Funds management and investment in the modular economy

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Last week’s 25th anniversary issue of BRW focused on the future 25 years forward, so not surprisingly included interviews with both Richard Watson, Chief Futurist at Future Exploration Network, and myself. The extensive interview with Richard was a fun and broad-ranging discussion on the future of technology, which unfortunately is not available online. I was interviewed for an article on the future of superannuation (the British/ Australian term for retirement plans). One of the points I made was about living longer healthy lives, the shift to flexible working structures, the blurring of the age of retirement, and the need for legislative structures to adapt to these changes. What I think was the more interesting issue I raised was about how investors will need to seek new investment vehicles.

“The fact is that listed companies represent quite a small proportion of the economy. We will need increasingly to look outside the stockmarket for investment opportunities,” Dawson says. “Private equity and venture capital are going to become far larger. Even today, private equity funds are pushing valuations up.”

“There will also be a growth in companies that are less capital intensive. They will need less money and so will not be so attractive to investors. Over the net 25 years we will have more services companies and flexible, loosely arranged organisations that do not need investment funds,” Dawson says. “Whole new layers of investment companies will build up around smaller sectors, such as micro-caps. In 25 years, althought it will have taken a long time, there will be pretty large segments of portfolios going into sectors that are currently classified broadly as alternatives.”

There is no question that we are shifting to an increasingly modular economy. Technologies such as web services and Web 2.0 are creating an intensely modular online and application environment, in which elements are combined at will. These technologies, together with the modularization of business processes, and easy flow and integration of processes across organizational and national boundaries, are creating a truly modular economy. The ultimate unit of the modular economy is the individual. Certainly there will be many reasons for organizations to exist in the future, not least in those industries that require significant capital. However as the economy inexorably shifts to the intangible, an increasing proportion of value will be created by aggregations of individuals or small organizations providing knowledge-based services, that mesh with other organizations large and small in economic networks. In many cases they will require little capital, and thus there will be no or little need for investors. Stockmarkets can only function effectively with large, highly capitalized companies that have highly liquid shares. Already the proportion of the economy that investors can reach is limited to fairly large companies, at most one third of the economy. It is likely that an increasing proportion of the economy will fall outside the listed sector, and thus be not directly available to investors. Much is made of private equity companies, but these focus on an extremely small subclass of opportunities. Venture capital also works within quite defined parameters, though it plays a very important role. There is a massive potential market in providing capital and services to very small participants in the modular economy, while also providing opportunities for investors to participate in this burgeoning sector. Mechanisms such as sharing in defined ways in future cash-flows of individuals or very small organizations could prove to be viable for both entrepreneurs and investors. While it is hardly a representative situation, Tom Cruise’s recent deal to fund his production company’s overheads suggests the kind of model that could be implemented on a smaller scale.

Peer-to-peer banking

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A new peer-to-peer bank, Prosper.com, is launching in the US, attracting articles in both the New York Times and BusinessWeek, with the latter titling the story “The eBay of Loans”. The principle is simple – you lend to individuals at interest rates based on their credit rating, and since you’re cutting out the bank as middleman, both lender and depositer get more attractive interest rates than they can get commercially. This is not a new idea – UK-based Zopa has been running for almost a year with essentially the same business model. Anecdotally Zopa is doing well, and intends to set up in the US soon. One of the differences is that Prosper.com focuses on groups that know each other or have common interests. It also has a more evolved bidding model so lenders bid to have the lowest (and thus winning) interest rate for a particular lender.

Banks are the archetypical intermediary, in this case between depositers and lenders. They get a very hefty spread for lending to individuals, however they do some things to create that value, including insurance (by pooling loans), risk assessment (making independent and accurate assessment of creditworthiness), and convenience (at their best!). Prosper.com allows lenders to split their loans across many borrowers, giving some loan pooling and security against default. Certainly, an online marketplace cuts out the middleman and the spread it charges – all part of e-commerce 101. However rhe really interesting part of this model is the risk assessment. In the first instance, people can find out about someone as an individual and make a personal assessment on their default risk. The next phase is when more sophisticated models are used to assess credit risk, aggregating a wide range of perspectives. This is not possible by a financial institution. However, with a borrower willing to disclose information, arguably more accurate credit assessment is possible. If some kind of effective deposit insurance through pooling or other mechanisms is put in place, in addition to superior credit assessment (not difficult given the paucity of the bank’s data and models), then there is no reason peer-to-peer banking will not over time become a competitive issue for mainstream banks.

