Beijing's Attack on the U.K.

Recent revelations of China's state-sponsored cyber attacks on U.K. financial institutions underscores that strategic financial power is high on Beijing's list of priorities. Moreover, these attacks are consistent with "Unrestricted Warfare," a white paper published in 1999 by two PLA Air Force colonels, Qiao Liang and Wang Xiangsui, in which they argue that future wars will be fought on many fronts, and that in fact economic and financial warfare will become an increasingly necessary and accepted form of conflict.

Whether Unrestricted Warfare represents today's official view of China's strategic outlook is unclear. What is clear, however, is that from a risk-reward perspective, Beijing must believe that, as a matter of national strategy, a policy of infiltrating foreign financial systems provides great enough rewards to offset the risk of significant political fallout. China's zeal for financial power is clearly beyond the realm of licit transactions.

But what specifically are the Chinese after?

Proprietary technology? The need for cutting-edge financial infrastructure in China is great, but Beijing could quite easily purchase needed technologies (or the technology providers themselves) and forgo the considerable risks associated with cyber-espionage.

Data? Discounting a criminal motive, Beijing could be interested in gaining access to transaction or pricing data as a means to gain a competitive edge in the marketplace, particularly in the commodities arena. China's explosive growth rate means that even a slight edge could save China billions in natural resources expenditures.

While theft of data or trade secrets could be the primary motive, Beijing is also testing information defenses and planting back doors - in short, developing a formidable information warfare capability. Beijing views the global capital markets as the naval philosophers of the early 20th century viewed the sea - that is, as the lifeblood of national prosperity, and therefore a medium for the projection of national power.

Facebook and the Financial Analyst

Investing has evolved into a highly social activity, as evidenced by the countless chatrooms, blogs, and message boards populating the Internet. With the Facebook Platform API now available we would expect to see a rash of applications for investment analysis and portfolio management. By incorporating Amazon S3 or Rackspace for data storage, a scalable, robust, and fully virtual analytical capability is possible. To date, however, the majority of viable finance-related applications populating Facebook are payments-related: Send Money, justgiving, ChipIn, LendingClub, PayMe. Perhaps this is because the platform has only recently become available, or that Facebook is still very much a SOCIAL network, and as such would not provide a legitimate environment for an analytical application. The prototypical Facebook user is keeping track of people, that is, looking for fun, friendship and relationships - not p/e ratios and risk-adjusted returns (though the FSX - Fantasy Stock Exchange - claims 18113 daily active users.)

But the network-form has already been embraced by analysts in various disciplines as an efficient way to share and analyze information. Even the CIA has developed a social network for intra-agency intelligence sharing. We believe Facebook is an attractive environment for the deployment of financial modeling applications and would provide financial analysts - risk modelers, financial engineers, investment analysts, and portfolio managers - with a highly effective means of sharing data and ideas. The need for the cross-pollination of ideas is of paramount importance not only in the intelligence community, but in financial services as well.

Opportunities in FinTech Localization

The globalization of financial services is accelerating rapidly, particularly in the emerging and pre-emerging market spaces. As the financial systems of G7 nations continue to evolve, these markets will need to undertake significant financial infrastructure reforms in order to achieve and maintain connectivity to the global economy. Chief among these reforms will be implementing systems crucial to credit access, orderly capital flows and liquid financial markets. At the same time, a shift is clearly underway from an aid-based to a market-driven model in global development. Recent deals to this effect include:

· The $250 million capitalization of two strategic African investment funds by the U.S. Overseas Private Investment Corporation which will, among other things, "enable companies in a variety of industries to expand and potentially to tap the capital markets," and "support financial instrument innovation and capital market development by expanding the pool of available investment securities in Africa."

· Citibank India’s deployment of biometric ATMs which assist microfinance customers in Hindi, Marathi, Tamil, and Telugu.

· Italian software vendor SIA-SSB’s contract to establish a new interbank payment system for the Egyptian market through a €2 million deal funded by the European Union.

· Dutch IT firm LogicaCMG’s contract to implement an interbank real time gross settlement (RTGS) platform for the Banco Central de la Republica Dominicana (BCRD).

· SunGard’s contract to provide its BancWare financial analysis technology to Beirut-based BankMed.

This shift will create opportunities not only for financial technology providers, but will generate significant demand for globalization and localization solutions in this space. As such, we recommend that both industry players and financial sponsors explore strategic acquisitions or joint ventures as a means to benefit from this emerging trend. Some attractive candidates include publicly held LionBridge, privately-held TransPerfect, and privately-held, Beijing-based CSOFT (all three of which maintain existing financial services practices), while publicly-held SDL, and privately held (venture backed) Idiom Technologies and Welocalize provide solutions which are readily applicable to financial services.

