In Defense Financial Engineering

These days it's fashionable to beat up on financial engineers and financial innovation in general, and understandably so - this discipline has been at the epicenter of the crisis we are currently facing.  The creation of "financial weapons of mass destruction" is, perhaps, not the most noble of pursuits, much as, say, the design and development of nuclear weapons.  There are surely people who would argue that better, more efficient nuclear weapons are necessary for the safety and security of our nation (or the world), whereas others will argue what's the difference: they're just going to kill people regardless, and why can't we devote the resources to the design and development of things that promote peace.  Interestingly, this argument appears to have been taken to an extreme when debating the need for financial innovation and Wall Street as a whole.  It seems that the horrific effects (and very real threat, as we see on the Korean peninsula) of a nuclear war, while highly undesirable, are no match for the clear and present danger of lost incomes and lost homes.

Whether we need nuclear weapons or not is not the subject of this post, however it is somewhat relevant as we ask ourselves whether we need financial innovation, or whether financial innovation adds value to everyday life.  If we believe such notable economists as Paul Volcker, the answer is no.  Mr. Volcker, you'll recall, was the one who asserted that the only useful financial innovation of the last 20 years was the ATM.  Google "financial innovation" and you'll see a slew of articles, papers, and reports skewering the industry and calling into question financial engineering as a discipline.

But to condemn the discipline of financial engineering as a whole is like condemning mechanical engineering for its contribution to the development of nuclear weapons.  It's just not fair.  Believe it or not, financial engineering isn't (and doesn't have to be) limited to the development of highly complex structures with little apparent regard for social good.  Securitization, for example, is regularly employed in the microfinance space as a means to distribute credit risk and ensure liquidity and funding availability.  Financial engineers are helping to wage the war against global climate change through the development of financial instruments used in the trading of carbon credits.  And financial engineers regularly contribute to the successful operation of institutional investors such as pension funds and charitable trusts which, last we checked, contribute significantly to the social good.

In fairness, Volcker's attack on financial engineering was from an economic growth perspective, not the betterment of society.  But are these goals mutually exclusive?  Maybe there isn't a "shred of evidence" that financial innovation has made a meaningful contribution in this regard, but some perspective is desperately needed to inform the public debate.

The Tyranny of Friction

My kids have the day off today, and they each invited a friend over to "hang out" (we dare not call it a "playdate" anymore). Eventually the question of lunch arose.  The question was not so much what to have (it would be pizza), but where to get it. In all there are around 8 different pizza brands that deliver to my neighborhood, but my family's choice is driven by 1) taste and 2) reliability of delivery. Personally, I place a higher value on the latter, however taste usually rules the day.  In general don’t care how great the pizza tastes, if you can’t get it to me in under 45 minutes when I have hungry mouths to feed, you’re off the list.

Flippin’ Pizza is currently my family’s favorite, so I picked up the landline and prepared to phone in my order as I always do. Unlike Domino's (the other family favorite), Flippin’ Pizza does not offer online ordering.  However, in the interest of reliability (and taste!), I'm willing to accept the hassle of dialing, waiting on hold, placing my order, saying no to the various cross-sell offers, then reciting my 16 digit credit card number, expiration date, and 3 digit security code.  That is, as long as someone picks up the phone, and they do not put me on hold.  For more than three minutes.  Twice.

While I was on hold for the second try with Flippin' Pizza, I picked up my iPhone and went to dominos.com to see if Domino's had a mobile website as well.  They did.  I logged in (I have multiple locations stored at Domino's for delivery - home, pool, skating rink, etc.), and began to enter my order.  Other than a slight delay due to bad reception, my order was entered, credit card info entered, and order submitted before Flippin' Pizza even came back on the line.  I hung up.  Domino's arrived 30 minutes later.

Flippin' Pizza had lost my business due to something those in the business world know well – friction. Other than competition, friction is the mortal enemy of revenues. Friction is what keeps customers from buying your product or service because, well, it was just too damn difficult. In my case, the friction came in the form of a deceptively straightforward landline phone call.  Not only did Flippin' Pizza lose my order, they are potentially losing countless others not only due to customer frustration, but by not adopting a by-now widely accepted sales channel - the Internet.

So what does pizza have to do with financial services?  Actually, a lot.  The financial services industry, being largely a commodity industry, is highly sensitive to friction and the need to mitigate, if not entirely eliminate it from the business equation.  The competition is simply too fierce to do otherwise.  This is why our industry is so often an early adopter of cutting edge technologies designed to further mitigate friction.  We see this in retail banking, in securities trading and processing, and in electronic payments.
 
There is, however, one space within financial services which has, until recently, been able to skate by with considerable friction - capital formation.  Why?  Imagine a marketplace with almost unlimited demand and a relative handful of suppliers to meet that demand.  We would expect to see high prices for that product or service, and we would expect to see little if any effort to grease the sales machinery.  This is exactly the case today with venture capital.  If we think of entrepreneurs as buyers, and funding sources (angels, VCs) as sellers, then clearly there is not much incentive to provide a frictionless marketplace.
 
While it's true we are living in times of unprecedented uncertainty, we are also living in times of incredible innovation and pent-up economic growth.  The problems of the world are many, but there are also many highly driven, smart people willing to solve these problems through market-based solutions, and who are willing to create meaningful jobs for people who, like them, want to change the world for the better.  What they lack, however, is capital.  The capital formation process is, in its current form, rife with friction.  Part of this is due to the apparent lack of liquidity opportunities for strategic investors, part of this is due to perceived risk, and part of this is due to the need for innovation targeting the friction at the very core of the process.

Sites such as GoBig, DealHorizon, TheFunded, MyVenturePad, and AngelList are examples of the type of innovation necessary to minimize or eliminate friction from capital formation.  But even greater opportunities exist in the development of social financial structures which would enable individual investors to participate directly in the funding of new ventures.  We have seen how the "democratization" of investing in established, publicly traded companies has been a key driver in economic growth during the 20th century.  Mutual funds, for example, were in fact one of the first "social" financial instruments by pooling the assets of anyone with a few hundred to a few hundred thousand dollars willing to share in the risk and potential reward of stock ownership.  And thanks to the explosion in the social and mobile Web, the 21st century has witnessed an incredible acceleration in social financial innovation in the personal finance space with P2P lending and mirrored investment management, as well as mobile payments, banking and trading.

The next frontier looms large - getting capital in the hands of start-ups and growth companies who will lead us out of this economic malaise.  Innovators in this space are already hard at work, but considerable friction remains - reactionary regulators, entrenched business models, economic uncertainty.  The infrastructure is in place - witness Facebook with 500 million users.  Clearly a more social model for frictionless capital formation is not only possible, it is essential.