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.

Game On

Once upon a time, finance, like health, was a private matter.  Discussions regarding personal financial decisions were conducted largely behind closed doors - between spouses or between individuals and their financial planner, broker, or accountant. With the advent of the World Wide Web and the creation of investing chatrooms and personal finance websites such as The Motley Fool, financial matters began to become a bit more public.  Perhaps it was the perceived anonymity of the Web, or the interaction with strangers who would not pass judgement, but having personal financial discussions in cyberspace became increasingly acceptable.

As finance in general became a social matter, a parallel phenomenon unfolded in the retail securities brokerage space.  Information technology revolutionized and even democratized financial services in the roaring 90s, and the rise of daytrading gave birth to the idea that "playing the markets" was a potential way for patient, disciplined traders to eke out a living.  The wild bull market of the latter 90s, and a frothy IPO market only served to bolster this belief, and "casino capitalism" continued to progress.  Surprisingly the eventual dot com explosion did little to dissuade the day trading appetite among investors, and as opportunities in equity markets dried up, enterprising companies sought to democratize a new asset class: foreign exchange.  A multitude of brokers popped up during the early and mid-2000s offering access to this trillion dollar marketplace at affordable rates.  Whereas the highly volatile FOREX markeplace was once the province of central banks, banks, and multinational corporations, it is now a playground for small investors with as little as $250 to trade.  FOREX is now one of the most popularly traded asset classes among retail securities traders.

Today, finance is truly social.  KaChing, Covestor, Zecco, and TradeKing are examples of both brokers and asset managers whose business models are actually built on a social media platform. Others have bolted on social media to enhance their value.  Despite the explosion in social media over the past three years, however, brokers and asset managers have lagged behind in terms of innovation, adoption, and the number of home runs in the space.  Of course, they can be forgiven for this - the industry has had bigger fish to fry.  Things like solvency and survival have understandably trumped IT spending..

What, then, is the next phase in the evolution of retail brokerage?  As finance continues to become more social, more interactive, and brokers offer increasingly lower commissions and cutting-edge trading technology, the securities brokerage landscape is changing.  Lowering commissions means emphasizing volume, and that means encouraging not an old-school buy and hold approach, but high frequency trading.  This fundamental change in philosophy is justified on a daily basis by unprecedented volatility in the financial markets, and reinforced daily by the new financial media - bloggers, twitters, and vloggers who publish up-to-the-second trade ideas designed to exploit short-term movements in stocks and FOREX.  This, coupled with social features that enable traders to mirror the trades of other "players," provide real-time ideas and analyses to followers, and even compete for prizes and a spot on the "leaderboard" can only mean one thing: financial services is rapidly become the next frontier in social gaming.

RIP Wesabe

It's always sad when any business is forced to shut its doors.  More than just a cash-generating entity, a business is also the manifestation of a dream, the real-world expression of an original idea and the unending toil necessary to bring it to life and to sustain it.

Wesabe is an example of a company with the right idea, at the right time, but with incomplete execution.  Wesabe's early success was impressive, and was largely due to the novelty of what it offered: the ability to manage the entirety of one's personal finances in one place.  The aggregation of personal financial data - credit cards, bank accounts, bills - was truly revolutionary, and in an era of increasing economic uncertainty and complexity, was embraced by many consumers.  Online personal financial management (PFM) seemed to have almost unlimited growth potential.

But Wesabe faced a host of challenges along the way, not only in the form of competitors (Mint, Geezeo, Jwaala, and Yodlee, to name a few), but a lack of revenue model.  In those "early" days of Web 2.0 (four years ago), the prevailing business model was (and in many cases, still is) free.  That is, offer the product for nothing to generate buzz and a sizeable user base, then monetize later.  Of course, sustaining operations in the absence of meaningful revenue can be a true test of faith (and capital), and investor patience is only so long.  Mint, Wesabe's chief competitor, realized early on how to leverage its data to generate substantial revenue via targeted ads.  Nine months ago Mint was acquired by Intuit for $170 million.