What About Personal Risk Management?

In 2003, Yale University professor Dr. Robert Shiller ("Irrational Exuberance") published his widely heralded tome, "The New Financial Order: Risk in the 21st Century." In it Shiller lays out his ideas for "radical financial innovation," and, specifically, the development of financial products and services which provide for the management of personal financial risk: retirement, home equity, job security. He also outlines his ideas for the development of "macro markets" wherein investors buy claims to economic aggregates such as national income and real estate.

Clearly there is merit to Shiller's ideas. Recent events in the housing marketplace suggest that there would be a large market for some form of product to hedge against adverse movements in home prices and interest rates. The market for a retail energy hedging product is enormous. Perhaps it is the complexity of financial risk management which makes such products unworkable in the personal finance marketplace, but surely the finest minds in marketing could devise a method for communicating such complexity to the masses.

The beginnings of such a project can be found in HedgeStreet, a trading venue which enables investors to take positions in foreign currency, Fed funds rate, precious metals, and energy markets. The system is based on binaries. At inception the underlying value of the binaries was only $10 but was raised to $100 about a year later. This platform is ideal for trading and speculating, but as for providing insurance or a true hedge against gas prices or home values, not so much. (The site currently only offers its "Mock Trader" platform for trading virtual cash. It appears to be undergoing some restructuring.)

It would seem that while there is a critical need for research and development in areas such as alternative energy to protect us from environmental ruin, there is also a need for research and development in alternative finance to protect us from personal economic ruin.

A FinTech Opportunity in National Security

In July, 2003, the Pentagon's Defense Advanced Research Projects Agency (DARPA) scuttled an ill-conceived terrorism futures market. While the project was a political failure, the idea underscores the ongoing need for innovative thought in the area of indications & warning (I&W). The construction of a terror futures exchange wherein market participants bet on events themselves is perhaps politically unpalatable, if not in poor taste, but conceptually the idea is grounded in rational thought. But rather than create an artificial market where explicit outcomes are at stake, a better analytic approach for purposes of intelligence analysis might be to translate existing financial and commodity data into finished intelligence.

Markets behave in a generally rational manner, particularly when factoring in the economic and financial implications of geopolitical uncertainty, and valuations represent a proxy for the beliefs of market participants. Financial markets are a form of communication, with the myriad data, transactions, and instruments comprising a distinct language. The challenge is to understand and interpret this language in the context of global security, and to divine the trends within markets which might suggest an impending terrorist attack or geopolitical crisis.

A financial I&W system would involve a comprehensive monitoring of global financial markets to uncover anomalous trading behavior in various asset classes. The difficulty here, of course, is establishing a general model of price/volume behavior based upon historical data which would enable analysts to discern anomalies from the general noise. Given the difficulty of this and the inherent imperfections in forecasting security prices, such a system would be valuable not as a sole-source of I&W, but as a piece of the larger I&W infrastructure which draws upon a variety of disparate sources and types of data. Financial I&W would serve well to clarify existing intelligence, or perhaps, as was likely the case prior to September 11, send up a red flag and initiate coverage.

Financial markets can provide intelligence analysts with valuable insights. Data could be useful in determining whether a bias exists toward the potential for a major geopolitical event, or whether there is deliberate activity within financial markets indicating trading designed to profit from a future event, suggesting foreknowledge. How do we effectively parse market behavior in an effort to understand how valuations might reflect the risk of an impending terrorist attack? Unfortunately, markets often overshoot the target, sometimes quite dramatically. However, for purposes of terrorism I&W it would not be necessary to accurately predict the correct valuation for a given asset or asset class, only to divine the trend and the underlying reason for the trend, to strip away the drivers underpinning the movement.

It is generally accepted that prices reflect all information that is known or knowable. By the same token, then, it should be possible to discern the information which is factored into prices and, by process of elimination, identify those factors as they relate to potential geopolitical events.

White Label Monetization for Financial Apps & Start-Ups

The sheer number of emerging technology start-ups is staggering, and even in the face of the worst financial crisis since the Great Depression, the pace of innovation is showing no sign of slowing. There are scores of young companies within the financial technology space alone. Many of these provide substantially overlapping services while seeking to distinguish themselves through easy-of-use, unique features, or corresponding iPhone and social networking applications. But given the intensity of competition, and the growing pressure not only to grow user numbers, but to generate meaningful cash flow, start-ups will have to be highly innovative when crafting a sustainable business model.

