Professor Michael Mainelli, Executive Director, The Z/Yen Group
[An edited version of this article first appeared as “The Pond For Markets: Social And Local” Journal of Risk Finance,The Michael Mainelli Column, Volume 9, Number 3, Emerald Group Publishing Limited (May 2008) pages 303-305.]
Big Liquidity Pools From Social, Local Ponds
Sitting above the Monte Carlo Casino in September 2007 watching Patrick Young’s Exchange Invest Conference in Monaco, you find that the new “stock exchanges” of the future are an interesting bunch. New exchanges get their start because existing exchanges don’t care about small, local markets. At the conference, Lamon Rutten described the firm of which he is joint managing director, India’s Multi Commodity Exchange (www.mcxindia.com), trading daily over $1.5bn. MCX announced in February 2008 that is has agreed to sell 5% of itself to NYSE for $55 million. Not bad for a firm less than five years old that distributes prices via bicycle as well as the internet. Existing exchanges ignore seemingly small and peculiar exchange opportunities. In the UK, Betfair (www.betfair.com), an online betting exchange less than a decade old has grown to be worth more, and have more transactions by volume, than the London Stock Exchange founded in 1761.
While the larger, older financial exchanges talk about “global liquidity pools”, the newer exchanges focus on helping their customers get better prices with lower transaction costs. They are also quite innovative at finding new customer needs. For example, there is a plethora of “prediction markets” hoping to capitalize on “The Wisdom of Crowds”. Some will become quite large. InnoCentive (www.innocentive.com) is a new stock exchange that connects scientists and engineers (“solvers”) with cash prizes for finding solutions to corporate (“seekers”) technology problems.
The new exchanges are social in two senses, they promote more direct social interaction and they are often socially responsible. For example, Kiva (www.kiva.org) is a social exchange that helps people lend to small entrepreneurs in the developing world in order to help them escape poverty. A New York Times article of 27 January 2008 by Rob Walker, “Extra Helping”, points out that Kiva and other similar initiatives are overwhelmed by donors. Intriguingly, in the developed world too there are several analogous exchanges for people who want to lend directly to other people, e.g. the UK’s Zopa (www.zopa.com – a P2P/peer-to-peer social money lending service) or the USA’s Prosper (www.prosper.com – an online auction site for borrowers and lenders). Zopa and Prosper are really just first-world micro-finance organizations, emulating Muhammad Yunus’ Grameen Bank and its third-world lending in the developed world.
People want to lend and invest within their communities. The problem is that “community” is many things, ranging from lending to people with similar ethnic, gender or religious biases, to investing locally. Sure, every market starts small, and the most successful rise stratospherically, but an interesting thing to note is the resurgence of ‘locality’. In the UK, a host of regional exchanges died by the 1980’s as trading centered on London. In the USA a century ago there were hundreds of stock exchanges, but things consolidated on a handful of national platforms. This national consolidation is not just competitive success, or “liquidity begets liquidity”, it is frequently driven by regulatory or legislative forces that believe centralization, consolidation or size are important to regional or national success.
Yet geographic risk is real. If you want to invest wisely, it can make a lot of sense to invest in firms you see daily. As you pass by you can see the customers’ cars or bicycles, you meet the employees socially, you can tell whether the firm is well off, or not. Studies of venture capitalist investment note that there is a bias for successful investments to be closer to the headquarters. This makes sense. Geographic proximity reduces uncertainty by improving information quality and interpretation. The ‘local’ venture capitalist knows more things of more relevance, and makes better investment decisions as a result. A simple, but real, example, when accompanying one venture capitalist on a tour of a potential foreign investment he remarked at how ‘quiet’ the local economy seemed, not realizing that it was a local religious holiday. He declined to invest in what turned out to be a fantastic company.
Often unremarked is the scale and organization of local barter networks or exchanges (e.g. www.nationaltradebanc.com or www.itex.com), but equally there are significant moves to create local exchanges for investors. In the UK, the regional development agency for the west midlands (i.e. the Birmingham area), Advantage West Midlands, has fought regulatory battles to get permission for a pilot project to build a local investment exchange, the LBX project. The basic idea is to promote investment opportunities in the region by matching local investors with local companies. It may sound strange, but it is hard to find local investment opportunities in a national or international environment. You can google investment opportunities half-a-world away, but not realize that the same opportunity might exist locally, around the corner from your house or office.
The Pond For Markets
So what can we anticipate? First, many of the so-called third-world or developing economy micro-finance models seem equally appropriate in the developed world. The developed world has its poverty too. Moreover, if necessity is the mother of invention, look to the third-world for inspiration. So, expect more application of third-world ideas in first-world contexts, e.g. mobile-telephony-based exchange applications developed in Africa moving to the streets of New York City or London.
Second, exchanges need to promote more social and local interaction. Too many exchanges believe that globalization should reduce social interaction. Actually, the more social interaction exchanges can provide, the more likely they are to keep their customers. Barry Fineberg promotes “spatial ordering: communities of interest at appropriate levels of need” as important for sanity as well as investment. Technology can help here, using geo-referencing and networking tools to create micro-clubs, but the human aspect is real people meeting other real people, not just cyber-bots transacting with avatars. So, expect to see as much investment directed towards social networking and tools, e.g. interest group meetings, conferences or magazines, as towards trading technology investment.
Finally, creative destruction shall continue, and existing exchanges need to think more like publishing firms than trading firms. In publishing, large publishers accept that among the numerous small new titles there will be some major successes. A successful large publisher needs an excellent scouting process that identifies winners early on, approaches them and successfully consolidates them before the competition. The largest publishers follow a “portfolio” model, not a corporate delivery model. It’s clear that many exchanges are already following a portfolio acquisition model. There are far too many exchange opportunities left, wherever risk or opportunity can be exchanged, direct peer-to-peer insurance, peer-to-peer pensions, property exchanges … for any existing exchange to try and develop them all in-house. Just as many exchanges have abandoned the “mutual” model for the corporate model, so too do many need to move on and swap the corporate model for the portfolio model.
Some of the new small ponds will attract enough liquidity to become great lakes. In turn, they will attract the attention of the biggest exchanges. Customers may want scale in technology and reach, but they also want it hidden behind a local face. Looking forward to Exchange Invest Monaco 2008, the challenge for exchanges will remain, as ever, “to think global, act local, be social”.
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