Wesabe went a different route, seeking to white label its product to credit unions.  Springboard, as it was known, only generated moderate success, and Wesabe signed on a handful of licensees.  Fierce competition from Yodlee and Geezeo posed a sizeable challenge to market penetration, and the Mint acquisition meant that Mint would be deployed to the 1,800 banks and credit unions serviced by Intuit.  As resources were allocated to the development of an institutional market for its product, Wesabe's ability to service its consumer user base slowly degraded.

Wesabe's failure may be due to a host of factors, but surely at the center lies a fundamental crisis of business identity.  The lesson for start-ups in any industry is clear: know who your customer is, and have a viable revenue model from the outset.

What Next for Bebo?

While the world ponders the breathtaking value destruction resulting from AOL's sale of Bebo to Criterion Capital Partners, we have been pondering the value of an ailing social network to an obscure private equity firm, one which, according to an AOL employee memo, "specializes in facilitating growth plans and turnarounds."

Since AOL acquired Bebo two years ago, site numbers have been dropping fast in the face of formidable competition from Facebook and MySpace.  AOL's $850 million bet on outsize ad revenues stemming from user growth never materialized.  Recognizing that Bebo would require a "significant investment in order to compete in the competitive social networking space,"  AOL threw in the towel in last April.

The question, then, is how does Criterion intend to realize any value from Bebo?  Assuming Criterion paid the reported amount of $10 million, that's less than $1.00/user (some media outlets are reporting a sale price as low as $2.5 million, in which case the cost/user drops to around $0.21). We've developed a few possible scenarios.

Scenario 1: 
Criterion paid less than replacement cost for Bebo.
Criterion may be planning to liquidate Bebo and sell off the underlying technology IP to the highest bidder.  The Bebo brand lacks any meaningful value.  However, given the scale, depth, and complexity of the site's architecture, the technology powering Bebo could conceivably be quite valuable to a company looking to quickly deploy a social network.

Scenario 2: 
Criterion intends to flip Bebo.
Criterion may have been in the right place at the right time as AOL was anxious to offload an underperforming asset.  Bebo's young (18-24), 12 million member user base could be extremely valuable to a trendy teen or twentysomething media company looking to buy a social media audience.  With a minimum additional investment (or maybe none), Criterion could realize a respectable return in a very short holding period.

Scenario 3:
Criterion believes Bebo can be saved in its current form.
Criterion may believe that Bebo has been the victim of uninspired management, and that, by implementing a creative, imaginative turnaround strategy, could be rehabilitated.  As pageviews have fallen off a cliff, Bebo's ad revenues have surely followed suit, so the difficulty here would be creating a unique, engaging user experience - one that is sufficiently sticky, that can be monetized efficiently (see scenario 4), and cannot be obtained via other social networks.  Perhaps Criterion intends to reinvent Bebo as a social network devoted exclusively to gaming or music or other interest.

Scenario 4:
Criterion believes Bebo can be monetized virtually.
Until recently, advertising was key to generating revenue on social networks, which meant constant pressure to grow the user base and generate pageviews.  Nowadays, however, networks are gradually diversifying their revenue stream by adopting a model driven more by user engagement.  Gifts and social games integrating virtual goods are increasingly becoming the standard for social network monetization.  This may very well be Criterion's plan for Bebo.  Given the young demographic, and the explosive growth in (profitable) social gaming, Criterion could be looking to redeploy Bebo as a game-centric social network similar to myYearbook.

Regardless of the outcome, AOL's sale of Bebo at a near-total loss serves as a cautionary tale for social network acquirers going forward, and could have a chilling effect on future transactions.

Our kaChing Presence is No Longer

If you've been monitoring the DRS Advisors portfolio on kaChing as of late, you may have been shocked, as we were, when our portfolio jumped nearly 1500% overnight.  It didn't take long before we zeroed in on the cause:  Our position in E*Trade had not been properly adjusted for the company's recent 1 for 15 reverse stock split.  We chalked it up to a bug, and waited for a day for the problem to be resolved (presumably other portfolios had experienced the same problem).  When two days went by without a fix, we became curious and when we went to the application to alert tech support, we were greeted with some unwelcome news.  As of Monday, June 7, kaChing would no longer be supporting its Facebook application, InvestingIQ.  Going forward, the company would be fully devoting itself to providing a one-stop, turnkey solution for small money managers.