White labeling has long been an effective business model in the software industry and has taken on particular significance in the era of Software-as-a-Service (SaaS). As a form of licensing it offers a reliable stream of revenue for developers, and for customers it offers faster time-to-market, relief from the burden of maintenance and upgrades, and a lower total cost of ownership (versus in-house development). For financial technology start-ups white labeling is particularly attractive given the increasingly crowded field, and given that there is a race to social media within the financial services industry which will only accelerate as economic recovery takes hold.

To date, two companies have already adopted this model. Wesabe, an online personal financial management site, is white-labeling its platform, Springboard, to banks and credit unions, and it has signed on at least one customer, Delta Community Credit Union. CreditKarma, which provides consumers with free access to credit scores along with exclusive offers and deals, announced at Finovate2009 that it would be white-labeling its service as well.

Hedge Funds Turning to I-Banking

Hedge Funds Turning to I-Banking:

Last month Citadel Investment Group announced that it is launching an investment banking division. The company sees huge potential for transactions going forward, and given its outsize capital base, has the distribution network and liquidity at its disposal to execute. Other firms could follow suit, such as publicly-held Fortress (FIG).

But is this the best strategy? It's true that there has been perhaps no better time to be a boutique investment bank. Wall Street has been decimated by the events of the last 18 months, providing small shops with the dual windfall of talent and competitive advantage.

Rather than build an investment bank from scratch, there are numerous firms which could provide hedge funds with access to the coming wave of M&A and IPOs. Even in this age of advanced financial (yet impersonal) technologies, traditional investment banking remains heavily relationship-driven, and cultivating those relationships takes time and resources. We believe that hedge funds would do better to consider a strategic partnership or acquisition as this would provide a more efficient structure, and hasten top-line revenue growth.

Social Financial Media: Challenge and Opportunity

Bank Technology News recently highlighted how banks are reluctant to fully embrace social media as it remains unclear how this phenomenon fits into the industry's traditional approach to customer engagement. Financial management is an inherently antisocial activity, and as one might expect financial applications do not possess the broad appeal of other app verticals such as social games. Nevertheless, as we move into the postmodern era of financial services the winners will clearly be those companies who display an innovative approach to customer engagement, and we believe this starts with deploying a rich and engaging presence on the social web.

Many financials have already begun this process. Numerous regional banks (Arvest Bank, Shore Bank ) and credit unions (Amplify, Fairwinds, Travis), exchanges (NYSE-Euronext, CME Group), and even H&R Block (with over 1800 fans) have developed a social presence by skillfully leveraging the viral potential of the Twittersphere and Facebook Pages. But this presence has been limited to communication - i.e., few have explored the potential for richer engagement through the deployment of branded applications or by leveraging Facebook Connect to provide for a more integrated social web presence. Until now Twitter has been more appealing to financial institutions in that it provides a unique communications tool and readily augments existing marketing and customer service programs. But two recent developments may drive more companies to develop an outpost on Facebook: the ability to stream posted stories directly to fan news feeds, and Twitter integration via the Selective Twitter Status application.

We believe that as social media matures and becomes increasingly mainstream, financial institutions will be compelled to develop a more engaging presence on the social web. Building a Facebook or Twitter application is not particularly difficult, but the requisite programming knowledge does present a slight barrier to entry, and custom development can be cost prohibitive, even for larger institutions with in-house engineers. Buying an existing application is an attractive option as it provides for an accelerated ramp-up, but, like off the shelf software, can be rigid in design and functionality, and may still require tweaking.

In the end, it's all about ROI, and the benefits of investing in IT are notoriously difficult to quantify. This is perhaps even more the case when attempting to justify a large capital expenditure on emerging (read: as-yet unproven) technology. But we believe that companies would do well to consider some of the many innovative applications currently populating the Facebook and Twitter ecosystems. We believe that several of these applications present attractive acquisition opportunities and would provide for both rapid deployment and genuine ROI. In future posts as well as upcoming research products we will be discussing some of these targets as well as suggested valuations.

The Lure of Global Infrastructure

Fueled by the explosive growth of emerging markets and the never-ending maintenance curse in developed economies, infrastructure appears poised to be one of the main growth engines in capital markets for the foreseeable future. It represents an attractive opportunity for both the sell and buy sides.

