Financial Innovation

Last week I gave my talk on Agile Banking at Reboot 11

This week I have taken my talk and turned it into a series of blog articles that I will post here once a day.

In the beginning was the bench. The word Bank comes from the Italian word for bench “Banca”.

Rather than a modern bench these were more like the above modern lottery stalls in Panama and were manned by money exchangers found in markets going back to roman times. By the middle ages the Banca’s in Italian trading centers like Venice and Genoa were not just exchanging money, but also lending and storing money to local traders, whom they probably new very well.

Genoa is famous today as the home of pesto. Very delicious indeed. However they were also home to the first modern company.

These always had a limited purpose, so investors like individual traders and Banca’s would know exactly what they were investing in. Such as conquering and taxing the Greek island of Chios:

Nowadays companies more than often attempt to be general purpose. Most normal company founding documents say something like “This company may perform any legal business”. Bank companies generally do have some limits and say something like “This company may perform banking business”, which really could encompass just about anything.

The above people are the kind of web 2.0 hipster you will find in San Francisco’s Blue Bottle Coffee everyday. If you follow anyone from San Francisco on Twitter, you have no doubt heard tweets like “Heading down to Blue Bottle for Coffee” or “Just bumped into at Blue Bottle”. Besides really good coffee it has become kind of a real world alternative to Twitter. Kind of like Jonathan’s…

These people were the hipsters of their time. They are seen here at Jonathan’s Coffee House. Jonathan’s was one of many popular Coffee Houses in the City of London in the late 1600’s and early 1700s. These places were where all the smart (and not so smart) business people hung out all day long. Drinking coffee, gossiping and most important buying and selling shares in the cool companies of their time. I don’t know if he was bored or what, but this guy John Castaing started to keep a list of trades happening during the day in what may be one of the worlds first mash-ups.

Jonathan’s and John’s list became what is now the London Stock Exchange.
In reality none of our financial institutions and instruments were thought up by think tanks, university professors or government employees. Rather smart entrepreneurs thought up solutions to the problems of the day.

Yet there were problems…

Many people think bubbles as being modern. We remember the dot com bubble and are now living in the immediate effects of the housing bubble. But really they have been around for many centuries. One of the coolest things about these early bubbles was that they were always documented by really cool cartoons.

Tulip mania hit the Netherlands and over a couple of months the whole country had gone tulip mad. Everyone The price of tulip bulbs started shooting up in November of 1636. Right before the bubble popped the following february, the price had risen 20 times.

“Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney-sweeps and old clotheswomen, dabbled in tulips.” MacKay

The South Sea Company was a really cool British company founded in 1711. They had the official monopoly for trade with Latin America. The stock price grew to crazy levels (no doubt people were drinking lots of Coffee at Jonathan’s) when at last the bubble burst. Spain was at war with UK and the Latin American trade dwindled. This became known as the South Sea Bubble and was probably the first time the word Bubble was used to describe such an event.

John Law was a very slick Scottish guy. Maybe the Bernie Madoff of his time. John was an ardent gambler and escaped a death sentence in Scotland after killing a guy in a duel. Somehow John, who obviously was a talented salesman, managed to become the treasurer of France. During this time he created his own private bank and pioneered the creation of Paper Money. The bank bought the Mississippi company, who’s job was to colonize and trade with French Louisiana in modern day US.

John then proceeded to convince the king to make his bank the Banque Royale endorsing all his paper money with a royal guarantee. At the same time he started a strong marketing campaign selling Mississippi Company shares.

People of all classes went crazy and the bubble was created. In 1720 when people realized that Louisiana wasn’t quite the Eldorado he said it was the bubble burst and the king was left printing worthless money to solve crisis. John himself escaped France and spent the rest of his life gambling in Rome, Copenhagen and Venice.

Why this history?

Innovation starts with people, it starts small, it starts limited. Bad stuff still happens.

In tomorrows post I will cover e-gold and how it relates to my idea of Agile Banking. Yesterday I wrote about Risky Business the core problem in todays financial services industry.

Last week I gave my talk on Agile Banking at Reboot 11. This week I have taken my talk and turned it into a series of blog articles that I will post here once a day.

The world is in serious trouble. Recession is hitting most parts of the world. While many people debate the exact reasons for it, most agree that the reason it has grown to the current extent is due to structural problems with our banks. We have become too reliant on them and they have grown so intermingled that our politicians believe they are too big to fail.

While we can talk about all kinds of things, such as sub prime mortgages, monetary policies etc. etc. The real problem is one of risk.

Risk is not a number

Imagine you going to a horse race to bet on a horse that is such a sure bet that it is only 1/10 chance that it will lose. The horse is faster than all the others, has a great jockey, you are set to win. You take out all your cash, take out all the money from your credit cards and remortgage your house to make a huge bet. After all there is no way you can lose. You make the bet and 10 meters before the finish line the horse falls. Against all odds you have lost all your money and are now in incredible debt.

