In the last post we looked at the 3 main sources of cash flow in the financial services industry:

1. Fees for loaning money to consumers & small biz

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

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

In this post we will look at some of the modes and ventures that are attacking these markets.

P2P Lending: Fees for loaning money to consumers & small biz

Peer To Peer (P2P) Lending is an obvious end run around the banks and ventures in this space are already quite mature. But the clear winner has not been declared, nor has this got even close to crossing the chasm into the mainstream.

P2P Lending is great when there is collateral such as a house. Mortgage lending could be totally disrupted by this model. The risk to the lender is low. That is why it is such a sweet business for banks. If you do a normally amortizing loan and get a 20% down-payment, the lender's risk is minimal. Only if housing prices crash more than 20% do they lose anything and it takes a much worse crash than that to really put the mortgage lending business into trouble (on normal amortization most borrowers will have more than 20% equity and borrowers don't walk from their homes unless they are very deep "under water").

On the other side of the transaction, a saver with some spare cash gets lousy interest on bank deposits. This is a classic Internet exchange model of disintermediation; the software is trivial.

Ventures with current traction in P2P lending include: Prosper, LendingClub and Zopa.

One holdup at the moment is regulatory restrictions. The most recent news is that this maybe lifting. This from http://www.wiseclerk.com, a site that tracks P2P Lending:

The House of Representatives yesterday passed a bill that will move regulation of p2p lending services from the SEC to the newly created Consumer Financial Protection Agency (CFPA) in Spring 2010, provided the Senate and President Obama approve the new legislation. Oversight by the SEC meant that Prosper, Lending Club and other p2p lending companies in the US had to go through an arduous registration process in the past, which forced them to close for new business for several months. Zopa even decided to exit the US market.

VRM: Reversing The Model On Credit Cards

P2P Lending firms are also going for this market, but credit card lending is harder than mortgage lending because there is no collateral. This business is driven by huge databases that determin interest rates based on credit status. This is where the credit card companies currently have the information asymmetry on their side.

There is another model that has not got serious traction yet, at least in America. This sometimes goes by the name VRM for Vendor Relationship Management (usually referred to as the inverse of CRM). In China there is a similar but simpler model of buying clubs (aggregating demand to get a discount). Many ventures in America have tried the buying club model and failed, but some do seem to be working in China. The value proposition is very strong and totally amenable to social media.

Here is how it could be applied to one of the big financial industry cash flows - credit card fees. You know those "click here to agree to our terms" that you never read and which come back to bite you later with nickel and dime fees? The credit card industry relies upon this. What if a million users signed on via some social media site to a standard set of terms that were reasonable to both parties? Then all million say to any credit card companies "click here to agree to our terms." If one person says that, they have no chance. If a million people say that, they have some clout!

VRM and P2P Lending are related models. If the "open model credit card agreement" was reasonable for the lender as well as the borrower, then the response to the borrower's request can come from an institution (ie VRM/Buying Club model) or via P2P Lending. The borrower gets the same deal.

Factoring Exchanges: Hope For Small Business Lending

Lending to small companies is a tough business for 3 reasons:

1. You have to evaluate the credit risk of both the individual and the business. That is complex.

2. The collateral tends to be weak. It is either rapidly depreciating equipment assets (try flogging off 2 year old PCs) or commercial property where the value is actually tied to the health of the business and the neighboring businesses (meaning that this is horribly complex to evaluate).

3. Evaluating the cash flow risk on a business is hard at the best of times and particularly hard at times of disruptive change. As an equity investor you can take the time to evaluate this as you have a good upside. If you are lending with a normal spread of 3-6%, you have relatively little upside and masses of downside.

That is why the reality of really small business lending is that it is based on home equity loans or credit card loans.

But we see one venture going after this market that is very exciting - Receivables Exchange.

The basic idea has been around since trade began. If you have an invoice to a customer with good credit quality that will usually get paid in 45 days, you can get cash now from a financial firm for a fee. This is called "factoring." Receivables Exchange applies digital economics to this old model. They are getting traction in the market and serious capital from smart investors. A group of investors led by Bain Capital Ventures recently completed a $17 million in Series C financing.

