Signal Aspect

If you've been reading this site you know that a few years ago I failed to get a job after giving a presentation, prepared in 45 minutes, on the subject of 'The Next Big Thing in Financial Services'. Looking back, it turned out I was more-or-less bang-on. So now let's take the question again.

Firstly - let's examine the question:

• the next big thing. Well, the "Credit Cruch of '08" seems pretty big to me, seeing as how we're still suffering the knock-on effects in the general economy, even if investment banking has seemingly recovered. I still expect a bounce as the consequences in the real economy rebound and douse the current 'green shoots'. So am I to predict something of such magnitude? I think so. Why not? Look at where the enormous imbalances are, the skewed incentives, the industries struggling to defend a business model that is eroding fast - especially where those models are defended only by legalities. So, yes, big things.

The next one, though. That's kind of a problem. The future is always further away than you think. And then a critical mass builds until the tipping point when the conventional wisdom is overturned. Suddenly we chuckle gently about how foolish we once were, and how enlightened we are now. In order to identify the next one, though, I would need to order the big things and this can't be done: there are too many details and too many variables.

• in Financial Services. I'll not limit myself to financial services this time. Then, I was in an interview. Now, I'm writing about what I care about, which takes in more than just the industry in which I work.

Secondly - what do I think is the next big thing in... whatever?

Next time.

So here I called the great credit crunch of ‘08. Well, nearly. My point was that banks were then in the habit of parcelling up the credit risks they had taken on as part of their business, and were then selling the parcels to all comers, a process called risk distribution. Dressed up as AAA by the PHDs and Quants these instruments looked like a good deal; low risk and high returns. Banks got to restore the capital they were originally required to set aside (apart from that amount needed to cover the unsell-able toxic waste), and could then go on to do it all again, a process called leveraging. In this way, massive amounts of credit could be parcelled up and sold on - far more than the balance sheet could cope with if stressed - but that was the point.

The buyers were firms which had not hitherto bought credit risk, insurance companies for example. However, they believed the talk of pooling and diversification, how the individual risks could be smoothed away by portfolio effects. No-one truly understood the nature of the risks being bought and sold. Warren Buffet had it right here - don’t buy stuff you don’t understand.

My point was that the next Big Thing in Financial Services was likely to be some sort of meltdown when the credit risks went bad. When it is just Banks who hold these worsening risks the market can adjust - when everyone holds the risks the whole market is in jeopardy. But I thought it would be worse than that - we’d not know who held the risks because of risk distribution. With no clearing house (trades are done bilaterally), there is no central record of who holds what. Which now are the bad firms lumbered with all this credit risk?

Given the forty-five minutes I had to think up and prepare the entire presentation, I didn’t do too badly, I thought. Given more time, I might even have thought about the inter-bank lending market, and the impact on credit default swaps. I was starting to be right, and how.

If banks are intent on getting credit risk off their balance sheets, well then OK - find buyers and allow a market clearing price to emerge. Finding buyers was easy but should have been hard - firms that bought these assets trusted what they were told, and often borrowed the money off a bank to finance the purchase (and so the credit risk whirled round and arrived right back on the balance sheets of banks, only now very hard to trace back to the original exposure). No market clearing price could form because the deals were arranged over the counter, bilaterally, between firms. No transparency there. Relying on regulators is foolishness.

I wasn’t believed, and in truth I barely believed it myself - more thinking was needed. The whole Windows/Linux thing had blown the chance of a job, so I thought no more about it. Which is a great shame because as it happened, I was right.

Being right is not enough (and it’s too easy after the fact). Acting right is another matter - and that’s what this blog is all about.

This turned out to be the most problematic of all my statements in the interview. A buyer, whether of large-scale vendor-supplied applications, or shrink-wrapped software, will lose all control over their data if the format in which it is stored is proprietary. Many licence restrictions exist to prevent end-users extracting their data from the application they thought would help them.

The key point is that the data belongs to the users - not the vendor. Vendors, however, want you to continue to pay, again and again, for the 'service' provided by their software. The recent chat about 'software-as-a-service' (SaaS) is led entirely by vendors, looking to gull otherwise sensible people with fear, uncertainty and doubt.

The growth and undoubted success of open-sourced software is seen by these people as an aberration, suitable only for niche applications, such as web servers. But even in these niches, fear is spread that the applications are unsupported, amply demonstrated by the lack of corporate contracts to provide support. This is totally wrong, of course. The main method hitherto of getting paid in the open source space is to hire out your expertise to others who need it; think Red Hat and Linux.

Even if your data is locked inside a proprietary database, which your licence forbids you to reverse engineer, perhaps there are tools to extract the data? Maybe programs exist to export your data from inside the box to another format, perhaps .csv? Don't be fooled. The reason these export tools are so weak is to make it hard for you to get your data out while appearing to be 'open'. Your data should wash seamlessly into and out of applications as and when you call upon an application to help you with your problem, right now. One-stop, full service solutions are not the answer either - what if you want to re-engineer your processes? Or decide to do Chinese rather than Indian after the regular early afternoon card game?

