Pyramid products in financial services

I've been banging around on this blog for months now on the  premise that technology-based innovation in financial services is not the way to drive sustainable differentiation. I've also said the same thing about product based innovation, by the way, and for the same reason: duplication occurs so rapidly that any competitive advantage available is short lived.

But now I'm wondering if it is, after all, possible to drive differentiated offerings for a specific class of product: that which makes use of network externalities to create significant barriers to entry.

A network externality (defined here in Wikipedia) is a situation where the value of a product or innovation increases with proportion to the number of users who have the product. Email is a good case of network externalities at work. Email is useful only because I can reach most people with it. In the early days, though, it was far less valuable because hardly anyone had it. Today, however, anyone that proposes an alternate email system to the Internet will be facing an uphill, if not impossible battle.

History is peppered with examples of network externalities that have driven significant competitive advantage for companies that were clever enough to utilise them. And there are lots of them around, even today. Consider, for example, the position of Microsoft with Windows. It is valuable, not because it is especially good or innovative, but because most people use it. You know you can find the software you want for Windows, because that is where most people are. Windows is a good case of the power of network externalities: there is nothing all that groundbreaking in it, yet it is the market leader. It is no surprise to me that competitors with practically no funding - I am speaking of the Linux world here - can replicate practically everything in short order without much delay. Here is a cheap, close to free operating system that does much of what Windows does. Do people install? No.

Imagine the effect of a financial services product that had this kind of ability to hold customers. It would, first of all, be something that people would want. And secondly, it would be something that people would keep, because its value to them would be constantly on the rise. Finally, it would be a product for which there would be few competitors, because the organisation with the most users (i.e, the one with first move advantages) has the most valuable product.

Now, I've been sitting here for an hour trying to imagine a product that banks could offer which has the key characteristic of increasing value with the number of people that use the product, and I've just worked something out.

In financial services, the presence of a network externality is almost always predicated on the presence of an intermediary, to whom the increasing value accrues. Consider a securities market: it is the exchange that profits most from having the best securities listed. And they get these listings by having the most people wanting to buy. The buyers themselves don't get much. Frankly, if I want to buy a security, I don't really care which marketplace I get it from, but of course I am limited in my choice to where the company is listed.

Here's another example: the mutual fund. Having more people means that the managers can buy more stuff, but this doesn't necessarily mean that the return on the fund increases. That is dependent on the skill of the managers, not on the size of the pot. But what does increase is the earnings from management fees. The intermediary gets all the value.

And the biggest and best example of all? The payment system, especially cards. Merchants take cards because there are a large number of customers who use cards. The value of the card network increases with the number of cards issued. Actually, there is quite good theoretical treatment of this particular network effect here. Note that increasing value of the card network is mostly beneficial to banks.

Imagine a product, on the other hand, that reverses the flow of value back to the customer. Rather than a static rate deposit, what might a product be like that rewards (through interest rate or other incentives) customers introducing their friends to the product? And what might happen if the reward follows through like a pyramid scheme?

In other words, the person gets bigger rewards, the bigger the network they've introduced becomes. What works for Amway could easily work for a bank.

Alternatively, consider the same situation for a mortgage - the rate goes down, and down, the bigger the network introduced by a customer. Who cares if the mortgage at the top of the tree generates negative value, if the the result has been the introduction of tens, or even hundreds of new mortgages?

For a customer in the hierarchy, whose rate is dependent on a network downstream, there is practically no chance of churn occurring. Furthermore, since the value  of the product is dependent entirely on the number of people using it, there are strong motivations to get friends and relatives to churn across to the product.

In other words, the bank that gets the most customers, would keep the most customers, through the power of the network externality. And ultimately, assuming that social networking in the financial services game makes sense (there is evidence that it does), then perhaps here is a source of sustainable advantage in what is otherwise a market of bland commodity product.

Comments

[Allain de la Motte]

Dear James,

I have recently started reading your blogs. Your comments on prosper.com, Paypall, etc. was on target. These innovators will change the banking landscape significantly, I believe. They are not alone though!