Who Will Disrupt International Trade Finance?

The final cash flow from consumer/small business finance we will look at is International Trade Finance.

This is a big emerging opportunity. It used to be that only big companies could trade globally. Now you can do that from your bedroom. We are entering the era of the "micro-national", really tiny companies that do business globally online.

This consumer and "micro-national" trade finance market is in early stages and needs solutions that are radically simpler and lower cost than traditional letters of credit offered by banks. This will leave the banks with a classic innovator’s dilemma; they don't want to cannibalize their existing trade finance line of business.

But this is a complex business, mostly because trading globally requires interfacing with local banking systems (in the end some cash is needed in a traditional bank account) and that is highly regulated and each regulatory authority/government guards the right to control that zealously.

Paypal is very well positioned to grab this and betting against Paypal is generally not smart. But Receivables Exchange, or something like it can come at this from a different direction.

Who will be the Skype of P2P Lending?

P2P Lending maybe in the phase that the VOIP market was in before Skype. Skype was hardly the first venture to go after VOIP, but it was the first to break through to the mainstream.

Who will be the Skype of P2P Lending? Here are the 3 components that drove the success of Skype:

a) Scalable technology,
b) A screamingly strong value proposition and
c) A viral model that reduced the cost of customer acquisition.

Two out of these three are not hard. Scalable technology is not hard; this is a simple exchange model. Nor is it hard to find a strong value proposition, as the spread charged by banks is big enough. The tricky bit is how to reduce the cost of customer acquisition. If you need Superbowl ads to sell your P2P Lending service you won’t be able to offer that screamingly strong value proposition.

It is not impossible to imagine viral growth as there are two parties to any transaction and once one party signs up they rope in the other party and each of those parties is talking to other potential parties in the transaction.

The basic model for P2P lending comes from social media. But we also see a role for big databases that help assess credit-worthiness and collateral valuation. In the past you needed to be a big bank/credit card company to access this type of data. Today we can see the prospect of Linked Data resources, driven by government initiatives such as Data.gov, making this available free to everybody.

Let's now move from the staid world of consumer banking (which is about to get a lot less staid) into the wild world of Wall Street. Lets see where the innovation might come in corporate banking.

Web Innovators In Corporate Banking

This is a B2B market and we gave it a B- Opportunity Rating: Proceed With Extra Caution. Since Web 2.0, the consumer markets have led innovation. In these Corporate Banking markets it is likely that the current incumbents will innovate and compete against each other as they have done in the past. A truly external disruption is less likely in these markets (but as always with these predictions that nothing new will happen, I love being proved wrong! Tell us in comments what I am missing).

Lets look at the different segments – IPOs, M&A, Bonds, Forex, Derivatives.

IPO

When Google did their IPO via an auction model, many of us saw this as Silicon Valley telling Wall Street that disruption to this cash cow was on its way. That never happened. Wikipedia has a good summary of the history:

"A venture capitalist named Bill Hambrecht has attempted to devise a method that can reduce the inefficient process. He devised a way to issue shares through a Dutch auction as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters, however, have not taken to this strategy very well. Though not the first company to use Dutch auction, Google is one established company that went public through the use of auction. Google's share price rose 17% in its first day of trading despite the auction method. Perception of IPOs can be controversial. For those who view a successful IPO to be one that raises as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open market-more institutions bid, fewer private individuals bid. Google may be a special case, however, as many individual investors bought the stock based on long-term valuation shortly after it launched its IPO, driving it beyond institutional valuation."

Why did the auction model not become the new normal for IPOs? There are two theories:

1. The IPO market was lousy, held back by Sarbanes Oxley, as soon as it returns the auction model will be the norm.
2. The auction model was seductive but flawed.

