(Part III of a series on the future of banking and finance)
By now I hope to have convinced you in Part I and Part II of this series on 21st Century Finance, that things are never going to be the same. My thesis is that new technologies (discussed extensively in Part I) have the possibility of disintermediating 20th century finance’s business lines and that is going to chop into the industry’s unreasonably high relative to its value add, profit margins.
Recall that all of finance rests on a Fundamental Transaction:
Those with a surplus of capital, but a deficit of good ideas about what to do with it – who I call providers of capital (discussed in Part II) – exchange their monies with those with a surplus of good ideas, but a deficit of capital – who I call users of capital.
An entire ecosystem has developed to facilitate this Fundamental Transaction. Note: I discuss the financial ecosystem in more depth in a reference article here at Sarasota Institute. Let us turn our attention now to the users of capital.
Users of Capital & What They Want From Finance
These are the entrepreneurs and investors who have an idea for what to do with capital in order to earn investment returns in excess of required returns. So, this includes entrepreneurs and their startups; businesses, both private and public; non-profits; and even governments. All have a need to raise capital, invest it in some return generating activity (even if it is just charitable), and generate economic returns. These needs led to the creation of 20th century finance creating multiple business lines:
- Raising of capital;
- Access to advice;
- Secondary markets to facilitate monetization of value; and,
- Secondary markets to provide pricing for the value of investments.
Raising of Capital
In a 21st Century Finance world raising of capital is no longer the sole domain of investment banks. Traditionally, these institutions extracted a high price (8% of a transaction was typical) to connect users of capital with providers of capital via their extended financing, investing, and banking relationships. Yet, like all networks, the secret sauce is knowledge of the connections that make up the network. This no longer has to be an investment bank’s proprietary client list, and instead can be handled via the Internet and social media. In other words, capital raising can now be facilitated by crowdsourcing (see Part I for an extended discussion of crowdsourcing technologies). Users of capital need only announce their intentions to raise capital and tap into any network to which they have access; which can include: Facebook, Twitter, LinkedIn, and even more arty networks, like Instagram.
A limiting factor in major markets, like the United States, used to be regulatory. Securities offerings to the public were extremely constrained and subject to regulations designed to protect the investing public. But with the passage of the 2013 Jumpstart Our Business Startups Act (JOBS Act) in the United States all of that changed. Essentially this was a legalization of crowdfunding.
In my opinion, this is the leading edge of a movement that is likely to only grow. Though the amount of monies raised via crowdfunding is admittedly low currently, there are few remaining barriers to raising capital using them, other than widespread acceptance. I believe it is a technology truism that if a thing can be done, it usually and eventually is done. For example, Microsoft was one of the first to create an interactive touchscreen environment with handwriting recognition. Though it did not result in a huge success, devices like the iPhone eventually did take off. The point is that the technology itself created a new capability, even if people did not rush to the first platform to host it. I think crowdsourcing is likely to be how most capital is raised at the close of the 21st Century.
Another 20th Century function of investment banks was to offer to Providers of Capital and Intermediaries, an opinion about the quality of the idea put forth by the Users of Capital. This helped assure Providers of Capital (the investors) that the Users of Capital had a sound idea for what to do with the capital. Oftentimes, with very new ideas and new products this can prove very tricky so this evaluation is critical for Providers of Capital who may be ignorant about global business trends.
Because underwriting, that is, an investment opinion rendered, tamps down the anxieties of Providers of Capital, it usually means that underwriting results in a lower required return for the Users of Capital. For example, if a Provider of Capital requires a 40% compound annual growth rate on an investment that is unique, the underwriting process can lower that required return to, say, 25% because of the professional opinion about the prospects of the investment rendered.
Previously, investment banks maintained substantial research staffs that followed global business and investing trends in order to underwrite new investment offerings. Very frequently these analysts were and still are finance specialists, and not industry specialists. That is, their knowledge of business is abstract and indirect, rather than concrete and first-hand. As a prospective provider of capital to new and risky ventures (Users of Capital) are you more comforted by the opinion rendered by a 20-something year old analyst, or by a crowdsourced network of individuals, many of whom, have direct industry experience with the global trend and investment idea being offered by the Users of Capital. I believe the answer is obvious.
