at Les Trois Vallees. Obviously weather risk is central to running or enjoying a ski resort. While there are many different types of risk you could look at in the context of a ski resort, in the interests of simplicity (ease of understanding/customer acceptance) and maximum pain relief, there are two risks that I would have loved to have had an embedded hedge for in our season ticket (and I suspect the same would go for someone buying a week-long pass for their holiday, in fact they would probably be even more sensitive/appreciative.)

  1. Not enough snow to ski risk: ie not that the snow is great or this or that…the basic risk that the pistes are closed. For most modern ski resorts this is actually a function of temperature and not precipitation, as they use snow-making machine to lay down a base. Temperature risk is much easier to measure and price (than snowfall) and has much lower geographic variability ie you don’t need a weather station on every piste on the mountain.
  2. Rain risk: ie the only time it is absolutely unpleasant to ski is when it is raining. Also, rain typically doesn’t help the existing snowpack, making skiing after rain often unpleasant as well.

Using Weatherbill to hedge their risk, Les Trois Vallees could offer a ski-pass that reimbursed me for every rainy day and for every day say less than 80% of their runs were open due to lack of snow. In an age of increasing climate uncertainty (or perception thereof) I am 100% certain this would help them market (and sell more) season tickets. And for week-long tickets, it would be a great marketing tool for advance sales (with significantly positive cashflow benefits), and great for improving the user experience. Imagine a vacationer whose week in the Alps is ruined by 5 days of torrential rain…getting their money back on the lift tickets (irrespective of whether or not they braved the elements) would go a very long way to having them consider giving it another try next year.

Of course this is but one example, I’m sure all of you can think of hundreds more. In fact it might be harder to think of services or businesses that are completely immune to the weather. So really, what are you waiting for? Start hedging!

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Spotting the losers.

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.

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

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

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

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

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

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Weatherbill inside.

Intel changed the paradigm of how microprocessors were sold with their 1991 “Intel Inside” campaign:

A second issue was that the processor, although a key component of personal computers, was only a component. To effectively market this component to the PC buyer it was important to work with the manufacturer of computers. After all, the processor was buried deep inside the computer and despite its significance it was hard to tell which processor the PC contained before it was purchased.

Carter and his team studied successful consumer marketing techniques and examined tactics used by well-known companies supplying a component or ingredient of a finished product, like NutraSweet™, Teflon™ and Dolby™. They also began a variety of marketing experiments and soon began envisioning how a branded ingredient program would play out in the computer industry.

Key to this strategy was gaining consumer’s confidence in Intel as a brand and demonstrating the value of buying a microprocessor from the industry’s leading company, the pioneer of the microprocessor. At the suggestion of its advertising agency, Dahlin Smith and White, Intel adopted a new tag line for their advertising: “Intel. The computer inside.” Using this to position the important role of the processor and at the same time associating Intel with “safety,” “leading technology” and “reliability,” the company’s following-and consumer confidence-would hopefully soar. That would create a new “pull” for Intel-based PCs. Later, this tagline was shortened to “Intel Inside.”

The important role of the microprocessor was being communicated, but to be truly effective the ingredient status of the microprocessor needed to be dealt with. In 1991 Carter launched the Intel Inside® coop marketing program. The heart of the program was an incentive-based cooperative advertising program. Intel would create a co-op fund where it would take a percentage of the purchase price of processors and put it in a pool for advertising funds. Available to all computer makers, it offered to cooperatively share advertising costs for PC print ads that included the Intel logo. The benefits were clear. Adding the Intel logo not only made the OEM’s advertising dollar stretch farther, but it also conveyed an assurance that their systems were powered by the latest technology. The program launched in July 1991. By the end of that year, 300 PC OEMs had signed on to support the program.

The PC business ultimately was redefined by this – moving to a barbell of high volume commoditized assemblers/distributors (Dell) and high value specialist niche players (Alienware) and of course the fully integrated hardware/software approach of Apple. The same thing will happen in financial services over the next 10-20 years. Only the ‘Intel inside’ isn’t hardware (except maybe for some high end high frequency trading applications where I think you’ll see people starting to design and sell custom chipsets…) but financial widget providers. FaaS or Haas or RMaaS. (For the few remaining bankers that read my blog and are scratching their heads, these are not tickers or Bloomberg functions – or if they are that’s not what I’m referring to – but acronyms for Finance or Hedging or Risk Management ‘as a Service’…) These will in turn get mashed up by enterprising distributors and channel managers to offer all sort of customer (from the head to the tail) the package of financial services and products that is right for them. This is what the mega-fauna of global finance (retail, commercial and investment banks in particular but also life and property insurance companies, brokers, asset managers, etc.) do now, in house, although the concept of “open architecture” on a fund management platform for example is a sort of distant evolutionary predecessor.