I tend to the latter view. We had a reasonable number of tech IPOs in 2005, after Google in 2004, yet the auction model did not take off. Think about it from the point of view of the founder/CEO/Board of a venture heading to IPO. Sure you can cut out those 7% fees by doing an auction. But if it was your venture and it took you 10 plus years of "blood, sweat, toil and tears", would you really take that risk?

M&A

After eBay, almost everything that could be sold via an online auction was attempted. The fees to buy/sell a company are high. This is the core of the investment banking business. Why can you not buy/sell a company like pork bellies or junk from your attic?

The low end of the M&A is always open to lower cost intermediaries. But this cannot be a large scalable online opportunity. That $2m company sale may look tiny to the intermediary but it is mission critical to both the buyer and the seller of this tiny transaction. This will always be driven by relationships and the process will be slow, careful and people intensive.

We may see incremental cost savings related to legal and accounting fees. This is critical but not a game changer for the whole process. (It is however a game-changer for the legal and accounting professions and we will look at that in future posts).

Bonds & Forex

The Bond market (corporate, government and municipal) is huge and already highly efficient and automated. The Forex market is similar.

These could be ripe for disruption, as they tend to be commodity transactions with simple parameters (in an IPO or M&A transaction, you have way more parameters and human issues to evaluate). But this innovation is likely to come from within Wall Street not from an outside tech venture.

The one area that is ripe for disruption is corporate credit ratings. Clearly the credit rating agencies failed us. New models based on standards such as XBRL, "expert sourcing" (crowd sourcing but where the expertise of people in the crowd is rated and that rating affects the rating that they give to a company) and open data may create a game-changer. There are ventures in this area, but nothing that has gone mainstream yet; this is not surprising as this is a complex market with in built conservatism.

Derivatives

These are what Warren Buffett called "weapons of mass financial destruction" and he said that well before the financial market meltdown in Sept/Oct 2008.

This is ripe for disruption using a mix of open data and open models to shine a light on all those murky pools of assets. This could come from outside Wall Street, because Wall Street firms are too invested in the current model.

But this is a complex Proceed With Caution opportunity. Just to get into the game you have to have a huge depth of knowledge about how these derivatives actually work. Then you have to codify that into models and systems.

And that is just the price of admission. Once you are in the game you will encounter fierce resistance from the current incumbents and these guys know how to compete!

But we think that a game-changer could emerge in the next few years and could be spurred on by regulatory pressure (given the systemic risk posed by derivatives).

In the final section of this post, we look at innovators going after the last of the 3 big cash flows in financial services, fees for managing and growing your money.

Flow # 3: Fees For Managing And Growing Your Money

In the old days, you had a stockbroker. Yes, a real person that you called on the phone. The broker would give you some stock tips and execute the buy/sell transaction you wanted.

When the Internet arrived, a bunch of entrepreneurs realized this was ripe for disruption and that the transaction could be done online much cheaper. Thus was born eTrade, Ameritrade and other firms that competed by offering increasingly lower costs to buy/sell stock.

The result was a massive decline in the price a broker could charge to execute a trade.

That's OK, the brokers made it up on volume. The ease and low cost of online trading brought on the day traders, lured in by dreams of making $ millions at home in front of their computer in their pajamas.

The Dot Com crash ruined day trading game and the fast money folks moved onto flipping condos in Florida. A few people still make a good living as day traders, using smarts and discipline to outwit the big guys every day. We are seeing the re-emergence of the ones who stuck with it in ventures such as Kaching and Covestor; more on them later.

Free Research: Like Free How To Beat The Casino Manuals?

The stock market is regulated. Insider trading is illegal and people who break this law do go to jail. So to win in the market, you need good research based on publicly available data. The base data as reported to the SEC (or their equivalent in other countries) is freely available, in the public domain. But the base data needs to be analyzed to spot investing/trading opportunities. The trouble is, good research costs real money to produce. It is not just a digit flip on a computer. You need humans who have a lot of training and experience to do this research and they need to be paid somehow.

