A FICCing Pain In The Ass

Another example of complexity driving better margins are the debt markets as compared to the equity markets. The debt markets have higher margins because there is more complexity in the variety of products, and because that complexity has been amplified as those markets have resisted the move to electronic marketmaking.  See the discussion below from the Economist:

Margins on the debt side of investment banking have generally held up much better than they have on the equities side mainly because debt markets are vastly more complicated. Large companies will typically issue a single class of shares, and any subsequent issues will usually be completely fungible with the ones already outstanding. Yet companies will often issue tens if not hundreds of different sorts of bonds, and even the simplest issue will differ from the previous one because interest rates will have changed and it will have a different maturity. This provides rich pickings for bond traders as buyers will often have to hunt around to find exactly the bond they want. Gaël de Boissard, the head of fixed income and Europe, Middle East and Africa at Credit Suisse, points out that there are 38,000 different corporate-debt securities in America alone, only a few of which trade every day of the year. But pressures for simplification are rising. Investors and issuers want it in order to lower costs and improve liquidity, and regulators want to make sure they can clean up quickly if a large bank fails.

Innovations that have transformed equity markets, such as ETFs and electronic trading, are also making their way into debt markets. Goldman Sachs, UBS, Morgan Stanley, BlackRock and Bloomberg, a financial-data and news firm, are all experimenting with electronic bond-trading networks that try to match buyers and sellers.

Lessons on Bigger Takes From Equity Markets

From the equity markets, the variation in spreads (“takes” in Bill Gurley’s phraseology) turns on the degree of complicated and bespoke big block transactions that a platform can facilitate.  As this clipping from the Economist explains, the ability to make those markets turns on capital deployed (i.e., willingness to be stuck with a transaction), greater intelligence to figure out for what transactions buyers and sellers can be matched (i.e., how risky it is), and technology (i.e, speed of making transaction happen).

BlackRock, a huge asset manager, frets that much of it is “phantom liquidity” that quickly evaporates when investors try to buy or sell significant numbers of shares, usually known as “blocks”. Being able to trade big blocks is important for asset managers because they may want to raise or lower their stake in a company without affecting prices in the market or tipping off their competitors. In a recent report BlackRock said that trading in blocks consisting of 10,000 or more shares in a single company now makes up less than 7% of the total trading volume of S&P 500 companies, down from nearly 50% in the early 1990s.

Yet part of the reduction is because most banks are allocating less capital to equity trading and are less willing to take on the risk of trying to move these big blocks. That reduces their opportunity to earn juicy spreads rather than modest commissions for carrying out the basic paperwork or trading. “Banks and brokers are our partners,” says Richard Prager, global head of trading at BlackRock. “We need their liquidity, their intellectual capital and their products, but if we have to take the execution risk, then the market tips to an agency model where we pay a commission and not a spread.”

The greater a bank’s market share, the better it is able to sense shifts in the mood of the market.

The challenge for investment banks, then, is to be able to take on execution risk from clients but without having to dedicate too much capital to it. Here again it helps to have a large share of the market. The greater a bank’s market share, whether it is trading bonds or currencies, the better it is able to sense shifts in the mood of the market and the more easily it can match buyers and sellers. That gives it an advantage in working out how risky a bespoke transaction might be, for instance, if a fund manager asked it to sell or accumulate a large block of shares without tipping off the rest of the market. And the more trading a bank does, the more it is able to invest in better and faster systems. The share of equity trading controlled by the five leading banks (Goldman Sachs, Morgan Stanley, Credit Suisse, JPMorgan and Bank of America) has increased by about one percentage point each year for the past few years, reckons Matt Spick, an analyst at Deutsche Bank. Estimates of the total for the five vary somewhat: Mr Spick thinks it is at around 44% but Brad Hintz, an analyst at Bernstein Research in New York, puts it at about 49%.

The Finance Tail Wagging the Dog

Interesting ratio re: finance for the sake of generating economic growth versus finance for the sake of finance:

Most of the finance the expanding banks provided, and the innovations they fostered, spurred economic growth, but a good chunk of it just inflated the size of the financial sector as banks created ever more securities to buy and sell from one another. McKinsey, a consultancy, reckons that about a third of the increase in the world’s debt-to-GDP ratio in the years before the crisis came from banks increasing the size of their balance-sheets; bond issuance by banks during this period was about five times larger than by companies. This trend accelerated after 1995, with only a quarter of the increase in debt to GDP coming from households and companies, an “astonishingly small share, given that this is the fundamental purpose of finance”, McKinsey says.