A more apt existing business model along these lines – that practitioners in the retail trading and FX markets will be particularly familiar with – is white labeling. Indeed companies like Saxo Bank have done extremely well with very sophisticated and industrialized white label partnership programs. You want to offer your customers trading on FX, FX Options, Forwards, Spot Gold & Silver, CFDs, Stocks, Futures, etc? Just plug into their machine and you’ve got yourself a trading engine and infrastructure. You want to offer your customers weather insurance? No problem – just grab Weatherbill’s new white label solution:

Image representing WeatherBill as depicted in ...
Image via CrunchBase

The WeatherBill White Label platform enables any third party to offer weather coverage to their clients, written on their paper, and using their distribution channels. It is an innovative end-to-end technology platform for pricing, transacting, settling, and managing weather risk. WeatherBill White Label creates new revenue streams and growth opportunities for insurance companies and weather derivative dealers, allowing them to leverage WeatherBill’s technology to offer fully automated, customizable weather coverage to their clients.

For any company who has customers that could use weather insurance in the context of their relationship with this company, this would seem to be a no-brainer; you don’t need to re-invent the wheel, weather algorithms and derivatives processing are probably not your core business and/or is not where you want to deploy resources. Outsource it. Add a plug-in. Did you write your own mapping software to show where your offices are on your ‘Contact Us’ page? No, you used Google or Multimap etc. and integrated it into your site and/or your service. It’s as simple as that, and makes just as much sense.

Financial mash-ups and FaaS. It’s just the start…

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Alchemy is not a good core strategy in financial services.

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

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

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

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

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

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

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

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

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

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

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

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Markets in everything, part 648.

British Aerospace 146
Image via Wikipedia

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

flybe 'Book with confidence' promotion

Flybe’s website goes on:

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

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

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

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

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

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Update on ‘Florida goes to Vegas’…

Last August I pointed out that the brave leaders of the State of Florida had in effect taken a huge punt on the weather. (Using the tried and tested gambit of bribing their citizens with their own money. Only better – leveraged!)

Well it seems that these same good folks have lost a bit of their nerve as 2008 hurricane season starts and the metaphorical roulette wheel starts to slow (from the Guardian):

Warren Buffett’s Berkshire Hathaway fund has taken a $224m (£113m) bet that Florida will not be hit by devastating hurricanes in the coming months. That is the amount the US state has agreed to pay Berkshire upfront in return for the fund coming to its rescue if hurricane damages cost more than $25bn this season, which runs from June 1 to November 1.

If damages exceed $25bn, Berkshire will buy $4bn in 30-year bonds issued by the state. The money will ensure Florida does not run into cash flow problems in the clean-up. Florida will have to buy the bonds back; the interest rate is 6.5%. State officials have agreed to the deal, even though they admit there is only about a 3% chance of damages going so high, because they believe the credit crunch could limit their access to funds if this is a particularly bad hurricane season.

So let me get this straight. Basically Florida lined up a loanshark, just in case they couldn’t pay their bookie if their bet didn’t come in. It looks like a pretty clever deal for Vinnie Mr. Buffett: if the terms have been correctly reported, effectively he is being paid $224mn for a ‘knock-in’ credit spread + interest rate lock. On $4bn of bonds, if the knock-in is exercised, the premium should protect Buffett up to c. 7% before he starts incurring mark-to-market losses on the overall trade. I’m no expert and it’s late so I’m not even going to try to hack a model together, but it seems like this is a pretty good deal for the man from Omaha. (And btw, a derivative by any stretch of the imagination…)

It’s also probably a relatively prudent thing for Florida to do, even though they obviously shouldn’t be in such a dire position to start with…and does beg the question, is this the best deal they could do? I can’t get the image out of my head of some hapless middle aged gambler, knuckles white as his nails dig deep into the felt, all the blood drained from his face, beads of sweat gathering on his pencil moustache, as the terror washes over him with the realization that the dice moving in slow motion down the table…might just come up snake eyes…

You couldn’t make this stuff up.

I guess there is no point mentioning the bats…

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Sunshine Guaranteed.

Image representing WeatherBill as depicted in ...
Image via CrunchBase

Great to see David and his team at Weatherbill line up another great deal – this time with Priceline, bringing the benefits of (weather) derivatives to Main Street:

Under the limited-time Sunshine Guaranteed promotion launched today, customers who book a qualifying Priceline vacation package between June 2 and July 17, 2008 and travel between July 1 and September 7, 2008 will be eligible for a refund if their vacation is rained out. For full details on Priceline’s Sunshine Guaranteed promotion, visit: http://www.priceline.com/promo/sunshine_guarantee.asp

Brett Keller, priceline.com’s Chief Marketing Officer commented, “Ten years ago with our Name Your Own Price® launch, and more recently with our elimination of booking fees on published-price domestic and international airfares, priceline.com has demonstrated a commitment to continually innovate in order to get great deals for our customers. Now we’re also offering them great weather. Best of all, these Sunshine Guaranteed vacations are available at the same great prices we offer for all of our packages. Our customers can book their Sunshine Guaranteed trips and rest assured that there’s a silver lining waiting if Mother Nature doesn’t cooperate.”

There is no additional charge to book a Sunshine Guaranteed vacation package. Qualifying vacation packages must be 3-8 days in length. Travel must commence at least 12 days after a package is purchased. If it rains more than 0.50 inches per day on half or more of the days of a Sunshine Guaranteed vacation (including travel days), priceline.com will provide a refund for 100% of the cost of airfare, hotel, rental car and attractions and services components of the Sunshine Guaranteed vacation package.

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