Relationships and Transactions, Clients and Markets

The Goldman Sachs story, such a headliner only weeks ago, is suddenly yesterday’s news, swept away by news of oil slicks, a trillion-dollar Euro bailout, and a hung jury in the UK.

Too bad, because I think there’s a deep lesson for us to learn. I for one haven’t figured it out. So I really want your help here. Those of you with a talent for economics and social sciences, please log in and comment on the following: I’m still trying to work this one out.

Trading Business is Crowding Out Client Business

Goldman Sachs went public in 1999. Many of us still think of it as an investment bank, involved largely in M&A work, advising companies on strategic decisions, and managing assets.

But in recent years, the company has become dominated by the business of trading. In 2009, 76% of its revenue came from its trading group.  (Not coincidentally, so did its CEO Lloyd Blankfein). Investment banking revenue was only 10.6% of revenue last year, having declined in dollar and percentage terms the last two years.

Goldman Sachs is not mainly an investment bank, and hasn’t been for some time now. It’s mainly a trading organization. Yet it hasn’t come to grips with that fact—nor have the rest of us.

Goldman’s Annual Report proudly lists its 13 Business Principles. The very first of them is: “Our clients’ interest always come first. Our experience shows that if we serve our clients well, our own success will follow.”

A lofty principle indeed. But how well does it apply to a trading business? Let me suggest—not well indeed. Goldman’s answers under oath in front of Congress showed their discomfort with the conflict between their past principles and their current business model. To a great extent, their answers about trading business boiled down to ‘caveat emptor.’ Which, I would argue, is not such a crazy answer at all when it comes to a trading business.

Goldman has gotten a bum rap for being accused of violating its client-focus principles in its trading business. The fact that they can’t articulately defend themselves doesn’t make them any less prescient than the Senators who berated them with equal lack of clarity.

Relationships vs. Transactions

In Sergio Leone’s The Good, the Bad and the Ugly, Eli Wallach’s character Tuco was fond of uttering statements beginning with, “There are two kinds of people in this world, my friend—those who __, and those who ___.”

To borrow Tuco’s construct, there are two kinds of businesses in this world: transactional, market-based trading businesses, and relationship-driven, client-focused businesses. Wall Street trading of CDOs, derivatives and SUV’s are of the former type; investment banking is (used to be, anyway) of the latter.

A friend tells me how he was recruited from college to trade bonds on Wall Street:

"There were 20 of us in the room. The recruiter came in and yelled in a loud voice, “Who here runs on fear and greed?’ Me and my pal timidly raised our hands; the rest were shocked. ‘The rest of you can leave,’ the guy said; ‘I’ve got my boys right here,’ pointing to me and my buddy. And I never looked back."

Most of the massive growth in the share of GDP that the financial sector has claimed in recent years—I think—has come from trading. (Data, anyone?). But it’s not Wall Street alone.

The ‘trading’ model has been the darling of Chicago economists, CNBC commentators, corporate strategists, ideology-driven MBAs and at least one major US political party for several decades now. It has been applied, with varying degrees of success, to running social institutions from prisons to elementary schools to public sector pension funds. Monetize it, put it out for bid, incentivie it, and let the cleansing forces of markets work their magic.

At the same time, we have become much more aware of the importance of ongoing relationships in business. Concepts like loyalty, holistic supply-chain management, CSR and corporate culture are moving us in the opposite direction—humanizing business, or least trying to connect society with business.

The Model of the future: Trading? Or Client-based?

What happens when these two worlds collide?  Think of–a market-driven approach to highly personal relationships. 

As the world becomes more interconnected, these two views of the world come into conflict. In finance—in which innovation has been forgiven if it increases ‘liquidity’—interdependence has come to be a curse. Push on one block in an interlinked trading world, and you get systemic chaos. The liquidity isn’t always worth the stress.

On the other hand, if you’re not careful about client-based industry models, you get corruption, sloppiness and lack of innovation.

I’m trying to figure out the principles that suggest when we need one, and when the other. It’s got me a bit stumped, to be honest.