Sell-side banks become consultants

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One of the issues I’ve spent much time on over the last decade is how financial markets buy-side/ sell-side relationships (usually those between investment banks and fund managers) are changing, and what the implications are for investment banking sales and research. My case has largely been that financial markets salespeople need to build “knowledge-based” relationships with their clients, which requires salespeople to add explicit value to the decision-making processes of the fund managers they deal with. Particularly now that so much trade execution and research distribution is automated, there is simply no reason for clients to pick up the phone when salespeople call, unless they can do something more than peddle the latest trade idea. An example of this in practice is CSFB’s Locus product, which enables fixed income derivatives salespeople to create sophisticated analyses of complex trades. The interesting part is that they can show these analyses to their clients online, and both the salesperson and the fund manager can change the assumptions or characteristics of the trade, and see the implications, real-time while they speak on the phone. This enables the salesperson to go far beyond sending pdf research documents to their clients, and to actively engage with clients in exploring possible trades, variations on these, and how these fit with their clients portfolios.

Now one of the most important trends in financial markets is that of algorithmic trading. In order to execute large orders, equity fund managers increasingly use automated systems that break up trades into smaller blocks, and execute these at different times and on different marekts. This allows anonymity and minimizes market impact. However implementing these algorithms effectively is an extremely complex task that fund managers do not have experience with. As such, an increasing part of the value that can be offered by salespeople is in consulting to clients on implementing effective trade execution strategies. Wall Street & Technology magazine recently had two very interesting articles on how sell-side salespeople are becoming consultants, and how this is contributing to fund managers reassessing their broker relationships. As such, the emerging domain of algorithmic trading – which largely automates trade execution – is in fact providing new ways for investment banks to create high-value relationships with the clients. However even greater value can be created by adding explicit value to clients’ decision-making processes. One example of this is how Morgan Stanley uses long-term scenario planning as a tool to help clients think through extremely broad issues such as the future of China or possible directions for government bond market structure. Another key issue is in changing the roles of sales and research so salespeople are more able to actively discuss the portfolio implications of trade ideas with their clients. Buy-side/ sell-side relationships have come a long way in just the last five years, and the pace of change certainly isn’t slowing.

The Future of Money

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Money is information. It would make sense that as we rapidly become hyper-connected, financial services will be transformed. Yet the pace of change – so far – has been slow. We still use notes, coins, and credit cards for most transactions. Certainly Internet banking and bill-paying is standard fare, however the promise of e-money and smart cards is yet to be fulfilled. So what is the future of money? I gave the keynote address at a recent industry forum, organized by Online Banking Review to address this topic. The conference summary provides an overview of what the participants – including myself, Richard Watson of What’s Next, and senior executives from a range of global and national financial institutions – discussed at the event. Competition is at the heart of the matter, with a swathe of financial services entrants from sectors including retail, telcos, utilities, technology and more now more able than ever to move into the most valuable elements of the customer offering. Trust, distribution channels, and pricing were the other key themes of the forum. I’ll explore some of these themes in more detail on this blog over time.

Review of Collaboration in Financial Services Europe

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A few weeks ago now I chaired the Collaboration in Financial Services Europe conference in London. The White Paper on How Collaborative Technologies are Transforming Financial Services is now available from my website. If you’re interested in the topic, the review of the original Collaboration in Financial Services conference in New York last September is also worth a look. Both in moving on nine months from the New York conference, and crossing the Atlantic, the shift in themes was striking. It was a great day, exploring in detail many of the fundamental issues the financial services industry faces in an economy increasingly centered on collaboration. The key sponsor of the Europe conference, Reuters, has played a significant role in the development of instant messaging in financial services since David Gurle left Microsoft to spearhead the company’s collaboration initiatives. Reuters has established interoperability with all the three public IM vendors. Now, companies like Facetime, Aconix, and IMLogic have provided the wraparounds to make public IM secure and compliant. At this point we can say that IM is pretty much a robust corporate tool, though the space will certainly evolve considerably in the next year or two. One of the most interesting aspects of Reuters’ positioning is its emphasis on chat and building communities. It wants its major financial institution clients to use chat as a primary medium for knowledge-sharing, and to create spaces that link buy-side and sell-side, for example for conversations around research issued by the firms. Intelligent agents will identify posts that are of particular interest to individuals, so they don’t need to trawl through everything themselves. In addition, they want IM to become embedded in workflow, for example automating trading and integrating into STP (straight-through processing). Another domain that was explored in detail at the conference was insurance. I moderated a panel with Christoph Harwood of Kinnect and Alex Letts of RI3K. Both are essentially new-breed B2B exchange for the insurance industry – Kinnect was set up by Lloyds of London for commercial risk, while RI3K is in the reinsurance space. Their challenges and progress over the last few years are great case studies for similar initiatives that can bring great benefits to an industry, but require collaboration between many players. Clifford Chance also presented on an advanced in-house system that provides partners and staff with a portal view of activity and communication around a particular client or matter, which is just being rolled out. As far as I’m aware, the system is more sophisticated than any of the investment banks have implemented for sharing information on complex transactions.