This is essentially what has happened to the worlds financial system. It is irrelevant (but interesting) to discuss why the horse fell. The real issue is the lack of understanding of risk that made you put all on that one horse.

The banks of the world all went together and borrowed all of our money and all at the same time made the same really, really safe bet. After all it was a sure thing. The only problem was that the impossible happened and now everyone is trying to hide from the bookmaker.

Banks like most other people don’t understand risk. In many cases Banks don’t even understand themselves. Most very large banks have no clue of their own liquidity (how much cash they have) at any given time.

Imagine if you started writing checks like crazy without really having an idea how much money you have in your checking account. Banks frown on it if you do it, but they themselves are for the most sake guilty of this.

Because of this you get situations where you have one risky trade and they’re gone. We have seen this before with individual banks, however this time all of them made the same bet and most of them are in serious trouble.

Traders love risk numbers. What I mean by risk numbers is a number generated by some magic formula that condenses certain factors about an investment. This makes it easy for them to compare how risky an investment is.

Regulators also love risk numbers. It makes it easy for them to regulate the banks. They can specify what risk formula their banks should use and then look at a spreadsheet and see quarterly risk numbers for each bank. If a banks risk number is too high, they can send scary letters to the banks saying you need to take less risks.

The Black Swan

The only problem is what Nassim Taleb calls the Black Swan. Before the discovery of Australia Europeans thought there was no such thing as a black swan, it was impossible. Yet they were in for a surprise when they discovered it in the land of the Koala.

In other words the improbable will happen. The Black Swan is an unforeseeable event, that nevertheless happened. If you can’t imagine something happening you can’t calculate the possibility of it happening, thus any particular risk number can never take a black swan in to account.

Nassim states that Black Swan’s happen all the time. Sometimes they’re good, sometimes they’re bad. Yet in most cases they have had much larger influence on the world than anything we ever planned for or predicted.
The current financial crisis could not be seen in the analysts risk numbers. Yet it happened and the banks were not ready.

Risk numbers are good for black jack and other casino games, where all different outcomes can be calculated. But they can never be trusted if you can’t 100% guarantee you have taken into account all outcomes.

Outside the casino there are very few areas where you can calculate all outcomes, thus they are useless in the real world.

In short “shit happens”.

For more on the Black Swan check out these quite entertaining two podcast interviews with Nassim:

• Taleb on the Black Swan
• Taleb on the Financial Crisis

Any fix to the banking system must accept this. Risk can be managed through limits and real diversity, but not by relying on a single number or forumla.

So, who is going to fix our banking system?

You would think the banks would like to fix themselves. They might but most are too big to fix. I am willing to bet they even know this themselves. The only way save them without huge fundamental changes is through some sort of artificial protection.

Who will protect them? The same people who are meant to keep them under control of course, the regulators. The regulators are the government agencies looking after the banks. In the US the FDIC and Federal Reserve. Every country has one or more government regulators.

So far the regulators have been very busy. They’ve given us lots of words, spent lots of our money and not made any real changes.

The problem is that regulators are not innovators. Their solution? Besides limiting the bonuses of high level bank employees, which has absolutely nothing todo with any of the causes of the current crisis, their gut instinct is to regulate harder.

They raise limits and increase reporting requirements. In reality they are not physically capable at the moment of doing anything but raising limita and telling people off after the fact.

What this actually does is that it raises the barriers of entry for new banks or banks trying to innovate. Large established banks can easily afford to pay themselves out of this by building up larger compliance departments. Regulators think this makes their job easier and it also allows them to say to the public that they are getting tough on banks.

What we really need is innovation. The system is broken and we need to think differently. We as entrepreneurs are stuck with the job. Innovation can only come from small startups and activists. These are the only ones without vested interests in keeping the system the way it is. But as I mentioned the regulators make it very hard to innovate in banking.

I have a plan!!!

Where in we go back to basics, but lets rewind things a bit first.

In tomorrows post I will cover some history.

Updated with video. I gave my talk earlier today at Reboot 11 about refactoring the banking system:

Anyway I’m interested in any comments.

Read my 5 part blog series based on this presenation here

Due to the SEC’s closing of Prosper I do think that it is time to address the SEC rules, which were created by FDR during the New Deal. It was a very different world then. Not that I think they did a lot of good at that time either.

We need the ability to innovate, even in the world of securities and investments. We need to lower the barriers to entry as the larger players who can cross them do not have real incentive to innovate.

The cost of creating a startup is lower now than ever. Often the cost of following existing security regulation is more than the amount sought.

Personal loans on an exchange are even less likely to ever pass existing securities law unless you happen to be David Bowie.

Here are my 3 basic ideas for innovation in securities and investments.

1. Warning labels

I know, I know. I hate warning labels as well. But I’d rather have warning labels and allow anyone to invest than the obnoxious innovation killing rule about Accredited Investors.