But here’s what I do know. Market-based, trading-based industry models should never again be confused with free-range, unregulated operators. No doubt there were peddlers of poisonous snake-oil who thought the creation of the FDA was a major step toward socialism. They were wrong, much as the laissez-faire critics of financial reform are wrong now. Their argument is always the same: the public just needs more education. 

No, it doesn’t: it needs fairly regulated casinos, lotteries, markets and trading exchanges. Nothing wrong with caveat emptor as long as the rules for entry to the casino are clear. (Don’t forget: the natural and quick result of an unregulated market is a monopoly.  Pure competition is highy unstable.)

But even more, the pendulum needs to swing. Trust in trading businesses is limited to things like transparency of data and track records. Quantifiable, metricizable trust has got its limits, humanly and economically.  Useful?  You betcha.  Plenty of legitimate business operations need clean markets to hedge plenty of business uncertainties. But that’s still pretty narrow trust.

Trust in relationship businesses is far richer and deeper, because it deals with the people for whom business is supposed to be operated. Here you’re talking about motives, relationships, connections, synergies, collaboration.  Not only more meaningful, but economically far richer than the zero-sum I-win-you-lose nature of trading transactions.

We need more of that kind of trust.

A Tale of Two Transactors

Shakedown Street Grateful Dead (Gilbert Shelton)Scenario 1.  After six years of work, Mike finally established his own retail business on Gotham Street in the Big City. His first week was a heady mix of first sales, getting to know neighbors, and realizing he’d accomplished his dream.

On Monday of Week 2, Mr. X came to visit. “Nice store you’ve got here,” he said to Mike. “Be a shame if something happened to it.”

“Why would anything happen to it?” enquired Mike, part disbelieving and part enraged.

“You just never know,” said Mr. X, slapping his walking stick repeatedly into his palm. “Things can happen. You got no control over ‘em. But we can help.”

“How?” asked Mike, dreading the answer.

“Think of it as insurance. A little extra off the top line, nothing happens to the bottom line. Safest neighborhood around, if you know how to get along.”

“Why me?” asked Mike. “I haven’t got the money, I can’t afford it.”

“Cost of doing business,” shrugged Mr. X. “You raise your prices, you cut your costs—you figure it out.”

“But it’s not fair!” shouted Mike. “Why can’t you cut me a break?”

“Not fair–that’s a good one!  Listen, if I cut you a break, everyone wants one. If it was up to me, I’d do it, I like you. But Mr. Big—he wouldn’t like that.”

“Maybe I could talk to Mr. Big,” said Mike.

“Oh I don’t think that’d be a good idea,”  Mr. X said drily.   “All right, I think we’re done here, Mikey. I’ll come by on Monday for your first payment.”

Scenario 2.  After six years of work, Mitchell finally formed his own subcontracting business, taking the plunge with a big deal from his former employer, BigCo.

As he read through the fine print of the contract, Mitchell noticed several clauses that surprised him. He called BigCo’s in-house counsel, Mr. Z.

“Mr. Z, this is Mitchell. I’m going through this contract, and it says I have to buy millions of dollars of insurance coverage, with BigCo as beneficiary, to cover things like lawsuits filed by anyone anywhere in the world for things like bodily injury, automobile crashes, etc. Look, I’m just an actuary—I’m hardly ever going to set foot there, much less cause all kinds of harm. These things will never happen.”

“Well, the most unlikely things have a funny way of happening, Mitch,” said Mr. Z.  "It’s a big world, you can’t be too careful.  We’re just managing risk.  Think of it as insurance.  Which of course it is.  It’s really for your benefit, you wouldn’t want to be liable for these catastrophes, now would you?”

“But why me,” asked Mitchell. “I can’t afford this kind of extra insurance. And you want me to buy insurance on people I sub to as well? Does this ever end?”

“Oh don’t worry about that, Mitch—you just pass it on to your subs in your agreement. That’s what we did, when our customer demanded we do it. It’s how it works.”

“Is that where it starts, with your customer? Couldn’t we talk to them?”

“Oh I don’t think that’s going to happen, Mitch. Just work out the cost and pay it.”

“But it’s not fair, Mr. Z.”