The brokers figured out a way to do this. It is called a soft $ commission. Here is how it works. If you buy/sell stocks through my brokerage I will give you access to free research. I will then pay independent research firms to give me access to their research, or if I am big firm I will have my own in-house team of researchers.

In short, brokerage fees subsidize research.

Cynics might equate this to a casino giving away free "how to beat the casino" manuals in the certain knowledge that in aggregate and over time the casino always wins. The analogy is a good caution against frenetic trading (as opposed to patient investing) but it is flawed. In a casino, it is almost all luck. In the markets, good research and discipline can lead to consistent winning. Just ask Warren Buffet. That is rare, but it is possible and it is not just luck.

Will We Go Triple F - Fixed To Flat To Free?

Will trade execution ever be free? We have already gone from Fixed (commissions were fixed before deregulation in the 1970s in US and 1980s in UK) to Flat. Will we see the final jump to Free? Matching buyers and sellers online is very cheap and getting cheaper every day. The marginal cost is close to zero. Web 2.0 models have shown us that when marginal cost approaches zero, entrepreneurs find ways to provide a free service and monetize it somehow.

The early disruptor in brokerage fees was Charles Schwab. They were the original, pre-Internet, discount broker. When the Internet allowed eTrade and their peers to disrupt the disruptor, Schwab floundered for a while. But now they seem to have found their feet again and have positioned as a custodian to service the independent financial advisers.

That is a smart move. The barriers to entry in the custodian business are high, because it is based on trust. Bernie Madoff taught investors the value of an independent custodian (His scam, simplified, was telling investors "I am holding these stocks worth $x in your account. The stocks were worth $x, you could check that on any site. But he was not holding the stock. Using an independent custodian such as Schwab is the best policy to prevent being scammed in this way).

Schwab figured out that trade execution alone is a race to the bottom. But, while a free service is possible, we don't think it will happen because the ways to monetize what will still cost something are suspect. Selling ads won't work when the execution happens deep in a server farm without any valuable eyeballs or when those eyeballs are not paying any attention to anything other than executing a trade. The only intention that can be monetized is to execute a trade - which is free....?

But we think trade execution will get cheaper and cheaper. Which means that trade execution is no longer a big cash flow that can subsidize everything else. Specifically, trade execution can no longer subsidize securities research.

Fours things are impacting this model:

1. Regulation against soft $ (paying for research through commissions on trade execution fees).

2. Declining brokerage fees (thanks to the Internet).

3. Availability of free online, ad supported, research (thanks to Yahoo finance, Seeking Alpha and their peers).

4. The advice of experts that frenetic trading is usually less profitable for individual investors than patient investing (and is certainly less tax efficient) is starting to get through to consumers. In other words, don't count on "day trading 2.0" to save the day!

But without research, analysis and insight we are all just swimming in a pool of useless data. So, who will pay for securities research in future?

The Long Tail & The Search For Alpha

Look at securities research as a pyramid of value. At the bottom is freely available base data. This has to be free, that is what the regulators insist upon. Reg FD makes sure everybody gets that base data at the same time. The Internet makes that data easy and instantaneous to distribute (no more sending of financial reports via snail mail).

There is no value at the base of the pyramid. The folks selling storage and server farms may make a bit of money but that's it.

The next layer up is analysis. This is what we use spreadsheets for. To boil it down it is about "comparables". That is what those spreadsheet jockeys (who used to be in New York and London but are now increasingly in India or other low cost centers) are doing. These comparables enable you to quickly compare one stock with a bunch of other stocks based on a set of parameters.

The tools to do this are getting better. The cost of doing what needs to be done manually is being reduced by off-shoring. The big game-changing technology here is likely to be XBRL. To take just one market, by 2012 all US publicly traded companies will be reporting in XBRL. We anticipate an explosion of tools to make it easier to analyze XBRL data and automatically produce comparables. Most of the tools will use open source or readily available low cost tools - the basic tool will probably remain something that looks very similar to our current spreadsheets.