Debt ceilings and political pressures have steadily eroded conventional approaches to public capital formation. Perennially cash-strapped states and municipalities have driven the development of innovative ways to design, build, maintain, operate and finance critical infrastructure improvements. One highly successful innovation is the Public-Private Partnership, or “P3" - a unique hybrid organization which provides a quasi-privatized approach to infrastructure challenges, enabling oversight by a public organization while benefiting from the market-based incentives and efficiencies of a private sector model. P3s have been particularly popular in Europe and Asia, and are gradually gaining legitimacy here in the United States. Notable U.S. P3s include Chicago's Skyway Toll Road, the Indiana Toll Road, Virginia's Pocahontas Parkway, and Texas State Highways 130 121.

Given recent market gyrations and the liquidity crisis in fixed income, we expect that in the near term we will witness a pullback in infrastructure-related deals. Long-term prospects, however, are bright, particularly in light of continued trends in public finance, and the need for pension funds and institutional investors to seek out higher yielding instruments while minimizing risk. A potentially symbiotic relationship exists between infrastructure funding needs and pension liability matching. The recent "repricing of risk" will drive institutions to find low-risk, cash flow-dependable investments and thus will encourage growth in the infrastructure space.

The NVCA Four Pillar Plan

The National Venture Capital Association yesterday unveiled a four point plan to resuscitate the dead IPO market currently vexing the VC community. The plan calls for greater cooperation among ecosystem partners, enhanced liquidity paths, tax incentives, and regulatory changes. While all of NVCA's proposals are compelling and needed, we are particularly interested in Pillar One and Pillar Two.

Pillar one calls for a reexamination of "ecosystem partners" - those institutions which currently make up the foundation of the IPO process - entrepreneurs, VCs, investment banks, buy siders, exchanges, law firms and accounting firms. NVCA recommends that boutiques step in to fill serve "No Man's Land" of IPO candidates raising up to $75 million and having a post-IPO valuation of up to $400 million. Other recommendations include greater cooperation between the bulge bracket and boutiques through joint book running and fee sharing, an emphasis on cultivating buy side interest in venture IPOS, and lower-cost accounting services for pre-IPO firms.

Pillar two calls for a reengineering of the liquidity process, with emphasis on alternative private equity platforms, innovative boutique advisors specializing in emerging technology, greater reliance on global funding sources and international stock exchanges, and VC-originated M&A which would roll up smaller portfolio companies.

We have blogged here before regarding such proposals, particularly with respect to the rise of boutique banking and alternative liquidity mechanisms. While the NVCA report cites wholesale institutions such as SecondMarket and InsideVenture as primary examples of "enhanced liquidity mechanisms," we continue to be bullish on such Web start-ups such as TradeVibes and Valuecruncher. We believe that social technology has the capability to transform the retail marketplace, to provide crowd-sourced price discovery, deeper liquidity, and access to a broad investor base.

We continue to be bullish on boutique investment banks. Companies such as Greenhill (GHL), Evercore (EVR), and Keefe Bruyette Woods (KBW) boast strong balance sheets, strong management, and solid core business strategy. We also expect a wave of consolidation in this space as firms seek to carve out or bolster current competitive positions. We see Thomas Weisel Partners (TWPG), JMP Group (JMP), and FBR Capital Markets (FBCM) as potential targets.

Implications of Facebook Credits

When viewed against the total universe of Facebook applications (numbering in the tens of thousands), the subset of financial applications is by all measures a tiny one. Most are related to “financial entertainment” – simulators, games, and “just for fun” apps enabling users to buy and sell their friends, or send virtual gifts such as bailouts or stimulus packages. The reason for this is evident: Facebook is first and foremost a SOCIAL network - a means for people to connect, share, and have fun, and in general people would rather do just about anything else than manage their finances. Yet the mass migration of social life to cyberspace continues, and virtual life will increasingly reflect real-world human needs: identity, self-expression, and interaction - social, political, and economic. Virtual economic interaction is currently the space which is undergoing the most intense transformation and growth, and we believe that significant opportunities exist given (1) the need/desire to integrate economic activity within the social web, and (2) the desire to monetize social networks.