“Mitchell, Mitchell, you know better than that,” said Mr. Z.

So here’s my question about the two scenarios:

What’s the difference between them?

My lawyer friends (I hope I still have a few) will say, “That’s insulting! Come on, one of them’s legal, and one’s criminal—how can you confuse them?”

But my economist friends (some of them anyway) will say, “Ha!  It’s a trick question. There is no difference, they’re exactly the same.”

“Both of them involve non-value-adding transaction costs. There is some amount of risk transfer between parties—swapping around, really–but to the system, there is no gain.

“In fact, at the system level, there is a net cost; and the distribution of that cost is disproportionately downstream, to Mike and to Mitch.

To put this in context: our economy used to grow by achieving scale through transaction costs—legal agreements, accounting, contracts, commission plans.

Today, we are so inter-linked and fragmented, and so paranoid about trusting, that the transaction costs have begun to overtake the value accruing from scale.

We have become a culture not of shopkeepers, but of tiny outsourcing transactors, fearfully insuring ourselves against our fellows-in-commerce at every step. 

As my friend Bill says, "What is a credit default swap except a statement that you don’t trust your customer?"

This is not the way to build a healthy economy.

From Financial Relationships to Financial Transactions, Losing Trust on the Way

The New York Times this Sunday has initiated an ambitious and comprehensive look at the financial crisis facing us. Gretchen Morgenson, a crack business writer, has not only her normal Sunday business page lead, but also the entire issue’s Main Section Front Page lead.

And rightly so. Count me among those who believe this is no ordinary recession; we’ll live to live again, but there has been huge financial misbehavior by all of us for a very long time; we’re going to have to pay the piper for some time to come.

Morgenson points out we doubled our mortgage debt in 7 years as a country; our savings rate—at 8% in 1968—is now 0.4%. And the biggest scorecard of all is the fall of the dollar, already precipitous, and likely to get worse.

One of the patterns that emerges is the conflict we have created in the world economy in the last two decades between efficiency and trust. It’s a major trust issue—one of social and political structure.

Here’s the idea.

The global financial system has gotten far more efficient by applying business process thinking “best practices.” Define processes so they can be outsourced to others, the thinking goes, who can then do those processes at a global level of scale, more cheaply.

That logic is what drives the outsourcing of payroll and benefits processing. It’s the same logic that drives mortgage lenders to sell loans to banks, and banks to package them to asset packagers.

It has in many ways worked: more capital became more available in more places to more people more quickly and at lower costs than had been the case 20 years ago.

Unfortunately, there was a side effectT—the substitution of short-term transactional fee income for longer term relational income sources (like interest).  And fee income has turned out to be the crack cocaine of the financial industry.

It isn’t just mortgages. It shows up in banks every time you get hit for $2 to withdraw $100 from an ATM not your own. It shows up in credit cards—in late fees and over-limit penalties, in huge rates for cash withdrawals. And of course if you refinance a mortgage, fees abound—enough to become the primary source of profitability for the refinancing institution.

Who cares about your damn loan when they can make money off of the act of taking out the loan, and more money out of selling it to someone else. Give ‘em a ten-year balloon loan at teaser rates. On Wall Street, the moral decline was captured with the phrase, “I’ll be gone, you’ll be gone—just do the deal.”  Gimme more crack—gimme the fee income, you can have the relationship and the loan.

So here’s the social trust issue.

One of the four Trust Principles (see my article “Trust: the Core Concepts” or my book Trust-based Selling) is the focus on relationships, not transactions; on the medium-to-long term, not just the short-term.

That idea is pretty simple and clear. Trust thrives in relationships, not in random encounters between strangers. Economic models that link entities—and people—allow trust to grow.

Economic models that structurally dissociate people—blind online bidding systems are an extreme case—are at best trust-neutral, and in many ways trust-destroying (in the case of blind online bidding, that is in fact the intent).

So we have a dilemma. The economics of outsourcing processes has indeed resulted in lower costs. It has also resulted in lower trust.

Can we have both? And if so, how?