Needless to say we are disappointed.  kaChing has been an integral part of our social media presence, enabling us to conveniently publish our equity research and manage a virtual model portfolio.  Our "IQ" was on the rise, and we were steadily on our way to qualifying as a "Genius" and moving from virtual asset management to running real money.  Sadly, our trajectory has been altered by kaChing's decision to focus solely on established Registered Investment Advisors. 

We have launched a search for a suitable replacement, but kaChing's unique business model, clean interface, and reliability may be hard to duplicate.  There is no shortage of virtual stock trading services populating the Web, but, unlike most, kaChing's provided aspiring money managers with a legitimate platform to prove and promote themselves, to cultivate a following and build a track record.

We hope to have our investment research back online soon.  Stay tuned.

And We're . . . Back

You may have noticed that I've been way for a while.  My seven month sabbatical was both an unplanned and unwelcome one.  Last October my wife was diagnosed with breast cancer, and for the past seven months I've been managing her care, as well as much of everyday life at home.  I simply had no choice but to put DRS Advisors on hold while we worked through this battle.  In addition to exacting an enormous physical and emotional toll on its victim, cancer is a full-time job.  Fortunately, this story has a happy ending.  After two surgeries and radiation (but, mercifully, no chemotherapy) my wife is cancer-free and on the road back to her normal life.

In the brief moments between accompanying my wife to doctor appointments, battling with insurance companies, or getting the kids out the door in the morning, I thought about DRS Advisors.  I knew the business model had to change.  If the last seven months has taught me anything, it is that life can pull the rug out from under you at any time.  And for me, more than anything else, my business needs to conform to my life, not the other way around.  There needs to be balance.

The result is a new structure which I believe is a more accurate expression of what I am seeking with DRS Advisors.  We will no longer focus exclusively on advising clients (though we will still do so on a select basis). Our focus will be exactly what our tag line says: Insight. Innovation. Solutions.  We will be focusing more on generating high-quality content focused on social media investment banking.  We will be focusing more on the research and development of innovative financial structures and transactions.  And finally, from time to time, we will provide financial advice and solutions.

What exactly does this mean?  This means that DRS Advisors is now a "digital" investment bank - a unique hybrid of financial services firm and digital media company.  We will conduct our business almost exclusively on the Web across an integrated array of social media (alt.capital, Facebook, Twitter, SlideShare and the like).  We will provide timely and actionable ideas for deployment by leading financial institutions - boutiques, full-service firms, sovereign governments, and multilaterals.  We will provide a welcome and original voice on financial matters in an increasingly crowded and watered-down blogosphere.

Can we make it work?  Time will tell.  But there's something about renewing a personal commitment that is uniquely empowering.

Here's to the future.  It's good to be back.

Why We Like JMP Group

For some time now we've been bullish on boutique investment banks.  In the fall of 2007, as the current crisis began to unfold, we predicted a shake-up in the highly concentrated investment banking model.  The crisis of the past 2 years has only served to underscore our belief (a belief shared by others) that the conglomerate model of investment banking cannot stand, and that smaller, more nimble, research-driven shops will be the winners.

One of the shining examples in this regard is JMP Group (JMP), a San Francisco-based boutique founded in 2000 by Montgomery Securities alumni Joe Jolson and Carter Mack.  JMP went public in 2007, and as a result has had to build its business in one of the worst market environments of the past century.  Nevertheless, JMP has survived, and in fact has thrived, capitalizing on the distress of its larger competitors, capturing talented managers fleeing ailing bulge bracket firms, and partnering with Qatalyst Group, a technology boutique founded by veteran tech banker Frank Quattrone.

JMP's recent financials are impressive.  Having posted a net loss in Q4 of 2008, the company returned to profitability in the first quarter of this year with EPS of $.03.  In the most recent quarter, the company posted record revenues, nearly doubling from $25.02 million to $49.63 million.  Revenues increased in all core business areas with the exception of asset management, which actually fell by 50%.  Quarterly EPS increased 667% to $.20.  JMP's balance sheet is strong, with $55.7 million in non-deposit cash and marketable securities, and minimal debt (8.5% d/e ratio).