The main benefit of open sourced production, and there are many, is that you regain control of your data. Nobody who sells you software wants to make this easy for you.

Simple, I thought. No elaboration into information asymmetries or game theory. Just common sense. New tools arise and are discarded all the time. A few years ago I used Yahoo for all my searches, and then Google came along and swept the board. The Microsoft vendor model is already dying. And this last proved to be my undoing.

"You mean we'll all be using Linux on our desktops, and not Windows?" she said. We might, I replied; the future is not set, but you can see the trends today, and there is no reason why Linux shouldn't become mainstream.

She couldn't see it, and hence couldn't see a future for me in her company. Neither could I, thankfully.

Ubiquitous - the property of existing or being everywhere, or in all places, at the same time; omnipresent. Tools to communicate are always around us. In the past we had the telephone - expensive, and anchored to a point (the desk at work, the hallway in your house). Then the telephone moved into our pocket and came with us when we went out. And then the network moved from the closed telco standard to the open IP standard and suddenly all sorts of new things could be done.

What was once hard and expensive to do can now be done cheaply and quickly. When I want to buy a new plasma TV I find the one I want, perhaps in a shop, and then Google it (also, perhaps, in the shop) and find the same thing for less money. Why pay the shop's prices? In the past such research would have been time-consuming and expensive (all those phone calls!), and so we consumers were happy to do the trade-off and pay the shop's premium. No longer. The information asymetries and inefficiencies that once allowed firms huge pricing power are being eroded by the power of ubiquitous communications.

The internet is a communication mechanism, not a channel. It's two-way radio, not broadcast TV. People who do not know each other can exchange views about firms and products in ways which firms cannot hope to control. The power of the central marketing message, that of the brand, can be undone in a flash by anonymous people telling each other what they think.

The internet makes digital distribution practically cost-free. If it can be digitised, marginal cost of production drops to zero. Price will also drop to zero because price tends to marginal cost, absent monopoly power. It follows that businesses which made money exploiting scarcity must re-position when that scarcity no longer exists. The record-label business made tons of money controlling the distribution of scarce goods - media - but since it's a snap to digitise music that scarcity has vanished. The cost to the consumer of obtaining music is now zero; and yet companies are still trying to charge. Film too, and images; news - the newspaper-led, broadcast, top-down distribution of news as a model is fundamentally undermined when people who don't know each other can exchange news and views instantly and for nothing.

So how would I advise a CEO? Don't bother with a CIO/CTO - that's a baby-boomer thing and baby-boomers just do not understand. Really. Just as boomers don't know what a typewriter metaphor is, generation Y-ers don't know what a typewriter was. What business are you in, really? Ask schoolchildren what they think your business is. Does it rely on scarcity? Perhaps start treating previously scarce goods as promotional material for genuinely scarce goods. What's scarce? Time, and attention. Trust.

It's a new world, indeed.

Market abuse, MiFID, collateral, IAS, IFRS, Sarbanes-Oxley; the list goes on. Each new regulation imposes costs on the industry it regulates, and it also opens new business opportunities.

As sellers of financial instruments and investment vehicles market their offerings to customers, so the regulator will follow. Governments are interested in orderly markets, the rule of law and taxpayer protection, and seek to use regulators to oversee markets and ensure that laws are obeyed and consumers protected. That’s what regulation is.

In the UK we have, in the City of London, the most interlinked and central financial centres of them all, and so almost any regulation made anywhere impacts firms that do business in London. London is pre-eminent not merely because of its location on the Greenwich Meridian, but because its regulations are relatively light, there is a good body of contract law and property rights are strongly upheld.

And yet regulation is a fallacy. We imagine cool-headed, competent people, selflessly devoted to the public good, impartially monitoring their market and enforcing the regulations for the good of all. Such people do not exist. Instead we have a system where the industry being regulated works hard to capture the regulator - to make the regulator serve the industry and not the wider public good. When industry achieves this it is called ‘regulatory capture’. Remember that no company likes competition in its own market and so will back anything that can serve to reduce competition - and it’s quite cheap to capture the regulator: a few plum jobs on the boards of large firms when one’s term of office has expired - well, one has school fees and a villa in Majorca to pay for, right?

Regulation is a fallacy for a second reason - any rule book can be gamed. The moment a rule is made concerning one thing - opportunities open up in everything else. There are loopholes to be exploited, exceptions to be sought and special cases to be plead. Often, regulations do no more than codify how firms are expected to comply with existing law, which gives comfort to a firm - it is a reasonable defence to claim that the relevant regulatory principles and guidelines were followed and obeyed.

Regulations add massively to the costs of the industry being regulated. There is a whole industry created to help firms comply with regulations; to understand the rules and their application, to run projects to change systems and procedures, and to monitor and certify compliance.

So, how would I advise a CEO? Create a chart of the regulatory change in the pipeline. Assess, at a high level, the impact on your firms’ operations. Get close to the regulator - offer them staff, facilities, expertise. Find out what the big consultancy firms are doing. Make full use of any comparative advantage your firm may possess.

Regulations are good things for the industry being regulated. Cynical, huh?