Product Market Fail
Vol #159: December 21st, 2023
It’s exhausting to follow startup culture.
The jokes about VCs congratulating themselves or grinding 21 days a week only make it slightly more palatable. The bleeding edge of investors all wear the same vests and get duped by the same cons. The noise is deafening, and the most replicable piece of advice I’ve found is “get lucky like I did.”
If there’s one thing this cohort focuses on more obsessively than self promotion, it’s the idea of product market fit. The myth goes that if you can lock your sights on this magical connection, everything scales to infinity. While obvious, it’s also insightful in that nothing else really matters if you can’t produce something people are willing to buy.
Software that triangulates the temperature, road conditions, and solar winds to give you an optimal tire pressure sounds very technically challenging and neat, but the vast majority of people just need to find a parking spot. Just as in risk taking, we’re driven more by the fear of failure, and facts take a back seat to emotional responses.
For financial innovations to find product market fit, there’s more than just a casual meeting of buyer and seller; the tango includes regulators, exchanges, and clearing houses.
“Products” in the investment business are abstractions all the way down. Unless you’ve paid off the machines, cash advance the supply chain, hold the keys to the building, and do all the labor yourself; yours and every other business relies on a collective belief in the value of paperwork. At the atomic level this paper splits profits amongst debt and equity, and molecules are compounded by mad spreadsheet scientists.
There is a broad collection of rules enshrined in the SEC Act of 1934 that defines how securities are created and traded. The strict reporting requirements and disclosures are enforced with an eye towards investor protection. By meeting these initial and ongoing requirements, products can plug into the deep infrastructure of modern finance that exposes itself to consumers in a mobile app with confetti.
ETFs are the best example of this today. There is a well trodden path to creating one (except if you’re trying to allow in-kind Bitcoin transactions) and now everything from simple baskets of utility stocks to actively managed options trading funds can be quickly brought to market. TSLY runs a poor man’s covered call strategy in TSLA and in a year garnered $800M of assets.
Anyone with a brokerage account can buy an ETF. There aren’t (usually) special permissions, you don’t need to apply for margin, and it settles just like an equity. This is a mile wide pipeline for assets to flow into a desirable strategy. There’s $250M of fit for investors who want to click a single button once that gives them exposure to a daily Nasdaq put smashing.
Behind the scenes there is a great deal of coordination, and everyone needs to be a willing participant. An advisor will cook up a great strategy, which then needs to get wrapped in legalese and submitted to the commission. The template here is well hammered and there is extensive case experience on what will and won’t get approved.
Once the regulatory hurdles have been cleared, the critical question is liquidity. Equity market makers want to trade products that both have good flow and are easily understood. An actively managed ETF is going to have wider spreads because under the hood the manager could be making impactful changes to the allocation. Market makers here will be well aligned with the issuer though, as more volume benefits everyone.
No matter what the market demand, if all of these pieces don’t line up, then the product market fit will never conjugate. For 18 steadfast years, the single stock futures (SSF) business attempted to bridge the gap between buyers and sellers and they were stymied all the way along.
Stocks are already a tradeable abstraction of a slice of business ownership, and futures layer one more coat of veneer. When you’re modeling financial exposure, numbers just go up and down. If an options market maker is long deltas (i.e. loses money if stocks go down) then he wants to sell stock to hedge that risk to neutral.
On paper this is a technicality, but in the real world shares need to be tallied, allocated, and borrowed. You can sell long stock you already have, but if you want to go short you need to get that stock from somewhere. In exchange for lending those shares, the provider is paid an interest rate. The value depends on the demand, and when everyone’s buying puts, the market makers need to sell stock and things get “hard to borrow”. The sketchiest businesses have the highest borrow rates.
Securing all of those borrows is tricky in the less liquid names. There are only so many shares outstanding, and even fewer held by those willing to hand their equity over to someone who’s going to firesale it in the public market. Clearing companies do a healthy business here, operating in a dark OTC corner of what’s typically a brightly lit public market. Phone calls and relationships with the right desk rule the day.
If only there was a way to publicly borrow and lend stocks, without having to worry about the rate difference between Goldman and Merrill. SSFs are perfect for this, because they represent delta exposure just like a stock, but have no underlying need for a borrow. The price of the future can reflect the prevailing market interest rate, but the physical shares don’t have to be found and accounted for.
The CBOE, CME and CBOT joined forces to create the OneChicago exchange where these could be traded in 2001. Their peak of activity was in 2015 when roughly 12 million contracts were traded. SPX trades more than that every week. It’s not that there wasn’t demand - many dealers were optimistic about what this could do for stock loan and customers were tempted - but that the market infrastructure did everything it could to throw friction in the gears.
The stock loan use case was quickly squashed when margin requirements were posted. A major benefit of futures is the leverage you get, but conveniently this didn’t apply to SSFs. Posting 50% margin like a Reg-T equity is a non starter. Institutions that might have happily lent their shares out now needed to post massive amounts of collateral, and capital inefficiency wiped out any increased premiums they might get by going direct to market.
One of the trades that managed to surmount this cost hurdle was the dividend tax swap. By exchange equity exposure for a future, an investor could keep the same position, but not receive a taxable distribution. Through SSFs, they could “sell” their dividend exposure above their net tax rate but below the market price of the dividend, and both parties win. (Not financial, legal, or tax advice, in any jurisdiction you’re reading this in.)
Even with this reasonable use case, every trade felt like a forced marriage. OneChicago was actively involved in connecting counter parties and negotiating trade details. When a certain 10 digits showed up on the phone, you knew it meant a lot of yaw for a little hay. While necessary in fledgling markets, this lasted for 15 years as the flywheel never kicked in.
As the hope slowly leaked out, you could tell that the business was getting marginalized. At the clearing companies breaks took longer to resolve, and generally support was worse than it was for the actively traded products.
The exchanges got desperate trying to find customers. While the operators of OneChicago were doing everything they could to keep the product alive (one client allegedly had a connection with the Peoples Bank of China?) it was clear that upstairs there wasn’t much interest. Development dollars were getting funneled elsewhere. When they introduced a central limit order book in 2015 it was little more than an Excel plug in.
It was five more years of dwindling volume before the exchange was eventually shuttered. There are currently no listed ways to trade a single stock future, and I don’t think there’s much interest.
Contrast this with a product like the 0DTE options. Up and down the industry, people are aligned with the promotion of these “new” products. They’re just the right amount of disruption, because despite what naysayers portend about a vol event, trading expiration isn’t all that new. But exchanges love the volume, dealers love the flow, and customers love the instant gratification. Best of all, the only feathers it ruffles are the barkers, not the biters.
The gatekeepers of financial innovation are powerful. It’s not just regulators who can obstruct the approval process for their own pet insecurities, but market participants who through powerful economic forces can shift the winds of incentive. There were plenty of good reasons why this product should exist, but to make it happen it needed the buy-in from people who had other profits on their minds.
The romantic notion of product market fit presumes there are but two parties in a relationship; financial innovation takes a village.
Programming Note: The Till will be off next week to relax with friends and family. Enjoy the holiday season, and we’ll be coming back to our regularly scheduled programming on January 4th.