At first traditional finance scoffed at the notion that individual experts would offer up their opinions for free. Yet, that is exactly what has happened with networks such as Seeking Alpha, SumZero [thank Len Costa for covering this in <gasp!> 2012], and companies, like Estimize. Here investment research is provided in a crowdsourced manner and includes industry insiders, traditional investment analysts, and sophisticated amateurs, alike.
If nothing else, a Provider of Capital, can use the interest from a crowdsourced community as an indication of zeitgeist and public interest in a new business offering. In other words, crowdsourcing provides both Providers of Capital and Users of Capital with transparency into the network of those interested in a new idea; no longer is a traditional 20th Century Finance investment bank needed.
One obstacle that 20th Century Finance never has overcome is its inherent conflict of interest since it both sells securities and earns commissions from secondary market transactions on these securities and for which it also simultaneously renders an underwriting opinion. This is the famous “Chinese Wall that isn’t” that supposedly divides investment banking and analysis in 20th Century Finance. Though mandated by numerous regulations, it is still the case that the overwhelming number of opinions issued by 20th Century Finance institutions and their Opiners (covered in a forthcoming part of this series) are “buy” opinions.
Underwriting of an investment is not the only analysis required by Users of Capital. They also need an understanding of the likely popularity of a new product or idea. Via the Internet and social media Users of Capital are now able to receive indications of interest about new products and ideas from the public, and well in advance of making use of precious capital.
Another minor requirement of Users of Capital in offering ideas for investment to Providers of Capital is rudimentary bookkeeping. Who owns the debt in my company? Who owns the shares of stock in my company? Who owns the most of my securities? Where are my securities trading? And so on. With blockchain technology the traditional role played by clearing houses, like Depository Trust Corporation, are no longer necessary. This again facilitates Users of Capital skipping 20th Century Finance players altogether. What is missing is regulatory approval for blockchain to be used in such a way. I fully anticipate this is likely to emerge before the end of the 21st Century.
[An important note, however: the cost to a User of Capital may be close to zero, but the cost of electricity used to process ‘trades’ is not free to the environment. More on this in a future post.]
Access to Advice
Though not generally appreciated by the general public Users of Capital frequently consult with investment banks and analysts for advice on how to invest capital, new product ideas, strategic direction, how to manage a business in the global economic environment, and so on. There is actually very little transparency into this process so it is difficult to evaluate the quality of this advice rendered by 20th Century Finance. Traditional investment banks justify the quality of their advice based usually on two bases: their supposed exclusive transparency into economic, business, and investment realms; and that because of their employees’ superior educations (i.e. that they are the smartest of the smart) that they know and comprehend things that mere mortals cannot know. Above, I discussed at length that transparency into networks is already disintermediated and likely to only grow. So, debit 20th Century Finance and its advice quality based on network transparency.
What about the quality of the minds of finance? Sadly, as stated above, there is very little objective evaluation of the quality of the mostly private advice rendered to Users of Capital by investment banks. However, Ho’s Liquidated: An Ethnography of Wall Street uncovers a business mostly self-obsessed with its own superiority, rather than a focus on ensuring that both Users of Capital and Providers of Capital are made better off by engaging with 20th Century Finance. Another data point that supports the idea that 20th Century Finance is not smarter than the crowd, is that crowdsourced – 21st Century Finance – earnings estimates and analysis have been demonstrated as more accurate predictors of future results to that rendered by 20th Century Finance and its investment banks. See for example: “Measuring Relative Bias and Accuracy with Crowdsourced Earnings Forecasts.”
In short, there is not much evidence that investment banks provide huge amounts of value add in providing operating advice to Users of Capital. Also, there are many competitors for advice: the board of directors, angel investors, venture capitalists, business schools, fellow alumni from schools, consultancies, and possibly even crowdsourced advice going forward. Now, on this latter point, this may sound silly, but consider the fact that the US intelligence apparatus many years ago actually created a ‘market’ for global geopolitical events so that they could crowdsource insights into likely hotspots in the future. Never heard of this? That is because it was shut down. Why? Not because it was unsuccessful – in fact, it was successful – but it was shut down because vocal members of the public believed it was garish to place bets on mayhem. But now crowdsourced intelligence estimates are back.
Can you imagine a world in the future in which Users of Capital on their websites or social media pages ask multiple choice questions about their strategy, such as: if you had $100 to invest in the following strategies for the XYZ company going forward, which would you place money on? Hmmmm.