The movement away from an ad-driven monetization model toward one which relies on a high volume of tiny monetary transactions continues to gain significant traction. Companies such as Tencent, Zynga, and MyYearbook have recently posted multi-million dollar revenues derived largely from microtransactions in virtual goods, items which enhance user profiles or avatars within social networks, virtual worlds, or social games. We believe that Fb Credits will provide Facebook with equally outsize revenues and will produce even greater results as the company leverages the social graph. We believe Facebook intends for Credits not only to facilitate e-commerce, but to provide a form of communication, to augment the overall social nature of the site. That is, Credits could become a medium of user interaction which transcends simple pay-for-service transactions by encouraging a new social financial framework. Facebook’s recent beta test, while at first somewhat puzzling, indicates that the company may in fact have ideas for virtual currency which lie outside the mainstream. Fb Credits represent the tip of a much larger iceberg in terms of user engagement and activity within Facebook, and perhaps even across the social web.

Valuation 2.0

Valuing companies is always great fun. Ask 100 different analysts and you will likely hear 100 different numbers. Even with reasonably good transparency and sound forecasting methodologies, the final value is highly subjective. The short answer is simple: a company is worth what someone will pay for it. The end.

Things have become far more challenging in the era of Web 2.0 - an era characterized by Sarbanes Oxley, private equity, and "free." The challenge for the analyst nowadays is not only to provide the most objective articulation of underlying assumptions and data, but to essentially invent whole new methodologies. One example of such an approach is Adonomics, a portfolio company of Altura Ventures, the Facebook-centric venture capital firm. Adonomics provides valuations for Facebook applications based on a proprietary methodology which takes into account the number of installs, daily usage, and advertising potential of each app. The site provides a searchable database, and publishes the Adonomics 100, a valuation ranking of the companies behind the applications . The top company, Slide, founded by PayPal co-founder Max Levchin and maker of the popular FunWall, Top Friends, and SuperPoke applications, fetches a $322 million valuation.

The latest entrant in the valuation game is the Silicon Valley Insider, a blog founded by, among others, former Merrill Lynch star Internet analyst and dotcom implosion poster boy, Henry Blodget. The SAI 25 is a listing of the "world's most valuable digital start-ups." SAI's methodology is fairly straightforward, taking into account industry comparables, financials (when possible), market share, and growth rate. SAI fully admits the hazards involved in this exercise, particularly the effect of information asymmetry, but there is clearly some serious thought involved. For example, SAI values Facebook at $9 billion, versus the $15 billion based on Microsoft's stake. The rationale? As part of the transaction, Microsoft agreed to sell Facebook ads and bought preferred stock, thereby reducing the value of the common. Overall, the SAI 25 it is an interesting contribution to a growing body of work in this area.

Conspicuously missing from the list are Finance 2.0 companies, and an accompanying "Contenders" supplement includes only Mint ($50 million), and Prosper (<$50 million). This is hardly surprising, given that the valuations of the SAI 25 range from $250 million to $9 billion. Moreover, the revenue models for Finance 2.0 are still a bit uncertain - advertising, data aggregation, or premium services. The ad model is losing favor as users are increasingly tired of intrusive banners, preferring a cleaner, richer, and therefore more engaging (i.e. stickier) experience. Data aggregation holds great promise, but is both unproven and controversial. Premium services are perhaps the best route to "hard money" results, but it is difficult to justify fees when competing sites likely offer comparable services for free.

Deal Idea: PFM Acquisition of Billeo

There are scores of start-ups in the emerging financial technology space, many of which provide substantially overlapping services, and all of which are, at some level, free. As we move through the current crisis on Wall Street into whatever awaits on the other side one thing is clear: start-ups will need to spend their equity capital wisely, as there may not be debt financing for some time to come. Given that the monetization of these start-ups has not yet fully taken hold, it will become increasingly difficult to survive.

We believe that a wave of consolidation could take place as those start-ups which have reasonably sound monetization models in place seek to expand their user base, and those which may be cash strapped but have a viable, innovative product seek to be acquired before failing.

One particular transaction looks increasingly attractive in the online personal financial management space. Personal financial managers (PFMs) such as Mint, Wesabe, Rudder, and Geezeo all offer the ability to track and manage personal finances from a single point. The aggregation of personal financial data is highly attractive for consumers, particularly in these economically volatile times, but as of yet there is no service which provides an integrated transaction capability. We believe there is substantial value not only in enabling consumers to manage their finances, but also conduct their financial affairs from a single environment.

We believe Billeo presents an attractive acquisition candidate for PFMs. Billeo provides users with the ability to shop and pay bills at company websites using payment and contact information stored in an online e-wallet. Users can also store, track, and search their receipts and payment confirmations. Billeo would enable an acquirer to strategically differentiate itself in what is becoming an increasingly crowded space.