Encouraging and constraining collaboration

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In one of those cases in which there is a whole world of implications behind a seemingly small news item, an article in the Financial Times recently stated that banks are in danger of insider trading by sharing information inside the bank on credit derivatives. Trading in credit default swaps (which are essentially financial instruments that represent the credit risk of corporate borrowers) has always being done based on the privileged knowledge that banks have of their clients. Now banks are being told that if they want to trade these instruments, the parts of the bank that know their corporate debt clients well, can’t talk to the parts of the bank that trade these instruments. In the first instance, given that this development represents a broad, long-term trend to regulation on similar issues, this suggests that diversified financial institutions – which are based substantially on sharing knowledge between their operating divisions – may have far less justification for existence than in the past.

In the context of the issues addressed by the Collaboration in Financial Services Europe conference I am chairing in London this June, this has crystallized some of my thinking about the future of collaboration. In a nutshell… Every organization is experiencing the imperative of collaboration. To survive, we must enable information flows and collaborative work. At the same time, there are many ways in which we must disable communication and information flows, inside and outside the company. This is particularly pointed in financial services, with old and new regulations constraining who can share information, from investment banking and research, to lending and trading. However similar dynamics apply to companies in every industry in that they both have to actively share information, and also have constraints from intellectual property, privacy, regulation etc., in how they work both internally, as well as with suppliers, clients, and other external partners. This tension between encouraging and constraining collaboration and information flows will be central to the evolution of organizations over the next years and decades. More on the Collaboration in Financial Services conference soon – this will be drilling down into detail on some of the leading initiatives in collaboration the financial services sector in Europe – there are some very exciting developments.

Wall Street’s view of collaboration

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The BDI Collaboration in Financial Services conference in New York went extremely well, so much so that we intend to run it in London in late spring next year as well as in New York again exactly one year later on September 29, 2005. The conference review describes what happened on the day. Taking a few quick top-of-mind reflections from the event…

The success of the event shows that collaboration and collaboration technologies are recognized as critical issues across financial services. In an industry driven by information flows and deep expertise, allowing professionals in financial institutions and their clients to integrate their work and thinking is clearly the way things are heading. We began to touch on some of the implications for bank strategy and value-creation in the industry in the event; this theme will play a bigger role in our future conferences. However a dominant issue on the day was the regulatory compliance framework as blocking collaboration efforts. For many reasons this is the context within which financial institutions are currently working. In addition to regulators ensuring they are not blocking innovation in financial markets, banks must not allow the regime to put them off implementing approaches that will differentiate them in the eyes of their clients.

I was delighted that we had Steve Wallman as our lunch keynote speaker. I have long admired Steve’s work since when he was SEC Commissioner in 1994-97. This article in Forbes magazine from 1997 shows some of his deeply insightful thinking on intellectual capital, which is still integral to my perspectives on the future of intellectual capital reporting. At lunch the day before the conference someone told me Steve was the best speaker he’d ever seen. I used that anecdote when I introduced him, setting high expectations from the audience, but ones that he definitely met. See the conference review for a few more details on what he covered.

Collaboration in Financial Services conference in NYC

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Collaboration – technological and otherwise – is central to the future of the financial services. In order to address these issues, in conjunction with Business Development Institute and Michael Ross Associates, I am designing and co-organizing a one-day conference in New York on September 29 on Collaboration in Financial Services. Full details are at https://www.bdionline.com/cfs.

We have got a tremendous response to the event. The current key sponsors are Intralinks, I-Deal, Microsoft, Interactive Data Corp, Vignette, Broadvision, and FaceTime, together covering the key technologies that support collaboration in institutional financial services, including real-time collaboration such as IM in a trading environment, document collaboration in deal-making including M&A and syndication, and internal collaboration systems. Many of the leading investment banks, including Goldman Sachs, Merrill Lynch, Deutsche Bank, CSFB, Bank of America etc. etc. are involved. Banks now see collaboration as a key driver both internally, and externally with clients. While there are significant compliance and security issues in the short-term especially, the core issues are first technological, and then process, organizational, cultural, and strategic. Banks are recognizing these will be major shifts, and there is lots to do in gearing themselves up to address these issues.

The reality is that we are far from achieving the potential of collaboration technologies in the financial services industry. Much of the reason is standards battles have at times dramatically slowed progress. A classic example is instant messaging, which is already at the core of communication in many of the financial markets such as bond trading, but the reluctance of AOL, Yahoo, and MSN to enable interoperability between their instant messaging systems has placed severe constraints on how banks can implement these technologies. Many similar issues remain in other domains, including establishing collaborative workspaces for M&A and other complex deal-making.

Part of my vision for the conference is to contribute to the industry – comprising both banks and vendors – acknowledging and beginning to address some of these standards issues. The last high-level panel session of the day will focus specifically on creating an industry roadmap to enable greater benefit from collaborative technologies in the near future. This conference will be run annually, and we may also establish some kind of working committees to help further these agendas on an ongoing basis.

