During September and October 2008, the financial markets had their meltdown moment. It was scary as hell for anybody who was even remotely close to the action. As a precipitator of the Great Recession, it has impacted us all. But that is all history, right? The stock market is up and everything is back to normal? Wrong. Politicians will regulate the markets so we can get back to normal? Wrong. What is happening under the surface is a much bigger wave, driven by the Internet that is fundamentally shifting the economics and power structures of the financial services business.

This is the first of ten markets in our Semantic Wave series (click here for the introductory posts that set the scene).

The Twit Summary

In the olden days an Executive Summary had the luxury of a whole page to get to the point. In the post-Twitter attention deficit age, we have to summarize in 140 characters. Here is the Twit Summary:

The function of financial markets – matching investable capital with users of capital - is ideally suited to the Internet & that changes everything

The matching function is digital. So the cost of doing that approaches zero. The price of doing that today is a long way from zero. That creates a lot of danger for incumbents and opportunities for start-ups.

Disrupters vs Feeding The Old Models

There are opportunities even when a market remains at Act 1, but they tend to be small and constrained. These ventures tend to just feed the old models. These incremental ventures typically either sell better technology to large financial enterprises, or they become lead generation engines for the current big intermediaries.

These are all viable, but they are not the big disrupters that create multiple new multi-$ billion companies. To do that, you need to go after one of the 3 big cash cows.

1. Fees for loaning money to consumers & small business

2. Fees for connecting providers and consumers of capital for large companies.

3. Fees for managing individual's (aka "consumer's") money.

Sticking my neck out: I will categorize each of the three cash cows by how ripe they are for disruption:

A: Full Steam Ahead (and damn the torpedoes). Somebody is going to make a fortune here, so it might as well be you.

B: Proceed With Caution. There is a possible opportunity, but wow it is scary out there, tread carefully.

C: Stay Clear. Probably a danger zone (I love being proved wrong on these!)

Flow # 1: Fees for loaning money to consumers & small biz

This is what we normally call consumer finance or retail banking. I put small biz in the consumer pot, because the way a bank lends to a really small local business is similar to how they lend to an individual.

There are 4 parts to this cash flow and they are very different markets – mortgages, credit cards, lending to small business and international trade finance:

a. Mortgage Loans. This is a sweet business. Banks get a spread of about 3% on sound collateral. Well they did before going off the deep end into sub prime lending. The old rule of banking was 6, 3, 3 as in "lend at 6%, borrow at 3% and tee off on the golf course at 3pm". During banking crises, the government helps out the banks that have messed up by loaning money to them at zero interest. So, during these times, the rule changes to 6, 0, 3. ("Hey, don't mess with the golf bit!").

Opportunity Rating: A. Full Steam Ahead. But note that P2P lending has already got some traction and is the obvious disruptive model.

b. Credit Card Fees to consumers. This is a more difficult business. At scale it is hugely profitable as the defaults are spread across a big base (and the interest spread is huge). But without huge data sets to work on, it is hard to assess credit risk. (Unlike mortgage lending, you don't have collateral).

The pain point opportunity is certainly there. Consumers are fed up being nickle-and-dimed through "click to sign here, we gotcha" contracts. But it is not obvious how to meet that need.

Opportunity Rating: B. Proceed With Caution.

c. Lending to small business. This is the engine of the economy. Small businesses need capital to create jobs and without job growth all the other opportunities go to hell. This is what we think banks should lend to. This is what regulators will tell banks to lend to. But that usually does not work. This is a tough business. But we can see at least one venture with a disruptive model going after this market.

Opportunity Rating: B. Proceed With Caution

d. International trade finance. I put this in the consumer/small biz pot. Traditionally this has been in wholesale banking and we called it Letters Of Credit. But now that individuals and tiny businesses can trade globally the market is way bigger. But this also has to be way simpler for consumers; don't tell them about Letters Of Credit. Trade finance is complex because the parties in the transaction don't trust each other, so you get this dialogue:

"pay me and then I will send it"

"no, send it and then I will pay you"

The trade finance intermediary takes a cut by taking way the risk, guaranteeing payment to both parties. They are effectively lending to ensure the transaction.

Opportunity Rating: B. Proceed With Caution.

Flow # 2: Corporate Banking

Here the main components of this cash flow:

a. IPO Fees.
b. M&A Fees.
c. Bond & Forex markets.
d. Derivatives.

Whereas Cash Flow # 1 is a consumer game, this is a B2B game. In general I rate this opportunity as a B (Proceed With Caution) for four reasons:

1. This is where Wall Street firms are already innovating and competing amongst themselves. This is their home turf.

2. This is mission critical for the consumers of capital, the big companies. So they won't experiment just to save a bit of money. They will take conservative "you never got fired for..." type decisions.

3. The business is driven by personal relationships - all those lunches and golf games – making this less suitable for automation.

4. These involve complex systems, processes and data. Just to get into the game requires a lot of development.

Flow # 3. Fees for managing/growing money

The fundamental basis of capitalism is that money makes money; as long as it is invested well. We often make the distinction between trading and investing, but the difference is not a conceptual one, it is simply about time duration. I might "invest" for 30 seconds using technology to exploit tiny price inefficiencies. Or like Warren Buffet I might invest for decades (or, as he puts it, "forever").

The money that is being invested is your money. This is about retail investors (aka consumers). Companies invest by buying businesses or growing existing lines of business and put their excess cash into bonds (which is part of Cash Flow # 2.)

It does not look like it is your money because there are so many intermediaries in the process. Follow this trail. You work as a teacher for decades and your savings go into a retirement fund that hires a manager to invest it. That Limited Partner (LP) puts money into a Private Equity fund run by General Partners (GPs) who buy stakes in private companies. It is still the teacher's money. She has just hired a bunch of folks to manage it - which means grow it into a bigger pile that will fund her retirement.

This market has a huge “disrupt me” written on its back! This is a Category A: Full Steam Ahead opportunity. It fits the Web 2.0 model of consumers leading the way. Not surprisingly, this is a sector where entrepreneurs are already very active, as we will see in the next post.

But we are at the very, very early stage of this game. The current innovators may be the straws in the wind of change. The big winners may have not made their entrance yet.

There is also a lot of money at stake. That means that the incumbents won't give up easily. This will be an interesting one!

In our next post we will look at the current innovators, the new ventures in what is sometimes being called Finance 2.0.