How to disrupt Wall Street

http://cdixon.org/2010/01/23/how-to-disrupt-wall-street/

by olalonde • 15 years ago

65 24 15 years ago

sachinag• 15 years ago

Between Blueleaf and BankSimple, I think all of these points (save the investment banking one) are being attacked. Fun note: we share an investor in Sean Park (http://seekingalpha.com/author/sean-park).

po• 15 years ago

A Cynical Theory: anyone with the power, money and government connections needed to disrupt Wall St. will choose instead to join Wall St. when the option is given to them. Fight the good fight or join the party? Those who aren't willing to make the right choice will be weeded out of the system before they are influential enough to disrupt. Any techniques used by outsiders who try to disrupt the party anyway will be made illegal through regulations, trademarks, patents, contract law or legislation drafted by lobbyists and rubber stamped by well-funded politicians.

I can think of a less cynical and more hopeful view too but I think it's something anyone entering this space needs to be aware of. I don't think it's a technology problem.

yuhong• 15 years ago

Reminds me of the mess created by both telcos and Google lobbying on net neutrality.

cletus2• 15 years ago

Firstly, the title is a misnomer. There's nothing here about how to disrupt Wall Street. It's all what needs to be done without knowing how.

Some thoughts:

Investing banking is an interesting case. On something like an IPO I see IBs as providing three benefits:

1. Navigating the significant regulatory hurdles;

2. Underwriting the offering; and

3. Marketing the offering.

(2) and (3) are related. (3) relies on them having clients with the money to invest in the IPO.

This isn't a simple issue of finding money. Part of a successful IPO is seeding the stock such that trading on the relevant market(s) is liquid.

Not that I'm saying disruption isn't possible but it is hard.

Investing in the stock market directly is, for most people, a sucker's game. The stock market is an insider's market. HFT is just one of many ways that the pros will take advantage of you.

Note: I quite deliberately differentiated between trading (short term) and investing long term. Long term investing reduces the significance of timing and transaction fees but individually picking stocks is still a risky business.

As for prop trading, for completeness I should point out that it is one model for market makers to trade for profit, paying for what is actually a valuable service. Market makers are commonly daemonized, unfairly IMHO. Market makers give you the liquidity to buy and sell whenever you want.

The other trading method is spread trading, basically making money off the bid-ask spread. The spread is basically inversely proportional to the size of the market. In smaller European markets, spread trading is still profitable. In the US government market (basically US Treasuries, possibly the largest market in the world) the spread is essentially zero so the only way to make money is prop trading. Prop trading means taking a position, betting on a particular outcome.

Arbitrage is another model but computerized trading system has greatly reduced the effectiveness of this. Arbitrage is buying some security on one market and simultaneously selling it on another for a higher price, pocketing the difference (eg buy gold in NY, sell it in HK).

As for mutual funds, they have been disrupted by ETFs (exchange traded funds), which greatly increase the liquidity of such investments and decrease transaction costs. Funds also like them because fund redemptions are a huge problem. Typically people take out and put in money at the wrong times. ETFs mean investors can get money out by simply selling them on the stockmarket.

Still, fund managers do make management fees.

Financial products are constantly changing. It's an area that, by its nature, must and does constantly innovate. For example, 10 years ago there was no way for retail investors to short stocks. Now? Most markets have CFDs (contracts for difference) that are a derivative that allows you to go long or short on a stock for a low amount of capital.

Research is an interesting one. Good analysis is a skill and requires access, something a name brand bank provides. That being said, it is an area rife with conflict of interest and late signals.

Retail banks have of course been somewhat disrupted by their online cousins.

Wall Street is constantly changing. It's an arms race where one side trades faster so all the other players do as well. Unfortunately, Wall Street enjoys significant government protection, much to our detriment (eg financial crises brought about, at least in part, by Wall Street having little to no aversion to risk, IMHO due to the almost guarantee of a bailout by the Fed if it goes south).

The most important area of the finance industry is retirement savings and here the US is extremely backward. Companies allowed to invest pensions in themselves, one part of a bank dragging down everything else with it and so on.

In Australia, for example, most people have individual superannuation accounts for retirement savings. There are very strict rules on what these funds can invest in. Such funds are separated from (and insulated against) whatever else happens to the financial institution. The funds are held in trust by third parties.

AlexMuir• 15 years ago

Covestor is more along the lines of disrupting Wall St.

mlinsey• 15 years ago

FutureAdvisor (YC S10) is addressing several of these - particularly the ones that involve Wall Street taking money in fees from unsophisticated investors.

btilly• 15 years ago

Yet another way to disrupt investment banks. Make every startup owner aware that the size of the "pop" on IPO day is the amount of money that the company failed to get and could have. Furthermore much of that money went to the investment bank that took you public, and that banker's close friends. In short, it is a form of theft.

Luckily there is an easy way to avoid this theft. And that is the Dutch auction IPO.