So, according to McKinsey, 25% of finance is funding the main street economy; the other 75% is arguably a casino.

Career Shorts

This has been sitting in my draft folder for months now, having been forgotten. Appropriately, I found this today and am posting.

This is the economist, Tyler Cowen, on career choice as distortion by short-term signaling issues.

“I think about this a lot: you’re young, you come from a smart, wealthy family, you’re somehow supposed to show that you’re successful quite quickly. Banking, law, consultancy allow you to do this; engineering, science and entrepreneurship less so. Your friends expect it, your parents, your potential mates do … So we see so many talented people very quickly having to signal how smart they are but that may not be the longest-term social productivity.”

Build, Buy, or Prize

I have discussed innovation prizes and Kaggle before as a source of algorithmic or other innovation.

But what about a vivid example in its fully glory.  How about about offering a prize and succeeding to gain publicity, get multiple self-selected teams working on a problem and coming up with a creative solution, and becoming, in the process, known as a place to do cool engineering, making it easier to attract talent?

This is what Netflix did, as described in a recent Businessweek profile on Reed Hastings and Netflix.

His geeky side became fully apparent in December 2005. He was convinced that the star rating system provided all the information Netflix needed to predict accurately what people want to watch. Others at the company argued that more indicators—whether people started playing something and then stopped, or searched for a particular actor, etc.—were needed as well. Hastings spent two weeks over his Christmas vacation pounding away on an Excel spreadsheet with millions of customer ratings to build an algorithm that could beat the prediction system designed by his engineers.

He failed. Still, the attempt sparked the creation of the Netflix Prize, a $1 million bounty to the person or group that could improve its ratings-based algorithm the most. It was the rare meaningful publicity stunt: The winning team, a collection of independent engineers from around the world, built Netflix a better prediction engine. And a company that was famous for red DVD mailers and outmaneuvering Blockbuster started gaining attention as a place for creativity.

Netflix can now hire just about any engineer it wants. That’s a function of the computer science the company does and its reputation as the highest payer in Silicon Valley. Managers routinely survey salary trends in Silicon Valley and pay their employees 10 percent to 20 percent more than the going rate for a given skill. Fired employees also get ultragenerous severance packages; the idea is to remove guilt as an obstacle to management parting ways with subpar performers.

bChat

You are nobody on Wall Street without a hulking Bloomberg terminal on your desk.

in an age of cost-cutting and easily accessible information, that reality is in tension with its $20,000/year annual cost per terminal

The reason for the terminal’s enduring power lies in one of the most powerful and enduring local network effects of our time in the messaging feature of the terminal:

A private network since its foundation in 1982, before email was widely used or social networks emerged, Bloomberg has used its messaging technology to turn its financial data service into the hub of a vast social network.

“Bloomberg is like a very expensive Facebook,” an executive at one rival data company observes.

In a world where many market infrastructure operators provide a cheap, often free messaging tool, Bloomberg reigns supreme. Each day, its 315,000 subscribers exchange 200m messages and have 15m to 20m chats. Rivals have tried for years to break its dominance in messaging, with little success.

Financial groups with security and compliance concerns about Facebook or Twitter like Instant Bloomberg for its security, including biometric identification, and the fact messages are archived and auditable. Users like functions allowing them to share complex data sets, integrate with Yahoo or AOL chat services, or simply see whether someone has received a message. Others have to have it simply because their customers use it.

But network effects while robust are not indestructible, and the current scandal is giving those customers that pay the bills the opportunity to reevaluate alternatives and chip away at the reliance on the terminal.

The Kids Are Doing It

While Facebook started with teenagers/young adults and spread to adults, Twitter is growing in the opposite way:

Adults started with it, and now it is growing among teenagers.  As related in the FT:

Twenty-four per cent of online teens surveyed by the Pew Research Center now  use Twitter, up from 16 per cent in 2011, and higher than the 16 per cent of  online adults who use the site.