But can the company continue to post such numbers?  We believe it can.  Management has clearly proven itself by building and sustaining a viable investment banking franchise in the midst of utter turmoil and uncertainty in the global economy.  In addition to being a beneficiary of the bulge bracket meltdown, we believe JMP stands to benefit greatly from increased M&A activity and, yes, the eventual return of the IPO market.  The universe of venture and private equity-backed companies continues to grow with no end in sight, and will provide a healthy stream of dealflow by mid-2010.

Developing Your Acquisition Profile

We recently blogged about an emerging trend in social media acquisitions: buying up assets and talent as opposed to streams of cash flows (i.e. entire enterprises).  We concluded that start-ups should consider positioning themselves as potential targets for asset acquirers.  But how can this be accomplished?

First, you must redefine the profile of your core customer.  While you should of course remain focused on your current user base (and growing it, if your value proposition involves increased market share or lead generation), your customers are now potential acquirers.  Determine what industries your product would serve, then generate a list of customers in each.  Recognize that you are now selling yourself as an off-the-shelf IT solution and, as is the case when contemplating an in-house IT project, you must justify the expenditure by demonstrating the ways your product can create value for the buyer's business.  For each customer, place yourself in the role of CIO.  How does your product fit into the customer's IT strategy?  Will your product help to streamline operations?  Increase market share?  Lower the buyer's customer acquisition costs?

Once you have the answers to these questions you can begin to approach prospective acquirers.  You may find that many will be receptive to your overtures, especially as the economy continues to improve and IT budgets increase.  However, once your pitch is complete the response you are likely to hear is: "You've got a quality product, a great team, and we see the benefits you can bring to a company like ours.  But why should we pay you what you're asking when we can build a comparable system for far less, or even outsource the development to India and get a comparable product for $50,000?"  In other words, why should they pay you more than replacement cost for a non-cash-generating asset?  For your response, you have several options:

Lower Total Cost of Ownership (TCO) /
Higher Return on Investment (ROI)
If possible, demonstrate how the all-in cost of acquiring you will be less than a custom-built application for the duration of a typical project length (five years). Point out that your costs are clear and are known upfront, whereas an outsourced or even an in-house build can suffer from significant cost overruns and result in outsize maintenance and support costs over time.  If applicable, underscore how your product will deliver a pool of account leads or eyeballs for CPM purposes, and, preferably, that your acquisition will result in an increased conversion rate for the buyer.  If the deal entails the transfer of human capital, underscore management's intimate bottom-up knowledge of the product as a key driver of value going forward.

Quality Control
Point out that, while an outsourced custom solution presents an attractive business option, it can be difficult to administer and, given the inherent complexity of software development, can often result in buggy code, sluggish performance, and an overall brittle application. Moreover, the identification and resolution of bugs occurs over time and in the live production environment. The result is at best an inferior product, and at worst additional costs in the form of lost productivity, lost customers and revenue, and additional capital outlays.

Evolving Functionality
Explain that custom-built applications tend to be rigid in their satisfaction of specific client requirements and do not provide the necessary flexibility to handle future changes. With your knowledgeable team in place, the customer will have the capability to regularly enhance the application with additional features, and to upgrade existing functionality. Conversely, upgrading a custom application will require a significant level of effort and expenditure.

Faster Time-to-Market
In addition to valuable resources, a custom-built application requires a substantial investment of time. Requirements analysis, design, development, testing, implementation, maintenance and support are all important factors when considering in-house or outsourced development.  Acquiring your product, however, will enable the customer to deploy in a matter of days as opposed to weeks.

Obviously you will want more than replacement cost, but how can you justify this?  In the absence of cash flows, you need to identify the unique value your product will bring to the acquirer over time.  They key is being able to the quantify the value, and to demonstrate it in dollar terms. This is difficult, and will likely require customizing your product's value proposition for each buyer, but with a bit of research and reasonable assumptions, not impossible.  In our next post we will focus on various methods for valuing your product as an asset acquisition.

