Pipeline Report August 2010

The Pipeline Report Incisive Analysis of Emerging Trends in Financial Technology August 2010 An Update: The April 2010 edition of the Pipeline report focused on trends in unstructured text feeds. If this topic is of further interest, we urge you to read the Razorfish report on nimble content. The Razorfish report focuses on publishing content across multiple venues. While having a slightly different focus than our Pipeline Report, it is well worth a read. The Razorfish team did a through analysis of the underlying technologies. We applaud their efforts. In the past, we have posted the Pipeline Report on Slideshare here. We are now also posting on Wordpress. Readers can now subscribe to the Pipeline Report here. GARBAGE COLLECTION THE MISSED MULTIBILLION DOLLAR OPPORTUNITY THE PATH TO THE REGULATORY NOOSE AND HOW WE GOT HERE Mary Shapiro, Chair of the Securities and Exchange Commission, has been cracking her whip. After a twenty year slumber under their desks, SEC staffers are rubbing the sleep sand out of their eyes and facing the bright lights of public scrutiny. Illustrative of the SEC‘s Rip-Van-Winkle siesta, the agency still collects information on insider trading scandals using…hold your breath…fax machines, a technology older than most of the traders they are investigating. It is easy to poke fun and incompetent or lazy bureaucrats, but the reality is that prior to Shapiro‘s arrival, this agency was the laughing stock of financial regulation. It has been disenfranchised and neutered for years. Now finally, the careerists have something to sink their teeth into now that they are being given mandates to get the job done. Prior to Shapiro‘s arrival, the SEC chair, under George W. Bush‘s administration, seemed to be occupied by a series of care takers, who, in our opinion, executed their duties with perfunctory resolve. The first in the series was the hapless Harvey Pitt. Under Pitt, the SEC‘s performance could be described as somewhere on the spectrum between Absent-Without- Leave and abject incompetence. In the early 2000s, concurrent with Pitt‘s incumbency, the SEC‘s lack of enforcement seemed so appalling and farcical that the nation turned its lonely eyes to Elliot Spitzer, then New York State Attorney General. Spitzer prosecuted a number of cases under New York State law on the premise that New York State investors had been harmed by various misdeeds. With this strategy Spitzer extracted a number of high profile settlements, and put the rest of the financial industry on notice. Interestingly enough, Spitzer filed only civil cases—and not criminal cases. Had he pursued and obtained criminal convictions, the guilty would have been forced to liquidate for fiduciary breach. In retrospect, he might have saved US taxpayers a trillion dollars had he pursued that course. In any event, we are deeply indebted to Spitzer for his work. Spitzer‘s motives for his prosecutorial zeal are unclear. We believe they were part altruism, part outrage at the SEC‘s abdication, and part self aggrandizement: build his political reputation as a non-nonsense law-and-order candidate. Spitzer parlayed his AG career into being elected New York Governor, a position from which he subsequently resigned when he was embroiled in a prostitution ring. So much for law-and-order Apparently Pitt‘s performance was so abysmal, that President Bush abruptly announced Pitt‘s replacement one day after the 2002 midterm elections, replacing him with William Donaldson, a man with extensive experience in the

capital markets. At least Donaldson was capable of looking an unmarked map of Manhattan and pointing to the approximate location of Wall Street. After Donaldson, the commission was run by Christopher Cox. Towards the end of his tenure, Cox was in the hot seat as the markets imploded. It is unfair to blame Cox for the meltdown, but we are still hard pressed to think of a single proactive campaign that the he led did to clean up the mess. This brings us to the present. The lax enforcement, the meltdown of major capital markets worldwide, the near seizure of the financial system, the massive governmental financings, and the subsequent populist revolts have led to regulatory ricochet. Enfranchised by an Administration focused on governing, and emboldened by the largest financial reform law in the past seventy years, Sherriff Shapiro is ridin‘ into town, and it ain‘t gonna be a pretty picture. She may be a straight shooter, but she ‗s gonna unload both barrels of her shotgun on the cheaters. That seems apparent given the renewed vigor of the commission. THE CONSOLIDATED TAPE In late May 2010 as a result of the ―Flash Crash‖, and prior to the Dodd-Frank Wall Street Reform and Consumer Act, the SEC proposed a consolidated audit trail system for tracking trading across multiple trading venues. The fragmentation of trading across venues was discussed in the March 2010 of the Pipeline Report. The consolidated tape is the SEC‘s attempt to gather trading information across trading venues. In summary, because trading venues have splintered, it is exceedingly difficult for regulators to get a view of the composite picture. Institutional traders and broker-dealers use multiple trading venues to execute increasingly exotic trading strategies. If the trade data across the venues is not consolidated, regulators will be playing a game of Whack-a- mole to follow the actions of individual traders much less a posse of them. For the record, sorting this issue out is is going to take much more than updated fax machines. The goal is to for all the king‘s men to put Humpty Dumpty back together again. In an era of enormous volumes of high frequency trading across multiple venues, following the behavior of a single trader is tantamount to finding the pea underneath the shell. In a contemporaneous and possibly related development, the SEC has proposed that high frequency traders register and obtain a unique identification. The purpose is traceability and accountability, again in retrospective investigations. With unique IDs, traders can be tracked across trading venues. Trader traceability and the ability to compile a consolidated tape all point to the inevitable conclusion: regulators want to gather and reassemble fragments of information to re-create a coherent picture. All of this may be eliciting a collective groan from the industry, ―What will the idiots in Washington think of next?‖ THE GLASS IS HALF FULL Well folks, we are here to tell you that the glass is not half empty. It‘s half full. That vendors of market surveillance tools are rubbing their hands in glee is to be expected. However, a far larger opportunity is being enabled by the consolidated tape. We predict the market surveillance vendors will completely miss an emerging and far more profound market opportunity. They face another challenge: the linear extension of their technology will be as laughable as the Yellow Pages trying to compete against Google. It is yet another case of a disruptive technology emerging from an adjacent market segment and upending the apple cart. The title of this Pipeline Report, Garbage Collection, the Missed Multibillion Dollar Opportunity, comes from a term in computer science called garbage collection. The concept of garbage collection is where small pieces of memory are reassembled into large contiguous chunks.