The financial products required for such strategies as you describe in your current Blog "Pyramid Products in Financial Services" are already here and our group is at the cutting-edge of innovations in this arena.

We ourselves do not however use what you refer to as "Pyramid" layering for compensation, but our products can easily be adapted by the Amways of the world in order to enter the banking industry - big time!

Our products are also ideal for a roll-out executed through licensing of such companies as Fiserv, First Data, Intuit, Prosper, Microsoft; Paypal/Skype, etc. Any bank that is willing to change its revenue model slightly also stands to acquire incremental business and gain a major competitive advantage that will result in pure profits.

Our products, structures, and processes are covered by some 17 US and international pending patents (more being filed). We expect our technology to gain momentum through exactly what you describe as "social networking" via the Internet (not the kind of pyramid scheme you seem to suggest though). In that: (a) our technology is available for licensing worldwide; (b) it allows any bank, savings & loan, credit union, financial institution, mutual fund, corporate employer, non-profit, church group, labor union, affinity group, social group or entrepreneurial person or entity to offer our proprietary banking products to their own networks of customers, employees and members; (c) our suite of financial products will allow our licensees to offer co-branded or private label products that deliver much superior benefits and features than those traditionally offered for demand deposit bank accounts; (d) the profitability for licensees is significant; and (e) our roll-out strategy is 100% Internet based; we believe we have something that will catch on and spread like wild fire. The banking lanscape is about to change in a major way and we have that technology today.

Due to the confidential and proprietary nature of our early plans and strategies, you will not find us on the web. However, if you are interested in discussing more with us, send me your e-mail address and contact info to (adlm@mellandgroup.com) and we'll contact you. We are extremely busy in worldwide licensing talks and we are not far from unveiling our plans.

We would be interested to talk to you in the meantime.

Warm rgds,

Allain

P.S. One interesting article for you to write about: the area of intellectual property (patents) and how they hold the potential to dramatically change the banking and financial landscape and are opening doors for smaller players to enter the industry with innovative and/or revolutionary products that have 20-year exclusionary rights (a virtual monopoly that must be legally enforced through law suits). An interesting case study of how this is now happening (ref. Check 21 infringements) and the type of settlements being paid by banks that infringe upon the patents of Data Treasury: www.datatreasury.com.

[Colin]

This is interesting. The email example would be Metcalfes law that talks of the value of a network being the square of the number of users. In other words there is an increase in value significantly greater than the rise in the number of users.

http://en.wikipedia.org/wiki/Metcalfe%27s_law

This law would apply to technology when the technology facilitates people's interactions. People could be customers, and/ or employees.

But network externalities seems to go further, and suggest additional value merely through scale.

The pyramid idea is interesting - referrals. I imagine it could be referring a friend, or it could be value of opinion through a social network, which would be read by other social network users.

[Michael Schoeffler]

You're on to something.

Credit scoring has huge network externalities. Hell, cash has enormous network effects.

Zopa and Prosper are one more type of network effect. Both firms hope to become a sort of trading platform for retail deposits/loans. As more people use their services, they deliver higher value to their users and also extract more value.

There will be other ways to cash in - you definitely have stirred the pot.

[Ozrisk]

James,
Interesting post and an idea worth exploring. I would suggest, however, that this business model may be limited by the propensity of people to open bank accounts or take other financial decisions on the advice of friends, relatives and associates. The margins per account in most products are pretty thin, so, unless the effect in opening new accounts was fairly large, the value given up by the bank would probably overwhelm the value gained from the new accounts.
In Australia we may also have a legal problem - does this turn the customers into brokers (and therefore subject to legislative provisions) if they are "paid" to introduce new business?
That said, I do not see these as knock-outs, but issues to be dealt with.

[carrol123]

You have really mentioned very good and useful things in your post and I am glad to be the part of it.
Carrol Spncr
Financial Service