Wanted: Healthcare Finance Start-Ups

For all its faults (and there are many), free market capitalism is arguably one of the most powerful engines of innovation the world has ever seen.  Time and again solutions to some of society's most challenging and seemingly insurmountable problems have arisen from the pursuit of profit.  It is time that this power be brought to bear on one of the most urgent problems of our time - affordable health care.

Like most industries, healthcare has embraced the Internet as a powerful communications tool, with scores of websites providing information, reviews, and recommendations.  The healthcare industry has also been one of the early adopters of social networking, a technology which seems tailor made for individuals seeking valuable peer perspectives on providers and available treatments, as well as advice and support.  Various digital media have recently emerged as a means for individuals to measure their "life stream data," to track their progress toward a healthier lifestyle.  Yet, ironically, while never before have consumers been so empowered with respect to their own care, the ability to pay for such care has never been so uncertain.

We believe an enormous opportunity exists in the application of digital media to healthcare finance.  A project of this scale would require as much financial as technological innovation, but we need look no further than P2P lending for inspiration in this regard.  People lending money to complete strangers would have been unthinkable ten years ago, and yet today we find individuals lending millions of dollars to fund everything from a new business venture, to home improvement, to a master's degree.  Likewise, we are (finally) seeing the first indications of P2P-type technology being applied to corporate finance (Sprowtt).

The democratizing effect of "Health 2.0" technologies has been shown to contribute significantly to administrative cost reductions, and this is an excellent start.  But is time to take the larger step of revolutionizing healthcare affordability. The surprising success of the P2P finance model should provide ample incentive for financial technology entrepreneurs with unconventional ideas.  The winner of this race will be rewarded . . . handsomely.

E*Trade Rumblings

There has been much commentary recently regarding the takeover potential of E*Trade (ETFC).  Analysts are largely bullish on the stock citing the bottoming of the housing market and resulting stabilization of ETFC's outsize mortgage portfolio, as well as the strength of ETFC's core brokerage business.  Recently selling pressure has been attributed to portfolio rebalancing by institutions with greater than 9.9% exposure.

Likely suitors include Schwab (SCHW) and TD Ameritrade (AMTD), both of whom have expressed interest in E*Trade's 2.7 million retail accounts.  However, we disagree with the contention that larger institutions such as Wells Fargo (WFC) or Goldman Sachs (GS) could also make a play.  While yes, these companies would be better positioned from a balance sheet standpoint to absorb E*Trade's mortgage portfolio, the synergy is simply not there, particularly in the case of GS.  The bigger question still is whether ETFC would even want to sell.  With the economy improving, and with the company still maintaining a highly competitive position, any offer would have to be at a considerable premium to the current price of $1.70.

Stripping away its balance sheet woes, ETFC is fundamentally strong.  The company is successfully growing its account base, as well as its brokerage-related cash while keeping operating expenses low.  In addition, ETFC continues to deploy cutting-edge desktop and mobile trading technologies, and remains one of the most recognized brands in online trading. 

Apart from its takeover potential, we believe ETFC is a strong buy at current levels with a one year price target of $5.00.

Facebook Credit Arbitrage

We have watched with great interest Facebook's slow motion deployment of its virtual currency, Facebook Credits.  One of the more obvious steps has been to offer payment options for Credits in 15 different currencies (70% of the network's users reside outside of the United States).  From an implementation standpoint, however, this could be tricky given the volatility of the currency markets. 

While exploring the Gift Shop shortly after Facebook's announcement, we discovered that this medium may in fact present opportunities for currency arbitrage.  Facebook has since changed the process for Gift Shop transactions.  Users now must choose their currency option under Account Settings - Payments, rather than make that choice at the time of purchase.  In addition, it would seem that the option to purchase additional Credits (i.e. more than what is necessary to effect the current transaction) has temporarily gone away.  Nevertheless, our conclusions still hold.

