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What Internet Revolution?

Despite all the hype about the Internet's role in the capital markets, precious little has actually materialized, argues Bidyut Sen, president of Lexam Capital.

On paper, the capital markets, more than any other area of economic endeavor, seem tailor-made for the Internet and the technology it has unleashed. After all, finance is about information. And information can be broken down into bits and bytes quite easily—and transferred over the Internet to interested parties at astonishing speeds.

The promise of the Internet is particularly attractive to people on Wall Street, and for good reason: In spite of all of the technological advances the financial world has made in recent years, it is still plagued with tremendous inefficiencies. This has led to a striking number of business initiatives from all over the world designed to capitalize on these inefficiencies.

Despite the media hoopla and the Pollyannaish proclamations of Internet CEOs, it's still unclear whether these ambitious undertakings will amount to much.

These initiatives have targeted five general areas: trading, settlement, risk management, research and e-security.

The most ambitious efforts have focused on electronic trading. Liquidity remains the principal hurdle. It's a classic chicken-or-egg problem. Markets need tremendous liquidity to attract traders, but without big liquidity right off the bat, no one will join the marketplace. It's a conundrum that hasn't yet been solved—although many have tried.

Consortiums developed by dealers have the best shot at attracting the necessary liquidity. Independent trading initiatives such as Blackbird, CFOWeb and ICor will have a hard time attracting users to their new, unproven systems. Their best bet would be to strike partnerships with the consortiums.

But the success of the consortiums is far from certain. Folks in the business will tell you that big banks have always had a difficult time doing anything together. I talked recently to someone at a leading investment bank, who said, "This time around it's different.” That remains to be seen. A lot of money has been spent, and a lot of articles written, but there's been very little to show for any of the activity.

Most consortiums have set up sites that show users an inventory and allow them to post bids. These are basically information sites. All this will do for the financial community, in my view, is make things a little bit easier. Rather than calling the broker on the phone for information, traders go to a web site. Yes, that's an improvement, but it isn't a major earthshaker.

Then there's the issue of settlement—record-keeping, documentation, regulatory reporting and so on. No one has figured this out yet. We've seen some Internet-based outsourcing initiatives, but none of them has caught on yet. We're years away from that happening.

If you ask Internet participants about this issue, they'll tell you that settlement is merely a technical problem that will be taken care of in the next year or two. In my mind, the devil in financial services is in the details. A technical problem? Sure. But it's a huge technical problem. Many of these well-funded e-finance startups are waiting and hoping that someone else will solve the technical problems. Those companies that are actually focusing on technical problems are the companies to invest in.

My favorite example of this kind of thinking is the notion that data interchange languages such as FpML are some kind of magic bullet. There's no such thing as a magic bullet in software technology. Data integration within departments is difficult enough. Integrating data between divisions is, at this point, still a strategy discussion at planning conferences. Fixed income and equity, for instance, speak two completely different languages. Even if a new language can move freely between these areas, we'll need an enormous amount of new software to apply the language en masse. It will be five years or more before we even begin to see solutions on the grand scale that's being talked about now. The people who write this off as a technical problem are putting what's known as a Nelson's eye on the problem—they're ignoring the obvious because it's difficult to face.

The area of Internet-based risk management is the least promising of all—especially when applied to the corporate world. In theory, the web allows companies to tailor-make analytics for customers, disseminate them and interact with the customer. But is there a demand for this?

Risk management systems have been available to corporations for a long time. Yet no one, myself included, has succeeded in making a business out of it in the most basic way: by getting people to pay for it. Banks have tried to provide the IBMs of the world with sophisticated risk management advice for a long time. They're nice to have, but do companies pay for them? At best it improves the overall relationship with the client—hardly a business on its own. Sure, I want all kinds of analysis from my Fidelity account, but do I sign up with Fidelity just for that? Will I pay for it? There are probably five more important factors informing my choice of Fidelity.

Research is somewhat promising. There's a lot of work being done in this area already, because the buy side is finding itself increasingly inundated with information. In fact, it has access to far more information than it needs, so companies are trying to tailor material to the level of detail clients want, in the form they want, at the time they want, and at the location they want. That's a huge challenge, and whoever does that well is going to win big.

There's also a tremendous demand for e-security products that guarantee the sanctity of financial and other transactions over the Internet. This is probably the most promising area. Whether the Internet dreams of today's e-finance sites materialize or not, there is no denying that the bulk of the transactional and settlement information will flow over the web. The volume of information is huge and will keep growing. Providing security and integrity to these flows will be crucial.

Internet-based applications service providers are somewhat promising. But that business has been around a long time, in the form of service bureaus. Is that now a new business just because of Internet delivery? I don't think so.

In spite of all the applications of the new technology to the e-finance industry, I have yet to see a new business paradigm that works. At this stage, the idea of capital markets on the Internet is still very much a work in progress. And judging by the advances made thus far, there's still a lot of work to be done.