I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Friday, September 30, 2016

Ecosystems and the Energy Source of Last Resort

It's fashionable for a company to proclaim itself an ecosystem. A mobile phone company makes handsets for users and curates an app market place for developers. The virtuous cycle of an ever increasing collection of apps motivating an ever increasing population of consumers. They have the benefit of steady cash flows from existing customers and constant growth from new ones attracted by an increasingly complex array of products. There are a number of self-proclaimed commercial ecosystems, ranging from online lending to conglomerates of retail, credit and loyalty.

Markets are kind of like ecosystems in the way participants reinforce one another. Buyers and sellers come together in sufficient numbers to perpetuate a market. As more buyers emerge, more sellers offer their wares in the market, which attracts still more buyers. An increase in the number of buyers triggers more complex and diverse products, making the ecosystem more interesting, if not more robust. To wit: demand for tomatoes triggers cultivation of different varieties, some of which are resistant to disease or insects that others are not, increasing the resiliency of the lycopene trade.

Ecosystems aren't inherently complex: a simple terrarium consisting of a lamp, dirt, water and seeds will yield plants. Commercial ecosystems aren't complex, either. We can stand up marketplaces for mobile phone software or money lending or property investing. In doing so, we hope to encourage people to risk their labor by writing software they hope people will buy, or their capital they hope will find a worthy investment. With the right marketing and promotion (i.e., fertilizer) we might attract ever more buyers and ever more sellers, creating a growing and ever-increasing community.

One thing an ecosystem needs to survive is a constant supply of energy. The sun provides an uninterrupted supply of energy to the Earth. It can be consumed immediately (e.g., through photosynthesis). It can also be stored: liquefied dinosaurs are effectively stored energy that originated with the sun. Energy from the sun can be concentrated in many other forms, and accessible to parts of the planet when they're directly exposed to it. This allows formation of more complex life and lifestyles. Some spot on the Earth may suffer drought or fire or some other disaster that wipes out the basic plant life that supports more complex life forms, but the constant energy from el sol means that a devastated area has a source of energy it can draw on to re-develop.

In commercial ecosystems, capital is energy. Markets are highly vulnerable to periodic contractions of liquidity. Both asset classes and tech products fall out of favor, destroying the fortunes of sellers quickly (bank equity values in 2008) or slowly (Blackberry software developers from 2008 onward). Turn off the lamp and the terrarium becomes barren.

Markets require a constant supply of capital in the same way that ecosystems needs a constant supply of energy to survive volatility and seizures. In financial markets, there are market makers who guarantee a counterparty to every trade and buyers of last resort who provide liquidity in the event of a sudden seizure of market activity. It's the latter - the Federal Reserve and the European Central Bank buying sovereign and commercial paper as well as lending to banks with the expectation that they will do the same - who act as the constant supply of energy that keeps commercial ecosystems functioning. Markets will surge and markets will plunge, but it is the "energy source of last resort" that sees markets through the peaks and troughs.

Economic cycles - credit or tech - aren't new phenomenon. When they turn, they expose the fragility of the businesses at their mercy. Late last year, lending marketplaces found themselves with plenty of loans they could write but fewer willing to buy them. The solution they turned to was to introduce a buyer of last resort, initially in the form of banks and eventually in the form of investment vehicles they created themselves.

Any self-proclaimed ecosystem without a backstop buyer - that is, without a constant and reliable source of energy - will be at the mercy of commercial cycles. Mr. Market will not hesitate to turn off the terrarium lamp when the cycle tells him to do so. Once off, he is not so willing to turn it on again. But he might not reach for the switch for the first place - and might very well be first to harvest green shoots after a devastation - as long as there is an energy source of last resort.