Note that Wall St really, really hates these. It took them some time to forgive Google for doing one. They result in less work for the investment banker, and avoid the hidden fee of having a first day pop.

cletus2• 15 years ago

/sigh, that simply isn't true.

1. IPO investors are taking on a risk by investing. For that they get a return. IPOs can drop on first day too.

2. The bank typically underwrites the IPO. That means if there is a shortfall, the bank kicks in the rest. That is a risk for which the bank gets a return.

3. By "close friends" you mean the bank's clients. If demand exceeds supply you can sure bet their best clients will be first in line.

4. A price band is determined ahead of time. Its required for the prospectus. Determining demand is aguessing game. Better to be oversubscribed than under.

5. Having the press of being oversubscribed is good for the bank and the company. Lookup the illusion of scarcity.

6. For the same reason a big day one jump is good for both and it sets the tone for the stock to the markets.

Auctions have been tried, famously with Google. Even then there was a big day one jump.

yummyfajitas3• 15 years ago

The thing is, Dutch Auction IPOs just don't usually work very well. They worked for google since it was a huge and well known name, but they don't work nearly as well for the long tail of AMEX.

http://www.marginalrevolution.com/marginalrevolution/2010/07...

patio11• 15 years ago

On the plus side, the Internet has already dealt a mortal blow to one value-destroying participant: human brokers. (Anyone remember the bad old days where you had to talk to an actual human being to place a stock trade, and would be charged hundreds of dollars for doing so? And they would call you up and give you bad advice to maximize their churn in your account and, hence, their commissions?)

I loved Prosper (crowdsourced P2P loans), which was mentioned. However, the primary barrier to Prosper's success has not been regulation (a somewhat surprising statement, considering they were shut down for securities laws violations for the better part of a year). The primary barrier to Prosper's success is that their product is strictly inferior to credit cards for anyone who can get a credit card, which means you have an adverse selection problem for borrowers -- the only people who apply have either maxxed their cards or would never be given one in the first place. As a result lender returns are terrible -- many lose principal, and a huge majority underperform substantially risk-free investments like T-bills or CDs.

I'd love to see an innovative option for consumer or small business loans, but it has to compete with this deal: up to $15k delivered instantly (or in 2~4 days), 4% transaction fee, 1% interest for 12 months followed by ~15% interest for life. That what Bank of America will offer me -- right now, instantly, no-human-involved-whatsoever -- for a cash advance on my credit card. Could that deal be improved upon? Yes. But the fact that that deal is possible is, and I say this with no hint of exaggeration, a triumphant monument to the success of capitalism. Many of us Prosper lenders thought it would be easy to beat that with a little human touch. We were dead wrong.

Prosper's original model was, basically, I put on a two week dog-and-pony show on their loan auction page, attempting to convince fickle lenders that I am a good credit risk. In return, I get $X,000 less a 1.5% or so fee (can't remember -- it is higher now) deposited in my bank account about four weeks after the day I start the process, at whatever the auction came up with for an interest rate. In my case, it was 12%ish.

I got a Prosper loan, and all participants in it (Prosper, lenders, myself) benefited from it, but that was for the quirky edge case. The average case was murderous to lender returns.

gdberrio4• 15 years ago

Disrupting Wall St. implies not just making a "new" UI/UX/Interface for banking clients (like Mint or Square), it implies looking at changing the Banks inherent Business Model. Can Silicon Valley pull it off? Well, from a foreigners perspective (commenting from Lisbon, Portugal) Silicon Valley has a very engineer centric perspective on problem solving, and while engineering inputs may be useful, this is not an engineering problem, it's an economics problem.

Take P2P loans (Zoppa, Prosper, Lending Club) for instance. Why aren't they gaining traction? Because while they try to change the main Business Model for banks, they fail to solve the fundamental problem of Information Assimetry. That's the "reason d'etre" of the Banks. Banks business model is not just "skin you alive in loan fee's", they solve what we economists call "Adverse Selection" problem: how to sort good from bad credit. They are basically information arbitragers. They pool your credit info, compute a score, and sort loan suppliers with loan demand. The cost of doing so is expensive for an individual investor. And there is a problem of "preference revelation", or, in layman's terms, people lie and try to free ride.

That's why banks exist. Is the model ripe for disruption? Yes, it hasn't really changed fundamentally since the last 300 years since the "Venizian Banca" but for that one need to solve the affordable decentralised sorting between creditors and debtors accounting for fraud, incentives to lie and free ride and asymmetrical information.

IMO, Facebook brought a good innovation to the table. And no, I'm not talking about the "like button", social hype (attach social to something and somehow you have an Alchemical transformation of iron to gold): Applied Network Theory.

Social Networking might be a good research direction to solving the P2P information problem solving, by revealing our preferences.

Payment methods have a different problem to it: fraud. You can, and usually do, bleed money on it. Paypal did, and still does. To counter it, you make it more painful to do transactions (that's why Paypal is, sometimes, bloody annoying). Pain acts as a filter to fraud. That's why Banking is so cumbersome. Again, pain as a filter for fraud. Think of it like this: Google could reduce spam by making it painful to search and index (reductio ad absurdum oversimplification). It's a simple "no innovation" solution.

