Wall Street is renowned for its ability to create innovative financial products and strategies that go on to earn billions of dollars of fees for their creators at banks like Goldman Sachs, JPMorgan Chase and other “sell side” entities. Folks at Salomon Brothers came up with one Big Idea – securitizing mortgages and other loan products – while Drexel Burnham Lambert is famous (or infamous, perhaps) for its role in turning junk bonds from an esoteric product occupying a tiny market niche into a mainstream corporate finance tool. Banks of all kinds turned the collateralized debt obligation, or CDO, into a household word, while the brain trust at J.P. Morgan (now part of JPMorgan Chase) spearheaded the development of the credit derivative.
So, what have they brought to the table lately?
Not all that much, it turns out – and that’s probably a good thing. In the financial sector, the locus of innovation seems to have shifted in the post-crisis environment, as banks have had to devote more time and attention to regulatory and legal concerns, and to regaining lost ground in their traditional businesses. Plain vanilla financing activities – underwriting bond issues by companies eager to take advantage of rock-bottom interest rates – has been one focus of their attention. To the extent that there have been innovations in equity financing, such as the new “secret IPO” process provided for in the JOBS Act, it hasn’t been the brainchild of a sell-side institution such as a bank or investment bank.
As one Wall Street lawyer pointed out to me recently, a lot of the attention within banks and financial institutions has revolved around managing their own capital, as national and global regulators have insisted they become better able to withstand any future crises. That’s why banks like Barclays and UBS have emphasized contingent capital securities, a kind of hybrid security that regulators are tending to view favorably when computing capital and that offers the issuer a kind of buffer against financial stress. The hunger for yield, in part, is making these “CoCo” bonds appealing to investors, in spite of the fact that some kind of “trigger” event (a market shock, a big change in the bank’s capital ratio) could lead to writedowns or a forced conversion into equity, ranking junior in the capital structure to other debt.
But if you scour Wall Street – or at least, the sell side institutions traditionally thought of when that phrase is used – you’ll look in vain for other examples of new products or trends that will affect ordinary investors. One New York-based partner at Boston Consulting Group notes that there has been more “process innovation” than product innovation on the Street, as banks have focused on issues such as outsourcing, standardization and other elements of doing business that can cut overhead and make them more efficient. The baton of innovation has been passed on, it seems, to the buy side – the asset management industry – as well as to companies that are profiting from the post-crisis disruption within the financial system.
On the asset management side, some of the products that have attracted a lot of interest tend to be related in some way to already-existing structures. So, in light of the popularity of exchange-traded funds (ETFs), some providers sought and received approval for actively-managed ETFs, although interest in these is growing only slowly. One example of a new, new thing on the buy side is the decision by fund giant Vanguard to tap into investor interest in ETFs tracking “low volatility” indexes. Vanguard is seeking SEC approval to launch its own variation on that low-volatility theme: an actively managed global stock mutual fund meant to offer a less gut-wrenching path to investment profits. (Unsurprisingly, most of these low-volatility funds were launched in the aftermath of the financial crisis.)
It’s beyond Wall Street’s traditional borders that most of the most intriguing innovations have been born, however. The Internet has made a host of financial innovations possible, while transforming the way financial markets work. So it’s not surprising that a bunch of new companies have sprung up that rely on the Internet’s ability to connect people worldwide to bypass banks.
Once, if we wanted to borrow from anyone other than a friend or family member, whether to buy a house or a car or take a vacation, we had to go to a bank. These days, we can turn to the Lending Club, a peer-to-peer entity that does exactly what its name suggests, enabling members to lend up to $35,000 to each other. “Investors earn better returns, borrowers pay lower rates,” the company brags, in part because the process is a direct (albeit anonymous) link between the investor in the debt notes and the borrower. So far, the Lending Club has grabbed $2.54 billion of lending activity away from the commercial banks. That’s chickenfeed in the grand scheme of things, but it’s significant enough to serve as a harbinger of things to come.
SecondMarket is part of the same trend, with an even more ambitious slogan (“Reinventing the Modern Stock Market”). Again, as a peer-to-peer network, it bypasses Wall Street by linking interested investors (in this case, mostly institutions or “qualified” investors as defined by the SEC – with a liquid net worth in the seven figures or higher) with companies like Rick’s Picks, a gourmet pickle manufacturer. “A SecondMarket company,” the company proclaims, “understands that the public markets have permanently changed and no longer serve the needs of today’s entrepreneurs.”
But it isn’t just entrepreneurs who feel short-changed by Wall Street today. SecondMarket caters to groups that few Wall Street institutions have ever accommodated, like investors in illiquid securities, pre-IPO companies and others who want to buy or sell. If you’re lucky enough to have worked for Twitter and been given shares in the company as part of your compensation package, a company like SecondMarket or SharesPost is where you have to head if you want to sell, at least until the company’s IPO.
The heart of all successful innovation is disruption of an existing model. The interesting twist on the post-crisis innovation in the financial sector is the fact that what is being disrupted may – in the long run – be the long-established institutional relationships on which Wall Street was built. That may be the final blow that the financial crisis ends up delivering: While Wall Street focuses on innovations to protect itself, could it be that it is allowing others to set the pace when it comes to the kind of innovations clients are likely to find most intriguing?