Facebook's local currency quotations are not in real time.  In fact, they appear to be based on the previous day's closing value, and they apparently remain fixed for the following day.  This means that Credit buyers have the ability to exploit this time distortion, and the pricing differential which may result.  Depending on volatility, buyers could realize a substantial discount.  Here's how it works:

1. Identify currencies experiencing a meaningful (i.e. 2% or more) intraday drop against the USD from the previous day's close.
2. Purchase credits in that currency (quoted at the previous day's close).
3. The purchase is converted into USD by your credit card company (for which you will be charged a conversion fee ranging from 1 to 3% of the transaction).
4. Enjoy your discounted Credits, or perhaps resell your Credits for dollars using Facebook's proposed transfer system when it becomes available.

Now, there are numerous caveats and assumptions here, not the least of which being that when using any of the myriad currency converters available to derive current exchange rates we are quoted the bank or wholesale rate - that is, the rate which applies to transactions sized in the millions of dollars.  Whether credit card companies use this rate when converting your transaction is a bit of a mystery, thus transaction costs could substantially erode if not wipe out any discount.  Also, this is of course not true arbitrage in the sense that (as of yet) Credits cannot be readily converted back into hard currency via Facebook.  But to the extent that Credits can be used as currency in the Gift Shop and within a growing list of popular Facebook applications, it's as close as you can get.  Should Facebook roll out its Credit transfer system (currently under private beta), however, things could get interesting.  Theoretically, one could buy Credits in a currency experiencing a significant intraday drop against the dollar, then use the Credit transfer system to offer Credits in USD at less than the going Facebook rate.  Using any number of payment providers to effect the transaction, the arbitrage is complete.

As with any arb trade designed to exploit tiny price differentials, in order to realize any meaningful return substantial sums would have to be involved.  Transaction costs (the credit card conversion fee and the payment provider's fee) would have to be minimal, and the rate at which credit card companies convert purchases into your home currency would be a factor as well.  Nevertheless, we find this to be an intriguing possibility, and as Facebook inches closer to full deployment of its virtual currency, we will continue to monitor.  We hope that Facebook will be hedging their exposure.

Asset Acquisition as a Path to Liquidity

Recent acquisition activity in the social media space indicates that start-ups may be increasingly viewed as attractive asset targets. In other words, given that many of these companies generate little (and in most cases, no) cash, they offer little value to a prospective acquirer outside of their ability to enhance the buyer's IT strategy. The target may bolster the acquirer’s top line by providing significant cost savings, faster deployment of new business initiatives, and, in many cases, talented managers who are compelled to stay on as part of the deal.

Nokia's recent acquisitions of mobile software maker Cellity, microsocial network Plum, and social travel site Dopplr are examples of such a strategy. Nokia is clearly seeking to buy a social network infrastructure rather than build one organically. Whether this strategy is viable remains to be seen (analysts have referred to it as rearranging deck chairs on the Titanic), but it is clearly warranted given the competitive threat from RIMM and Apple. Interesting note: The language of the Cellity press release actually states that "Nokia and Cellity have reached an agreement for Nokia to acquire the Cellity team" (emphasis added). Cellity is going away, and apparently Nokia values the 14 member team at somewhere between $10 and $20 million.

Intuit's acquisition of Mint, also motivated by competitive concerns, is an example as well. Intuit clearly was not purchasing a set of cash flows with Mint. Rather, Intuit saw an opportunity to buy an asset in the form of Mint's user base which could then be monetized via Intuit's current platform offerings (and dispense with a significant and growing threat).

As economic recovery takes hold, the popularity of these transactions will likely increase as businesses seek to develop a social media infrastructure, whether for internal efficiencies or for external growth. This is both good news and bad news founders and investors. The good news is that a path to much-needed liquidity is now opening for start-ups without much hope for an IPO. The bad news: valuations will adjust downward as they reflect the difference between a cash-generating enterprise and one which adds value as a strategic asset. A recent extreme example: Shutterfly's acquisition of Tiny Pictures for $1.3 million in cash. Tiny had raised over $11.2 million, and just closed $7.2 in series B in February, 2008. This is clearly not a happy exit, and is a cautionary tale illustrating the risk of valuing non-revenue generating entities.

The upshot: Rather than rely on faith (and burn cash) waiting for a market to appear (not everyone can be Twitter), start-ups and investors would do well to consider positioning their companies as attractive acquisition targets from the outset.

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.