From a usage perspective, a Billeo acquisition would offer a distinct competitive advantage for Wesabe, Geezeo, and Rudder, as Mint is clearly the frontrunner in terms of unique monthly users, which we may assume translates into higher user conversion numbers. Mint, however, boasts a high valuation ($46.3 million post money in Q1 of this year), and may be better positioned for an equity-based transaction.

No Exit

One of the more salient features of the current financial environment is illiquidity, a feature which has largely been associated with the credit markets. However the liquidity problem has infiltrated the private equity marketplace as well. Though still well capitalized and continuing to invest, on the horizon looms the question for the VC/PE community of how to cash out. Without an IPO market, investors are left hoping for strategic transactions, yet the crisis of value we are witnessing throughout the markets makes this approach increasingly difficult to engineer. Without reliable comparables or cash flow projections, the VC/PE community faces an uncertain but potentially very lengthy time horizon for committed capital. A significant pullback in VC/PE activity is now expected in 2009.

We believe one of the keys to restoring vibrant and liquid capital markets lies in the development of alternative means to liquidity. We believe that social technologies hold the key to the development of such alternatives, whether in the form of entirely new classes of financial instruments, or, in particular, a highly liquid, socially networked capital marketplace. We need look no further than the consumer lending space where P2P technologies are revolutionizing the way individuals gain access to debt capital. These technologies could be readily adapted to the development of an equity capital market.

Several ideas currently in their infancy offer a glimpse into future "socialized" securities markets. We see the movement toward a social, "wisdom of crowds" approach to investing currently underway. Companies such as kaChing and Covestor offer the ability for investors to establish track records and to leverage their expertise by managing actual portfolios. In addition, markets for "virtual shares" in start-ups, private companies, and even standalone applications have sprung up, and include TradeVibes, exchangeP, and AppBroker. We are also watching with great interest developments in the virtual goods/microtransaction space for potential capital market applications. We believe these ideas and others signal the beginning of a significant industry shift.

Given the current upheaval on Wall Street, the need for investor liquidity, cries for a new financial regulatory regime, and ongoing innovation in the social technology space, the stage is now set for profound disintermediation in capital markets.

Facebook's Micropayment Non-Strategy

Rumors continue to swirl concerning the deployment of a Facebook payments system. Recently the company unveiled that it was beta testing (via the VentureBeat and Facebook networks) functionality which would enable users to engage in small transactions using Facebook Credits, the network's nascent virtual currency, via comments to news feed items. Users can reward each other for useful or entertaining commentary. Whether this structure is practical or will be widely used to this end remains to be seen, but we see broader applications. At the moment the only way to purchase Facebook Credits is through the gift shop, and this means having to first purchase a gift. The maximum purchase for now is $10 (for 1000 credits).

While Facebook engages in sleepy R&D, movements are clearly afoot in the social payments space which present a mounting competitive threat. The most recent event: PlaySpan’s acquisition of competitor SpareChange. With this single acquisition PlaySpan managed to garner access to over 1,000,000 users and 700 applications spanning Facebook, MySpace, and Bebo. Moreover, this acquisition comes on the heels of an agreement with Hi5 to white label 2 of its global payment services - PayByCash and Ultimate Game Card - to enable Hi5 users to purchase Hi5 Coins, the network’s virtual currency.

There is a serious time-to-market issue which Facebook needs to address. Rather than focus on in-house development, Facebook should be looking outside (or inside) for systems to quickly integrate and deploy. SpareChange was clearly a logical choice, and the company's failure to act may have been costly, but not fatal. Facebook should look closely at AceBucks, a virtual currency platform/application from Buddy Media which enables users to accumulate currency through games, referrals, and surveys, and to spend it on real-world items via a virtual shopping mall. Facebook could also look to acquire PlaySpan - a bold strategy which in one move would not only solidify its position as the dominant payments-enabled social network, but could effectively shut the door on Hi5, Bebo, and MySpace.

There Will Be Deals

Looking at recent market activity it is difficult to imagine a time when companies might actually decide once again to engage in strategic transactions. Nowhere is this more apparent than in financial services - particularly in the brokerage subsector - but this market turmoil is creating an environment ripe for dealmaking. Many financial firms are sitting on piles of cash - Schwab, Lehman, KBW, Evercore, Jeffries, to name a few, and PE firms are still raising giant funds. These companies are (wisely) sitting on the sidelines waiting for signs of a bottom (they may be waiting a while), and surely scoping out potential targets. But they will have to act decisively if they are to significantly undermine the hegemony of the bulge bracket.

