
How to disrupt Wall Street - olalonde
http://cdixon.org/2010/01/23/how-to-disrupt-wall-street/
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patio11
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.

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

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btilly
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.

~~~
cletus
/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.

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sachinag
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>).

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gdberrio
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
_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.)

~~~
yummyfajitas
_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).

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

~~~
gdberrio
As a trader, I totally agree!

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

~~~
gdberrio
The complexity of the platform is cumbersome.

In first place you need a special purpose terminal (the Keyboard essentially)
because you need special functions, that are only found on that keyboard.

Second the usability of the thing. It's just appalling. To search a quote you
need to know codes similar to the names of x86 CPU register (not jocking...
you want to search by topic? TNI <Go key>. Want to view some equity analysis?
Hit <Equity key> NN <Go key>). The interface is confusing, cluttered, horrible
to navigate through, and concept of "back" is skittish at best.

For the privilege of a steep learning curve, horrible design, proprietary
formats, little integration with outside tools (except for Excel) and a
horrible looking keyboard, you pay 1500$ a month.

They are, however, the best source for Data in the market. Stocks, futures,
fixed income, you name it, they have a price quote for it.

So yes, it's a good market for disruption. But (there is always a "but"): it's
not a easy market to get in, and bloomberg as a very good choke on the Banks.
The other competitor is Reuters. And IMO, it's easier to disrupt B2C
companies. B2B reminds me of the "Nobody ever got fired for buying MS". Well,
no trader desk director ever got fired for buying Bloomberg.

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jreposa
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.

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

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cletus
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.

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yummyfajitas
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.

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paulodeon
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.

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MrMan
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?

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wheaties
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.

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AlexMuir
Covestor is more along the lines of disrupting Wall St.