I don’t have the full answer, of course. But I believe the answer is going to rely on two things:

  • The political will—in government and in business—to recognize that, in the long run and in the big picture, we are all inextricably linked, and we’d better behave as such. In other words, an ethos or common belief-set based not on competition, but on collaboration.
  • The insight that low cost alone does not drive value; that relationships, in fact, are the source of far greater value than the micro-process-here-now-self-aggrandizing instincts we have been propagating as “best practices.”

It ain’t going to be easy, though.

30 Minutes, 30 Cents, 30 Billion: Fragmenting Business

A few weeks ago I sat next to an investment banker on a long flight. He works hand in hand with some of the super-quants on Wall Street who perform high-wire arbitrage through mathematical techniques so arcane that “I’d have to get two more math degrees just to understand them,” as my seatmate put it.
“Basically what they’re focused on is predicting the next 30 minutes,” he said. (Actually it may have been “the next 30 seconds,” I forget.  Anyway, day-trading for the Big Bucks, with lots of Other People’s Money).

At my destination, I heard a senior exec of one of the world’s high-tech success stories talk about their business model—“30 cents a transaction times billions of transactions, pretty soon you’re talking real money.” (How many of you remember Everett Duerksen, the originator of that line? Hey I’m not old, just well-read!).

30 minutes, 30 cents, 30 billions. Not your father’s bizmodel.

There is no shortage of economists who will gladly tell you the wonderful role these business models play. They mitigate risk; they lower costs; they create greater liquidity; they globalize geographically fragmented businesses.

Gosh, is there no downside? Of course there is. And it’s one of those two-sides-of-the-same-coin things.

The business world of today is heavily driven by two trends—fragmentation of processes, and globalization of scale. Break everything into tinier and tinier processes, and scale them globally. You get all the benefits listed above, but—what happens if no one has the big picture anymore?

You occasionally get myopic consultants and bankers—for a great example see this blog post from last year. 

But more importantly, you get situations where everyone is transaction-oriented, and no one has a stake in the integrity of the entire process.

The airline industry, many decades ago, was largely financed by insurance companies. The insurance companies tended to have ties to multiple airlines, partly to hedge their own risk.  Then the banks got into the business. Each bank picked a favorite—and given the peculiar economics of the airline industry, all the airline-bank pairs began to beat each other into the ground with excess capacity. The industry hasn’t made money for decades.

For a more current example, of course—subprime mortgages. When an industry gets dissected, disaggregated, and disintermediated, there may or may not be a problem. If a regulatory agency is there to see the big picture, that may be OK. If a risk-assessing industry is in place (bond ratings, accounting firms), that may serve to keep things in check.

But if none of those things are true—if Glass Steagall has been eviscerated, financing products escape regulatory purview, if financial institutions are selling off and collateralizing loans and if credit card companies are chasing fees (read transaction) instead of loans (read relationship)—then watch out. No one’s minding the business store.

In such cases, business becomes a combination of Russian roulette and musical chairs. He who gets in and gets out fast wins. He who stays is a sucker.

How fast is 30 minutes? How small is 30 cents? Small, and getting smaller.

Would You Buy a Used Car From This Scientist? Not If You’re a Scientist!

Peter Calamai is Science Writer for the Toronto Star. He recently wrote about the demise of society’s trust in its scientists. He’s got a lot of statistics that ought to cause scientists great concern about the level of trust in scientists.

And, as he says:

After two days of provocative ideas and spirited exchanges at an international gathering recently in Toronto, British museum curator Robert Bud neatly summed up the collective wisdom.

"The scientists are terrified."

Calamai’s most cogent point may be this:

Scientists might ask themselves about the erosion of the traditional trust relationships among researchers, who once readily exchanged things like specialized strains of mice or reagents, custom chemicals used in experiments.

Increasingly such exchanges are now circumscribed by material transfer agreements, complex legal documents that spell out details like liability and indemnification, due diligence and standards for care. Some even feature "reach-through" clauses, guaranteeing the supplier of the materials a share in any subsequent commercialization because of subsequent research done elsewhere.

Use of these agreements is exploding. In 1998, the University of Toronto handled about 30. This year, +*officials have reviewed 170.  Similar growth at U.S. universities prompted this wry workshop comment from Notre Dame’s Mirowski: "Why should the public trust science when it is becoming apparent that scientists less and less trust each other?"