While there is substantial value to be found in the public markets, things are becoming interesting in the private marketplace as well. As mainstream Wall Street continues to struggle with the unfolding credit crisis, a new wave of start-ups and early-stage companies are poised to redefine (or at the very least, disrupt) the face of financial services. The lineup at this April's Finovate Startup reads like a who's who of postmodern finance, and an analysis of investors reads like a who's who of the technology VC community. Their business models remain largely unproven, but once properly engaged we expect a flurry of liquidity events as these firms seek to raise additional capital and cash out backers. When Wall Street finally wakes up to this undercurrent, we could see a flurry of panic deals as they seek to play catch-up in the post-crisis marketplace. But if the boutiques have played it right, by then it may already be too late.

Financial Innovation and Global Security

It is no secret that there is a highly symbiotic relationship between economic affairs and national security. One is hugely influential on the other. In today’s hyper-dependent global economy this is perhaps truer than ever, and it would seem that opportunities for (and threats to) financial services can be readily identified by monitoring this relationship. Below are some global security-related issues which will continue to drive financial innovation for the foreseeable future.

Poverty: What was once a matter of humanitarian intervention is increasingly viewed as a matter of national security. Poverty breeds instability, something markets abhor. We should expect, then, that there will be an increasing urgency in coming years to develop market-based antipoverty solutions. We have seen a great deal of innovation in this area already, and even one IPO (Compartamos), but the mainstreaming of microfinance remains elusive and the subject of much debate.

Islamic Finance: Clearly a high strategic priority for both the United States and the West is fully integrating the global Muslim community into the global economy. While governments have been reluctant to identify and approach this as the strategic priority that it is, banks have seized upon this market opportunity. There also will be opportunities for the cultivation, financing, and strategic guidance of companies devoted to capital markets development in this region. Iraq is clearly at the forefront of need in this space, and there will be an increasing need for the development of other national and transnational systems in the region, such as Lebanon, perhaps a Palestinian state, and perhaps one day Iran as well.

Aging Populations: A looming global pension crisis presents a significant threat to financial stability. The current credit crisis notwithstanding, we will likely begin to see an acceleration in the shift from public to private management of resources, thus providing a huge opportunity for banks, brokers, and asset managers.

Climate Change: We expect to see a great deal of capital poured into the development of alternative energy and related "green" enterprises. We also expect to see further expansion in carbon trading, climate-related derivatives, and the development of alternative instruments to underpin the new green economy.

Futures Are the New Stocks

Futures trading has entered the investing mainstream thanks to a long list of innovative, low-cost online brokers. What has for some time been the province of large institutions is now accessible to the little guy: hard asset exposure. Commodities and indeed foreign exchange are now viewed as legitimate and appropriate asset classes for retail investors seeking a broadly diversified portfolio. While we have witnessed an explosion in exchange-traded products devoted to these assets, investors are able to derive primarily indirect (albeit liquid, with finite downside risk) exposure via these instruments.

Enter the discount futures brokers, with their low commission rates and cutting-edge technology, and, in some cases, the exchanges themselves through their development of retail investor-friendly contracts, such as e-minis. The great hurdle these institutions face is investor education - futures are still mysterious if not utterly terrifying to small investors. For discount futures trading to take hold, further innovation in both investor-friendly products and communications will be necessary.

Rogue Implications

Once again the vulnerability of global financial institutions is illuminated by the operations of a single individual. Today's announcement of EUR5 billion in losses at SocGen adds to an ever-expanding list of Nick-Leeson style trading debacles - Chinese metals trader, Liu Qibing's copper loss of $100 million, a Mizuho broker's sale of 610,000 shares of J-Com for 1 yen, Allfirst currency trader John Rusnak's $691 million loss.

Whenever these events occur it conjures up an even greater anxiety - sabotage. We see the damage caused by simple incompetence and mismanagement. International financial markets are more vulnerable than ever to the influence of a single actor or group of actors acting within the financial establishment to bring down a particular institution or destabilize global markets. While no evidence exists that this has ever occurred, that high-profile financial debacles occur with alarming regularity certainly raises the question of whether it could.

In August, 2004, the U.S. Secret Service published "Illicit Cyber Activity in the Banking and Finance Sector," a report detailing the threat posed by the so-called "rogue insider" to financial institutions and, by extension, the financial system generally. The Secret Service concluded that the threat posed by rogue insiders is even greater than previously thought based on the fact that, historically, insider attacks have come from a broad spectrum of individuals with relatively modest access and technological skills. Most startling perhaps of all the report's conclusions is that the success of insider operations depended not so much on technological skills, but on skillful exploitation of existing or in some cases nonexistent supervisory procedures.