There is a lot of innovation to be made. But it's a bit more complicated. It's not just "make a new cute web 2.0 interface to sort your personal finances" like Mint.

Just my 2 cents.

(PS: pardon the occasional english typing error. Not a native speaker)

stcredzero• 15 years ago

Banks business model...they solve what we economists call "Adverse Selection" problem: how to sort good from bad credit. They are basically information arbitragers. They pool your credit info, compute a score, and sort loan suppliers with loan demand. The cost of doing so is expensive for an individual investor.

So one way to disrupt banks would be to put these resources in the hands of an individual.

Social Networking might be a good research direction to solving the P2P information problem solving, by revealing our preferences.

I heard or read somewhere that much of the lending for small businesses and startups happened through one's personal network. Here may be an excellent opportunity for Facebook. This is also an area where the information asymmetry is often reversed. (For example: Your crazy uncle Zeb might look a good credit risk to the bank, even though you know it's all because your aunt was managing the money until she ran off to Belize with the plumber last year.)

gdberrio4• 15 years ago

"So one way to disrupt banks would be to put these resources in the hands of an individual."

Well, not quite, IMO.

Because technically those resources are not the Banks own resources. They are the Deposits. That's why Banking is an inherently leveraged business (and unstable by definition). You take deposits to fund credit, making money circulate (and earning your fee's for the "job", aka, arbitrage).

And, by putting the resources the Bank has in the hands of an individual creates another bank, i.e., a single institution whose porpuse is to evaluate and arbitrage information assimetries and balance fund demand with fund supply.

"Social Networking might be a good research direction to solving the P2P information problem solving, by revealing our preferences."

Yes, it could, but it implies they go over the engineering culture they have. It's not an engineering problem, it's an economics one. It's like Google trying to solve a Customer Support problem. They're really not good at "human interaction" ;) Point is, you don't solve it with some hard coding. You solve it with proper incentives structures and market design.

yummyfajitas3• 15 years ago

how to sort good from bad credit...So one way to disrupt banks would be to put these resources in the hands of an individual.

This has already occurred. It's called a "credit report" and is available even to individuals (my landlord, for example).

lefstathiou2• 15 years ago

As a banker, I am painfully awaiting the day someone comes along and disrupts Bloomberg. What an unbelievably frustrating system...

gdberrio4• 15 years ago

As a trader, I totally agree!

dabent• 15 years ago

I'd love to hear what the pain points of using Bloomberg are.

jreposa• 15 years ago

Disruption is happening. We're about to launch a platform which takes a $100 Bn market and democratizes it by putting it online. And, we have some key Wall Street support.

The people who are creating these disruptive technologies are the insiders who have intimate knowledge of these systems. It's not necessarily going to be a new GUI on top of an old idea, as someone else put it in this thread.

My original comment to Chris is over a year old on that very same blog post. It's actually a bit embarrassing, since I really should have found a better way to try to contact him.

yummyfajitas3• 15 years ago

Wall Street is disrupted all the time. Major disruptions in many of the specific items he talks about:

4) The internet disrupted trading on the broker side (you pay $0-$8/trade now). Used to be a LOT more. HFT disrupted trading on the market maker side. It used to be that you paid a human a nickel for liquidity, now you pay a computer a penny for it. Various brokers are further disrupting trading by allowing anyone to become an HFT (e.g. Interactive Brokers).

There isn't much left to do on the trading side - trading is nearly free now.

5) Goldman Sachs seems to have come up with a disruptive innovation in IB - go semi public through an SIV to avoid all the hassles of becoming an actual public company.

7) Mutual funds - he seems aware that low fee ETFs are already disrupting mutual funds.

paulodeon• 15 years ago

I think you have to split retail from investment banking.

Retail is ripe for disruption, bad service, poor websites, limited products etc. Creating a Retail Bank 2.0 could really change the sector.

I have difficulties seeing investment banking ever being disrupted. For one you have to be intimately involved to know what sort of products are needed. A 23yo SV hacker simply hasn't a clue what the mutual fund manager or forex dealer needs to make his life easier.

Once you're in the industry it isn't really radical disruption, if it were, the industry would be being disrupted all the time. Banks are massively competitive and any potential advantage inferred by new technologies and approaches would be assimilated into their business model rapidly.

wheaties• 15 years ago

Research a loss leader? That's sort of true but there are already a couple of sites which are doing just that and charging for it: www.morningstar.com, www.fool.com and www.quantumonline.

MrMan• 15 years ago

I am not sure Wall Street needs disrupting, other posters have noted that because it is so competitive disruptions constantly occur. But one thing could change Wall Street a lot -- if for some reason the core function of capital raising, either through issuance of debt or equity, was less necessary, then Wall Street's role as a middle man would be reduced. What could cause companies to need less capital to carry on growing their businesses? Or what could cause capital to be more readily available?

How to disrupt Wall Street

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