To make this concept tangible, think of it in the context of a word processing document. When the document is initially loaded into the computer memory, internally the document sits as a large contiguous portion of memory. As the user inserts and deletes paragraphs, the updated version of the document continues to appear contiguous on the user‘s screen. However, the internal representation fragments with each edit. In the end, the internal representation looks like novel scattered across a pieces of confetti. An internal data structure ties these fragments together so they appear on the display as a coherent whole. At some point, a process in the computer and invisible to the user, collects all of the little pieces and restores the internal representation to a contiguous whole. The notion of collecting the fragments to reconstruct the whole is called garbage collection. In the context of the consolidated tape and unique trader IDs, the regulatory goal is to be able to collect the garbage and present it as a coherent whole. This is the back office market surveillance opportunity. Regrettably, the capital markets view this as a back-office function as yet another burden—the glass half empty. THE EMERGING OPPORTUNITY The opportunity that the industry is missing is in next generation analytics—analytics that combines information from disparate data streams into a coherent whole. The very technology that is required to address the SEC‘s consolidated tape proposal can be leveraged for huge competitive advantage. Most of the Buy-Side and most financial technology vendors will miss the superb opportunity sitting right in front of them. Mary Shapiro may have unknowingly handed the analytics industry its next major market. The explosion of information—from structured feeds, to news wires, to the blogosphere, to Twitter streams has created a massive analytics headache for any trader looking to gain competitive advantage. A recent article in the Economist, The click and the dead, discusses the phenomenon of information transparency and velocity another context, e-commerce. The principals of e-commerce apply also apply to the capital markets. After all, all markets are about buying and selling. The article states: In the past economists have paid most attention to the effects of the internet on prices. These fit snugly into a standard economic model of competition. The internet acts mainly as a mechanism that reduces consumers’ costs of acquiring information about products and prices. The article goes on to say: E-commerce ought therefore to lead to intensified price competition and through it to lower variation, or “dispersion”, in prices. A large scholarly literature has found that this is true. In the capital markets competitive advantage comes from exploiting ―dispersion‖, either to obtain faster access to the same information or to gain insight from new information. The trader‘s dilemma is that in theory everyone has access to all information. To gain advantage cutting edge traders must go to the ever farther reaches of cyberspace. News Feeds are insufficient, so traders look at the blogosphere. When everyone has access to the blogosphere, cutting edge traders need to go to the Twittersphere, and so on. It is a never ending arms race. One weapon in the arms race is the technology that can gather and reconcile the mass of information across the splintered sources.