“Adults were the first to colonise Twitter,” said  Mary Madden, one of the authors of the new report. “However, teens are now  migrating to Twitter in growing numbers, often as a supplement to their Facebook  use.”

…

Despite its popularity, maintaining a Facebook account is sometimes seen by  teens as an obligation or even a burden, while newer services are more  appealing, in part because they are “less social” or because parents are less  likely to be there.

“Yeah, that’s why we go on Twitter and Instagram,” said one 19-year old  survey respondent. “My mom doesn’t have that.”

A Penalty-Free Cushion

Larry Page, reminiscent this past week of my view on innovation sandboxes and five yard safe zones for permission-free innovation:

“There are many exciting things you can’t do because they are illegal and not allowed by regulation,” he said. “That makes sense – we don’t want the world to change too fast.

Nonetheless, Mr Page said he wished there was a “small part of the world” where such laws did not apply, akin to the anarchic Burning Man festival, held in the Nevada desert every August.

“Technologists should have some safe places where we can try out some new things and figure out the effect on society and people without having to deploy it on the whole world,” he said, citing the limited progress of Google Health as an area where regulations constrained his ambitions.

The New Prison Labor

From Felix Salmon’s article about Bitcoin and digital currency more generally:

That said, credits in World of Warcraft are valuable enough that Chinese prison guards reportedly force convicts to perform monotonous tasks within the game for 12-hour stretches at a time, building up credits which can then be sold for many times the guards’ official salary.)

Perhaps more seriously, there is a great discussion of the relationship between a currency and commodity:

In reality, then, bitcoin doesn’t really behave like a currency at all. In terms of its market value, it looks much more like a highly-volatile commodity. That’s by design: bitcoins were created to be the most fungible commodity the world had ever seen – to the point at which they would effectively erase the distinction between a commodity and a currency.

But is that a good idea?

Dollars are a universally accepted unit of account: if something in the world has a price, it has a price in dollars. Dollars are not, on the other hand, physical commodities. The overwhelming majority of dollars in the world are deposited safely and electronically in banks: there’s something weird and self-defeating about the kind of people who keep their savings stuffed under the mattress. In Hollywood, if you show someone counting out huge sums of cash, that’s an easy way for the director to say that he’s a criminal.

Bitcoin was constructed to behave like a currency: it’s very easy to use bitcoins to pay for goods and services, especially if what you’re buying is in a different country. Right now, there’s literally no way to build a website selling some kind of service, and have a meaningful fraction of the world’s online population be able to pay you for that service. Bitcoin was designed to solve that problem; to be, in effect, thelingua franca of online commerce.

But it’s very hard to be a currency when you’re also a commodity, governed by rules of scarcity and subject to speculative attack. And it’s also very hard to be a currency – or even a commodity, for that matter – when you’re as smallas bitcoin is. Even now, at the top of a huge bubble, the total value of all the bitcoins in existence is the equivalent of about 2,000 standard gold bars– not remotely enough to revolutionize the global payments and currency systems as we know them. Given the choice between something old and solid, on the one hand, and something new and virtual, on the other, the market is still voting for the asset class which has proved its worth over millennia.

Navigating the Cusp

Failure is really about failing in ambition rather than results.

One of my favorite quotes about ambition and “failure” is by Google’s Larry Page:

“His intelligence and imagination were clear.  But when you got to know him, what stood out was his ambition.  It expressed itself not as a personal drive (through there was that, too) but as a general principle that everyone should think big and then make big things happen.  He believed the only true failure was not attempting the audacious.  ”Even if you fail at your ambitious thing, it’s very hard to fail completely, he says.  ”That’s the thing that people don’t get.“”

This is by the other search engine founder – Gabriel Weinberg of Duck Duck Go and it reminds me of Larry Page:

hinking back, a lot of my motivation has to do with a feeling that I’m on the cusp of something big. I pretty much always feel this way. If we just do x, y, z then this is going to be big. There is always something around the corner, within grasp.

For this to work you can’t be completely delusional, only partially. The difference is having a plan.

Of course plans change and things don’t always work out. That’s why picking an ambitious idea is advised; in a huge market almost everywhere you turn you are on the cusp of something big.