From Fees To Trade To Fees To Manage

If the first money pot - the fee to buy/sell a stock - looks like it is getting smaller where is the cash flow today? It has shifted to fees for managing money. This can go as high as 3% for a fancy hedge fund to as low as 0.2% for passive index funds. But even 0.2% at a huge scale is a very big business. Just do the math on managing $100 billion in passive funds at 0.2%. Yes that is $200 million a year in revenue. "Passive" means that there are expensive humans making decisions. Therefore digital economics apply and marginal costs approach zero. That sounds like a good business.

Which is why ETFs are taking off like a rocket.

Low Cost Index Funds Are Sensible, But….

In the old days, individuals bought stocks and bonds. Then it became accepted wisdom that individuals could not do that properly so the mutual fund was invented. Now it is accepted that actively managed mutual funds don't in aggregate earn enough extra performance to pay for the fees. So now we have index funds with very low fees (Exchange Traded Funds, ETF).

ETFs are hot. The basic rationale, promoted originally and consistently by Vanguard, is now well accepted. But at some stage this runs against two hard problems:

1. Index Funds are a free ride on the active stock picker. At some point, somebody has to make buy/sell decisions on individual stocks. Today Mutual Fund managers do the stock picking. But if ETFs eat their lunch they cannot do that.

2. You can only make money on Index funds at massive scale (while the data processing is cheap, the marketing is expensive). A few firms, such as Vanguard and BlackRock, have that scale. That does not leave millions of other fund managers with anything to do. So they are inventing actively managed ETFs with higher fees!

3. It is human nature not to like being average. The “you cannot beat the market so you should just track the market as cheaply as possible” advice is totally sound. So is the advice to eat your greens and abstain from booze and rich food!

Profiting From The New Search For Alpha

“Alpha” is what “hot” investors/traders tell you they have when they beat the average. It is human nature to believe this and search for it. In the day trading days we saw a lot of amateurs give this a go and fail. Now some more seasoned veterans are returning to the game using social media models. This time they don’t just want to trade their own money, they want to trade your money as well. They are becoming like Mutual Funds. More accurately they are becoming like Hedge Funds as they are very lightly regulated – “investor beware”, the government is not there to protect you.

You see these hot investors/traders turning up on many online sites that have moved beyond the simple stock forums of Web 1.0 to sophisticated social media investing services. There are 4 new ventures that are getting traction:

1. SeekingAlpha. Their content is provided for free by bloggers who want to show off their expertise. It is unclear how Seeking Alpha or the bloggers will make money but they are getting a lot of free content and good traffic.

2. StockTwits. This started on Twitter but is now a standalone site that interfaces to Twitter. The focus is fast moving news about stocks. But the basic model is the same – free content from experts who want to promote their expertise.

3. CoVestor. This enables you to “follow” a hot trader’s deals and automatically do the same deals.

4. Kaching. The model is similar to Covestor, but the style is different. Kaching is brash, rhymes with bling and a cash register ringing; Covestor is more like an investing club, tea and biscuits at the library. But the end game is the same, fees under management. These are not the 0.2% passive fees, these are hefty fees for hot traders who can outperform the market.

Or maybe they cannot beat the market. The message that "fees matter" is resonating with ordinary investors. So who will be attracted to these Hedge Fund 2.0 types with high fees? It is possible that if they went to a pure performance model that consumers will buy in at scale. Hedge Funds and Private Equity Funds work on 2 and 20 model (2% of funds under management and 20% of the profits). What if these disruptive ventures and the new style Hedge Funds that drive them were to take away all your risk and offer 0 and 30? You pay no fees until the profit is created and then you pay 30%.

Or even more enticing, what about 0 and 50 but where the 50% is above the market index. Would you give somebody your money to play with (assuming it was safe with an independent custodian) if the money manager only made money if they beat an index like the S&P 500?

In the third post on the Semantic Wave hits the financial services industry we indulge in a bit of science fiction. We will assume that technology that is currently developed becomes widespread and then imagine what this will do to the current market landscape.