How to disrupt Wall Street

Some thoughts:

Investing banking is an interesting case. On something like an IPO I see IBs as providing three benefits:

1. Navigating the significant regulatory hurdles;

2. Underwriting the offering; and

3. Marketing the offering.

(2) and (3) are related. (3) relies on them having clients with the money to invest in the IPO.

This isn't a simple issue of finding money. Part of a successful IPO is seeding the stock such that trading on the relevant market(s) is liquid.

Not that I'm saying disruption isn't possible but it is hard.

Investing in the stock market directly is, for most people, a sucker's game. The stock market is an insider's market. HFT is just one of many ways that the pros will take advantage of you.

Note: I quite deliberately differentiated between trading (short term) and investing long term. Long term investing reduces the significance of timing and transaction fees but individually picking stocks is still a risky business.

As for prop trading, for completeness I should point out that it is one model for market makers to trade for profit, paying for what is actually a valuable service. Market makers are commonly daemonized, unfairly IMHO. Market makers give you the liquidity to buy and sell whenever you want.

The other trading method is spread trading, basically making money off the bid-ask spread. The spread is basically inversely proportional to the size of the market. In smaller European markets, spread trading is still profitable. In the US government market (basically US Treasuries, possibly the largest market in the world) the spread is essentially zero so the only way to make money is prop trading. Prop trading means taking a position, betting on a particular outcome.

Arbitrage is another model but computerized trading system has greatly reduced the effectiveness of this. Arbitrage is buying some security on one market and simultaneously selling it on another for a higher price, pocketing the difference (eg buy gold in NY, sell it in HK).

As for mutual funds, they have been disrupted by ETFs (exchange traded funds), which greatly increase the liquidity of such investments and decrease transaction costs. Funds also like them because fund redemptions are a huge problem. Typically people take out and put in money at the wrong times. ETFs mean investors can get money out by simply selling them on the stockmarket.

Still, fund managers do make management fees.

Financial products are constantly changing. It's an area that, by its nature, must and does constantly innovate. For example, 10 years ago there was no way for retail investors to short stocks. Now? Most markets have CFDs (contracts for difference) that are a derivative that allows you to go long or short on a stock for a low amount of capital.

Research is an interesting one. Good analysis is a skill and requires access, something a name brand bank provides. That being said, it is an area rife with conflict of interest and late signals.

Retail banks have of course been somewhat disrupted by their online cousins.

Wall Street is constantly changing. It's an arms race where one side trades faster so all the other players do as well. Unfortunately, Wall Street enjoys significant government protection, much to our detriment (eg financial crises brought about, at least in part, by Wall Street having little to no aversion to risk, IMHO due to the almost guarantee of a bailout by the Fed if it goes south).

The most important area of the finance industry is retirement savings and here the US is extremely backward. Companies allowed to invest pensions in themselves, one part of a bank dragging down everything else with it and so on.

In Australia, for example, most people have individual superannuation accounts for retirement savings. There are very strict rules on what these funds can invest in. Such funds are separated from (and insulated against) whatever else happens to the financial institution. The funds are held in trust by third parties.

I loved Prosper (crowdsourced P2P loans), which was mentioned. However, the primary barrier to Prosper's success has not been regulation (a somewhat surprising statement, considering they were shut down for securities laws violations for the better part of a year). The primary barrier to Prosper's success is that their product is strictly inferior to credit cards for anyone who can get a credit card, which means you have an adverse selection problem for borrowers -- the only people who apply have either maxxed their cards or would never be given one in the first place. As a result lender returns are terrible -- many lose principal, and a huge majority underperform substantially risk-free investments like T-bills or CDs.

I'd love to see an innovative option for consumer or small business loans, but it has to compete with this deal: up to $15k delivered instantly (or in 2~4 days), 4% transaction fee, 1% interest for 12 months followed by ~15% interest for life. That what Bank of America will offer me -- right now, instantly, no-human-involved-whatsoever -- for a cash advance on my credit card. Could that deal be improved upon? Yes. But the fact that that deal is possible is, and I say this with no hint of exaggeration, a triumphant monument to the success of capitalism. Many of us Prosper lenders thought it would be easy to beat that with a little human touch. We were dead wrong.

Prosper's original model was, basically, I put on a two week dog-and-pony show on their loan auction page, attempting to convince fickle lenders that I am a good credit risk. In return, I get $X,000 less a 1.5% or so fee (can't remember -- it is higher now) deposited in my bank account about four weeks after the day I start the process, at whatever the auction came up with for an interest rate. In my case, it was 12%ish.

I got a Prosper loan, and all participants in it (Prosper, lenders, myself) benefited from it, but that was for the quirky edge case. The average case was murderous to lender returns.