Secondary Markets to Facilitate Monetization of Value
In 20th century finance many businesses began with a smart idea originating with an entrepreneur whose dedication and passion led to a viable product, then customers. If the idea was especially attractive and might scale up in size it attracted “angel investors.” These angel investors (i.e. Providers of Capital) desired for the business to become viable enough that venture capital investors (Providers of Capital, again) came along and provided liquidity so that they could earn a return on their investment, and in some cases, exit it entirely. VCs, in turn, wanted many businesses to “go public,” meaning that the entrepreneurial business was so attractive that it could attract the attention of a wide network of investors.
20th century finance institutions, investment banks (i.e. Intermediaries) shepherded entrepreneurs and their businesses through the labyrinthine securities laws and once this hurdle was cleared they granted access to these Users of Capital of the investment bank’s network of investors. This, in short, is a primary market transaction: the sale of new securities. Yet, investors participate in the primary market mostly because they are hoping for a bump in the price of this Initial Public Offering (IPO) in the secondary markets. Thus, the secondary markets are key for monetizing the value of the business.
As this article’s discussion makes abundantly clear, the largest network in the world is not the secondary market, it is the Internet, followed by Facebook, followed by other social media sites, and very importantly for 21st century finance, e-commerce sites, like Amazon. Because of crowdsourced financing and crowdsourced analysis there remains very little reason for smaller companies to utilize traditional investment banks.
For example, Spotify recently announced that it is going to forego the traditional investment banking channels in going public. My prediction is that this is not an anomaly, but a sign of things to come. For example, can you imagine a point in the future in which you, as an Amazon customer, login to shop for whatever and Amazon asks you a question: “Do you feel like investing $50 today, based on your user profile and its stated investing interests?” Similarly, a User of Capital may also login looking for bridge financing to make this month’s payroll and see that you and another 1,000 investors are willing to provide financing today for an herbal-infused dog food company.
Note: currently there is very little incentive for larger companies to use crowdsourced funding because the size of any follow-on equity offering (because many of them are already publicly traded entities) or new debt offering dwarfs the monies available to them via crowdsourced networks. In other words, the current crowdsourced networks are too small/do not have enough nodes in order to serve as an alternative to traditional investment banks at this time. Crucially, this is NOT a problem of the viability of crowdsourcing, but a problem of scale. But who has greater customer data and access to customers willing to spend money, JP Morgan, or e-commerce sites like Amazon and Alibaba?
You may scoff at this notion, but did you know that Alibaba actually launched a new bank, called Mybank in 2015? Or that Amazon has filed for banking licenses in the United States? So far Mybank has made as of October 2017 441.3 billion yuan in loans so far. Clearly these entities can provide scale in crowdsourced funding. Last on this point: can you imagine a world 50 years from now in which the power of the Internet and social media networks are not used to facilitate primary market financing/circumvent investment banks? I thought not.
Secondary Markets to Provide Pricing for the Value of Investments
Here we arrive at one of the business lines that traditional investment banks may be able to continue to add value: serving as market makers in secondary markets to support the prices of companies who went public using traditional investment banking. One of the little appreciated qualities of investment banks by the public is that after an IPO the investment banks who brought a company public provide support for the price of the shares or bonds in the secondary markets. Unless Alibaba, Amazon, and their like want to become fully fledged investment banks which requires the hiring of a very sophisticated type of staff or development of an algorithm, and importantly backed by $billions in capital, then investment banks may still play a role here for Users of Capital.
Why is this function important? If you are a User of Capital and you want to be able to realize the wealth gain of you starting and managing a highly successful business, an IPO is the best way to facilitate massive scale. Furthermore, since entrepreneurs usually retain an interest in the company, and they want to be able to continue to access public markets to raise monies from Providers of Capital, then they want a floor/support for the prices of their securities. Investment banks actively make markets in their underwritings to ensure this is the case. Perhaps this is the last vestige of investment banking going forward.
The future for users of capital in 21st Century Finance looks to be much improved from previous centuries. Specifically, it is likely an era of lower costs to raise capital, close to free underwriting, practically zero-cost bookkeeping, more varied sources of advice, and possibly less expensive involvement in secondary markets. For the institutions made gigantic by 20th century finance, the future, in a now familiar drumbeat, looks bleak with significantly lower margins, and with much lower influence over the financial ecosystem.