Small is (Increasingly) Beautiful

There is a trend underpinning Web 2.0. It is a turn to the small - the micro, the nano - whether in payments, transactions, communications, niche, enterprise or economy. It may be too early to label this as a paradigm shift, but the expansion of the microsphere is clearly underway.

While the "micro" prefix may be largely associated with international development - finance, lending, enterprise - the increasing acceptance and adoption of the Web 2.0 model ensures that the microsphere will grow to underpin mainstream economic expansion as well. The opportunities are many, and as the global financial behemoths are distracted by the credit crisis, the development of the microsphere is well underway in several areas.

Social Financial Applications: The microsphere emphasizes the "sovereign self" and as such urges and empowers individuals and small enterprises to assume ever greater control of their lives, and to interact in a manner which is both social and self-interested. This is particularly true in the realm of financial services, and as a result there will be an increasing need for social financial apps which enable individuals to originate, develop, and maintain social financial relationships.

Micro VC/PE: There is an increasing demand for micro investments in Web 2.0 start-ups. The most vivid example of this phenomenon is the booming demand for Facebook app financing.

Virtual Finance: The emergence of virtual worlds and their underlying economies has created a demand for financial services - virtual banks, brokers, and exchanges. Second Life's decision to ban unregulated real world financial institutions from providing virtual banking services will encourage the creation of legitimate virtual and hybrid institutions structured to meet this booming market demand.

MicroBanking: The increasing acceptance of P2P as a legitimate platform for borrowing and lending will drive the micro trend even further as smaller customers - individuals and small businesses - find greater success in capitalizing each other.
It seems fitting, then, that we would see a potential strategic opportunity emerging within a subsector of the microsphere - the microcap financial services space. Microcaps in general are typically shunned by mainstream institutional investors as they tend to be illiquid, volatile, and, generally unloved, and a cursory examination of data reveals that the case is no different for microcap brokers (National, Regional) and asset managers. On closer examination, however, it appears that many have a promising infrastructure in place, or interesting technologies, but perhaps are suffering from strategic drift. We believe that microcap brokers and asset managers would benefit greatly by retooling their business models to better reflect this changeover to the Web 2.0 model. With a little imagination, clever financial engineering, and a modest amount of capital, these companies could be at the forefront of the expansion of the microsphere.

Financial Power 2.0

It would seem that we have entered a period of bipolarity in global financial affairs. On the one side we have (Eastern) sovereign wealth funds charged with investing vast sums amassed through explosive economic growth (China, Singapore) or the skyrocketing price of oil (Saudi Arabia, Qatar, Russia) and on the other, (primarily Western) private sector financial institutions who, though wounded by the current credit crisis, still wield considerable power through their role as capital mediators and gatekeepers to the vast infrastructure through which the world's wealth flows.

The national security anxiety surrounding SWF investment in U.S. financial institutions can be traced to one word - sovereign. The question is really one of financial power and whether nation-states maintain the ability to project power via the financial markets. When China took an 8% stake in Blackstone last year, for example, objections were rooted in a kind of populist counterintelligence - that is, critics argued that Beijing could gain access to sensitive information via Blackstone's holdings in national security-related industries. Setting aside such painfully ill-informed analysis, would the same objections have been raised had the investor been Deutsche Bank? What about Renaissance Capital, or Nomura?

Similar anxieties are harbored by many emerging market governments with respect to global financial institutions, particularly when many sport market capitalizations which exceed the GDP of a great many emerging market economies. The activities of such financial giants are often viewed as a proxy for national policy, and perhaps this is reasonable given that national prosperity is increasingly tied to globalization. While the sheer magnitude of the wealth being deployed ($2 trillion) by sovereign wealth funds should indeed raise eyebrows, the issue is really whether the governments behind these funds can influence U.S./Western policy through their activities in global financial markets. To the extent that they cause a stir in the media, and as such in the minds of voters, the answer may be yes. But when one considers that hedge funds (who know no national allegiance) control over $1.3 trillion in notional (i.e. highly leveraged) value, and that institutional investors in general control over $50 trillion worldwide, perhaps the SWF issue is a bit of a distraction.

By the way, this week's Economist cover story: "Invasion of the Sovereign Wealth Funds," and the December issue of Euromoney: "The New Rulers of Finance."