Hope to see you there!

Investment banks lead the charge on Instant Messaging

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I opened Living Networks with the examples of Macromedia using blogging to get messages out to its developer community, and the institutional bond market on Wall Street using instant messaging to enhance information flows. Stowe Boyd has written a very interesting piece on financial markets instant messaging (IM) in his publication Message, looking at some of the drivers of adoption, and incorporating an interview with the co-chair of the Financial Services Instant Messaging Association (FIMA).

There are a whole suite of interesting issues here. One is simply how the investment banks have become enormously more collaborative over the last five years, largely as a result of technology drivers. When I speak about how very high levels of collaboration are becoming mainstream in business today—even in intensely competitive industries—one of the most convincing examples to many is how the notoriously aggressive investment banking community is now working closely together on a whole variety of issues.

A key interest for me in the adoption of instant messaging is how it changes buy-side – sell-side (client-supplier) relationships. The commoditization of information and research means that increasingly the value to fund managers of interacting with financial market salespeople is in “knowledge-based” interactions, in which they gain highly relevant knoweldge and perspectives that integrate into their portfolio decision-making, rather than generic information. A good example of this is CSFB’s Locus product, that enables salespeople and fund managers to look at the same analytics screen on possible trades, and to jointly play with assumptions to make them relevant to the client’s portfolios, and provide a basis for useful discussion of risk and return parameters. Thomson Financial—having bought WorldStreet just in time for me to update the coverage in my book—has integrated it into its Connect product, which provides a peer-to-peer XML-based platform for customization and filtering of content delivery. All of these new tools shift the client-supplier relationship, and force the development of new skills, processes, and strategies for the investment banks.

Another interesting angle is that while SMS has played a major role in changing interpersonal communication in Europe and Asia, IM has played a similar role in the US. IM still has low adoption outside the US, just as SMS is only picking up in America now. Different levels of familiarity with these emerging communication technologies affect how they are being integrated into business applications. However all around the world, it’s good to see that investment bankers are leading the charge in taking instant messaging out from teenage girls’ bedrooms into the world of business.

Creating the transparent corporation

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Aaargh! Being on the road means I’m getting stimulated by lots of very interesting stuff, but it’s hard to find a moment free to blog it. I’ll try to get a few things down… Last week I got dragged in at the last moment as a pinch-hitter to speak at the KMWorld (Knowledge Management) conference, the largest in the field in the US, in San Jose. It was in the “ROI and Measuring Value” stream, which is not what I spent most of my time on, so I decided to title my talk “A Financial Markets Perspective on Intellectual Capital”. The KM crowd don’t tend to get exposed to finanial markets thinking much, so it’s worth giving some insight into how investors view non-financial or intangible indicators. The story in a nutshell is that it has become increasingly obvious that non-financial indicators are vital in getting an accurate picture of the value of a company. Employee turnover and changes in customer loyalty are just two examples of a myriad of things that investors would very likely want to know, but don’t get told.

Over the last 10 years many have attempted to build models that take into account these intangible indicators. After spending a lot of time several years ago looking closely at these issues, and talking with the top people in the field, I came to the conclusion that there was no simple answer. The heart of the issue is that investors use different valuation models—that is they assess the value of intangibles differently. That’s what makes a market. Steven Wallman, who was then SEC commissioner and now runs the very interesting customized mutual fund service foliofn, stated it clearly. Currently financial reports aggregate all of the vast amount of information inside a company. What is required is a shift to disaggregation of that information, so it is all available to everyone, who can then choose to aggregate it into the financial models of their choice. We have yet to see whether companies, large investors, or regulators will drive this shift, but 10 years is the sort of timeframe we have to expect for it to happen. What could help accelerate this dramatically is XBRL (eXtensible Business Reporting Language), which is an XML-based standard for financial reporting that I discuss in Living Networks. This makes it very easy for analysts to take financial information into their own models. A recent study showed that analysts accounted for stock options in reports more accurately if they were presented in XBRL format rather than in a PDF. The beauty of XBRL is that it is extensible, so it can easily be used to report on non-financial indicators as well as financial ones. XBRL offers the promise of disaggregating information flows in company reporting. Investors will be far better informed, and be able to make decisions based on what is actually happening in the company. Earlier this week I met the executives at the American Institute of CPAs who are driving XBRL. They believe it will be far harder for the Enrons of this world to get away with what they did in an XBRL world. Companies will be far more transparent. And a little further down the track, we will shift to real-time reporting, when you can see what is happening in a company as it happens rather than two months after the end of the quarter. It’s hard to exaggerate the potential impact on how business is done. I will post my slides from my KMWorld presentation in the next couple of weeks, with a link from this article.