THE NEXT LEAP IN ANALYTICS The scope of information and its rate of expansion renders current analytic tools impotent. The dilemma becomes how to grapple a problem that is two orders of maginitude more complex—and increasing in complexity. Where does the financial industry go to solve this problem? Start with the intelligence community. The fundamental dilemma and core competencies to solve both the intelligence and trading problem is the same: disparate pieces of information from multiple sources that need to be gathered, linked, re-assembled, curated, correlated, and analyzed as a coherent whole. It‘s the same problem. A number of key technologies—some of which have been discussed in previous editions of the Pipeline Report— have emerged to tackle aspects of the problem: ● Semantic extraction – At its core, semantic analysis turns unstructured text into structured data. Semantic analysis is a foundation technology, but far from the complete picture. Semantic metadata, and its close cousin linked data, are at best a lubricant. ● Next generation distributed database technologies, for instance Hadoop and Cassandra. ● Next generation analytics engines. In our opinion, next generation analytics is fundamental, not tangential, to solving the problem. We are seeing some exciting technologies that will catapult the industry forward. In fact, one such technology is the most exciting development we have seen in a long time. The next generation analytics is not your father‘s analytics engine or Complex Event Processing. Next generation analytics has to be able to ingest a massive number of sources, and correlate seemingly unrelated events across a highly fragmented set of inputs. The ability to assemble, analyze or correlate across highly fragmented inputs is the key differentiator. That is the garbage collection opportunity. Our prediction is that the incumbent vendors, for instance market surveillance companies, will completely miss the new opportunity. We believe that these vendors will be crawling across the ground their hands-and-knees using a magnifying glass to examine bugs in the dirt only to be crushed from above by the analytics steamroller. It‘s the Yellow Pages versus Google. We don‘t have a lot of optimism for traditional analytics companies. Though they may handle complex analytics on a single database or even a small set of databases, they will be stymied by the emerging requirement to reconcile trade information coming from hundreds of sources. Figuratively, the challenge is not to align the planets in the solar system, but to align all the stars in the universe. It is one thing to be working from a consolidated feed. It is quite another to be handling inputs from across the globe, in real time, for seemingly uncorrelated events. The reality is that is that high frequency traders are placing trades on multiple venues. Even absent the Twittersphere explosion, the information is already being fragmented. Having the capability to go to hundreds of venues, ingest the feeds and reconstruct the threads across the breadth of traders is a huge analytics advantage. The current generation of analytics engines may work well in the single dimension, but we believe they will fail miserably in the emerging complex world. The emerging company in next generation analytics that we like best is Palantir, a Palo Alto start-up focused on the intelligence community. The founders of Palantir were instrumental in developing PayPal‘s fraud detection— technology for correlating seemingly unrelated events across the Paypay customer base. They used their insights as the core technology for Planatir. The company boasts that it has no salesmen, a bravado belied by the engineers in online videos who effectively sell the product. We are happy to see the lack of empty suits with spinning bow ties and slicked back hair. However, rhetoric aside, if someone is buying, someone is certainly selling. Our sniping notwithstanding, Palantir seems to have developed a flexible analytics engine that collects inputs from disparate sources and connects the dots. If even only one tenth of their marketing hype is to be believed, they still have made a monumental leap forward. In this market space, they are the company to beat.

Palantir claims to have built a completely open access platform, eschewing the vendor lock-in strategy of other analytics and complex event processing vendors. Not only do we applaud them for this, we think this approach makes eminent strategic sense. Another company, also in the Intelligence Community space, but struggling to find its voice is Saffron Technology. A third vendor is i2, which has solely focused on the intelligence community. Both Saffron and i2 could reposition their technology for analytics in the capital markets, but we do not hold much hope for them against the quick- witted and glib Palantir. Another company meandering in the space is Open Gamma, a recently unveiled start-up in New York. Open Gamma has really focused on building an open platform for financial analytics and risk management. As with Palantir, we applaud the open access approach of Open Gamma, but believe they will miss the larger opportunity on consolidated analytics. Their focus seems to be in intraday risk management, which in itself, is an interesting market opportunity. Palantir‘s major challenge at this time is that its tools do not provide real time (in the sense of Capital Markets low latency) analytics capabilities. The technology‘s sweet spot is more in depth, recursive analytics, for sharing collaboratively across analyst communities. As such we, do not see it being applicable to applications such as next generation complex event processing, or trading on news. CONCLUSION It is very early days. The short problem of solving the dilemma of the consolidated tape is likely to consume legacy market surveillance firms such as Progress Software. Their challenge is to avoid becoming the next Yellow Pages. We do not believe that the next generation analytics firms, such as Palantir, have even contemplated the consolidated tape opportunity, through systems integrators may emerge to bundle the Palntir engine into a complete offering. We do believe that technology such as Palantir‘s is going to be fundamental to next generation analytics in the capital markets. Companies that embrace and adopt will gain immense competitive advantage as compared to their slow-witted peers. About the Pipeline Report The Pipeline Report is a periodic report produced by Chris Lamb, a business strategy consultant in financial technology and web services. Previously he was at Thomson Reuters, in which he stills owns some shares. The opinions expressed herein are his own. To contact Chris, please email him at clambresearch@gmail.com Twitter Feed: @c_lamb To unsubscribe, respond this email with Unsubscribe in the Subject Field. © 2010. Chris Lamb. All Rights Reserved. V12

Pipeline Report August 2010

by clambresearch on Jul 30, 2010

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Pipeline Report August 2010 — Document Transcript