2. Special registration rules for micro securities

A $1000 loan should not have to follow the same rules as a $500,000 angel funding round. Why not just require them to be offered through a regulated exchange service instead. I think special rules should be in place for sub $100k securities. I’d be willing to accept sub $25k if it would allow it to be passed.

While I don’t think any kind of registration with the SEC really is needed, I could be persuaded to accept the idea of a very simple free REST based web service for registration of the security with the SEC.

Think tax id, amount, offer date, description and a url to more information on the exchanges web site. The SEC could publicize this information and allow queries of the data. Of course I really think this service should be offered to be run by a private industry organization and not the SEC or we would likely have to wait for 5-10 years for it to be implemented.

3. Regulate the exchanges and not the securities

While I personally don’t think we need any form of regulation. The realities of the day are not really about less regulation. An innovative approach would be for the SEC or congress to regulate a new form of exchange. This exchange would be regulated and have to follow certain rules, but would allow smaller micro securities to be exchanged.

I was working on a project with a couple of really smart people nearly 8 years ago for creating an equities market for micro financing in the 3rd world. The project never came out of prototype stage, but one idea that fascinated me was to tax and regulate the exchange rather than the startups offered within. This would allow developing world governments to achieve revenue and regulation, while keeping a low enough barrier of entry that even very small micro businesses (like these ones in Panama ) could utilize the exchange.

This was our solution to the problems that Hernando de Soto the brilliant Peruvian economist believes for the basis for most of the economic troubles in the developing world. I have written before in A global virtual shanty town about how similar issues stop innovation and growth even outside the developing world. The SEC/Prosper debacle is evidence of as much.

Prosper were just sent a cease and decist by the SEC for offering investments without registration. Prosper is/was one of a small handful of P2P lending markets offering an innovative approach to lending, allowing normal people to lend money to each other.

Not that I am a lawyer, but from reading the ruling, it appears that for Prosper to be allowed they would need to register each and every loan with the SEC as well as every investor would need to be an Accredited Investor. Either of these 2 would be impossible to do for them or anyone else trying to offer a similar service.

Using existing rules, I think the SEC were following clear rules. That does not stop them from being evil of course. Personally I can’t see either how the constitution even permits them to shut down Prosper without a trial. They are somehow allowed to both make the rules, execute them and judge them.

Reves ruling

The SEC metions the Reves ruling and lists the following rules from it:

(i) the motivations of the buyer and seller; (ii) the plan of distribution; (iii) the reasonable expectations of the investing public; and (iv) the existence of an alternate regulatory regime.

They argue that (i) is breached as:

… Prosper lenders are motivated by the desire to obtain a better return on their money than they otherwise could in another venue. While some Prosper lenders may be motivated, in part, by altruism, altruistic and profit motives are not mutually exclusive.

Oh, horror that someone would like better returns than in the bank.

(ii) is breached because as they say:

With respect to the plan of distribution, the Prosper notes are offered and sold on the internet to the public at large. There is no special level of financial sophistication or expertise that Prosper lenders must have.

Those are the rules, I know but just look at the current financial mess and read anything by Nassim Taleb to see what happens when “sophisticated” investors are let loose.

(iii) is breached because:

bla. bla. bla. … Prosper lenders reasonably expect a valuable return on loaned funds and would reasonably believe that the Prosper loans are investments.

Again they are right according to the rules. Obviously lenders believed they were making an investment.

(iv) is breached because there is no alternative regulatory scheme:

Finally, with regard to whether an alternate regulatory scheme exists to reduce risk to potential investors, there are currently no appropriate regulatory safeguards for Prosper lenders, such as those against misleading statements by a borrower about the purpose of a loan, the borrower’s employment and income, or even the borrower’s identity, or against misleading statements by Prosper.

This is where I believe they are wrong. Granted there is office anywhere in Washington DC called the “Person 2 Person Lending Exchange Regulatory Commision”. However in the US we do have these 3 great regulatory schemes called the free press, contract law and the judicial system.

Prospers.org and apparently a whole host of blogs are busy auditing and criticizing Prosper all the time. There is plenty of information available to anyone, which should make you think twice about investing in Prosper if they are risk averse.

E-Gold were under similar constant crowd sourced regulation via their mailing lists and online tools. Read more about E-Gold’s innovations.

While Prosper may claim they weren’t a bank or under the SEC, they were always under contract law (Both Common Law and UCC). The same can be said for their borrowers and lenders. They have apparently been pursuing law suits in the courts for some time. I have no idea if they have done enough here, but then it is the job of a crafty lawyer to come up with a class action lawsuit to keep them on the right path.

Innovation is needed, new rules are needed. The SEC followed their rules and protected the existing financial industry who have done such a bang up job in recent years protecting our wealth.

Updated: Just posted 3 ideas for innovating securities law where I talk about how the SEC could allow innovation.

Updated: Thanks to David for pointing out that they aren’t actually closed, but just not able to post new loans until they get registered