Why indeed.

Let’s break this down. There’s a bigger trend going on here—two, actually.

One trend is the fragmentation of big things into little modules. The other is the re-connection of modules into big things again.

Take business processes. Companies used to have HR departments. Now they have many specific HR sub-processes, which can be outsourced, which in turn requires standardization. Big things broken into little; little things reconfigured into big. Now companies can configure their own HR departments.

Take music. The record business used to record artists on vinyl and sell the product through physical stores. Now artists, recording, and marketing are going off in dozens of directions. A big business broken into little parts; little parts reconfiguring into dozens of designs.

Take software, movies, travel, training, banking. All used to be made of monolithic structures. All can now be configured in myriad ways.

But here’s the catch. The main way we reconfigure modules in the world is by contract, in some kind of market.

That means transactions. That means costs, complexity, and lawyers. It means every little module has to be priced, defined, tracked, and contracted.

The trend has hit absurd levels in many places by now.

• How many levels of automated phone answering software can you stand before exploding?
• Sampling of a half-second of music is subject to copyright law so we can write royalty checks to dozens of people from thousands of users;
• And now scientists don’t share because we need to prospectively track the rights to thinks that might be invented in the future.

This is what happens when a new technical/organizational reality meets an outmoded ideology.

The new reality is the ability to connect everything and everyone to everything and everyone else.

The outmoded ideology is the idea that everything is property—and is therefore definable, trackable, assignable and salable.

Put those two together, and something’s got to give. Eventually, it will be the outmoded ideology that gives. The question is, how long will the forces of resistance hold it back?

How long can we live with outmoded laws governing intellectual property, water rights and patents?

How long can we put up with outmoded business models that define relationships by boundaries rather than by bonds?

How long can we live with corporate and social governance models that can’t figure out how to make individuals accountable to the public good, and present generations accountable to their heirs?

Chief Seattle, in 1854, supposedly said, “The earth does not belong to us; we belong to the earth.”

With a little updating, that’s exactly the thinking we need. The more complicated and topheavy the contract/ownership model gets, the more economically superior becomes a model based on trust and mutual interests.

Flaky? Not at all. Read, for example, a Nobel Prize economist’s lecture here, or read a Harvard Business Review article here.

Trust is not flaky, it is commonsense. It’s just not common. Yet.

The CEO vs. the Bankers: Death by Transactions

I spoke to the (non-American) former CEO of a large company—the profitability leader in its capital-intensive global industry.

“Why do American CEOs listen to 30-year old investment bankers?” he asked me. “They don’t know anything.”

“I used to get calls from them—Morgan Sachs, Goldman Stanley, you know—the supposed crème de la crème of MBAs. Here’s how they went:

Bankers: Why do you keep so much cash? Your leverage ratio is half that of your industry. You’re earning nothing on it, like keeping it under a mattress. You’re destroying shareholder value. If you have opportunities, you should invest. If not, you should return it to the shareholders.

CEO: Let me ask you—who’s the global market leader in software?

Bankers: Microsoft, of course.

CEO: And how much cash do they have on hand?

Bankers: Way more than the industry average; too much; they should return it to the shareholders.

CEO: Uh huh. And who’s the global market leader in semiconductors?

Bankers: Intel, of course.

CEO: How much cash on hand?

Bankers: Again, way too much, more than industry average, they’re destroying shareholder value.

CEO: Uh huh. I too am the market leader, and the profitability leader. I don’t focus on your options pricing models and portfolio theory and risk hedging. I focus on “buy low sell high,” “keep your powder dry,” “bide your time,” “strike when the iron is hot,” “find your niche,” “beat your competitor don’t copy him."

My industry—like every capital-intensive industry—has cycles. I buy my expensive assets at a huge discount—when the market is cold and my suppliers have no backlog. I get what I want, when I want it, pay less, and have grateful suppliers. My competitors buy when their profits are high—they overpay, wait years for delivery, and irritate their suppliers—as do their competitors.

I make strategic moves when I’m the only one who can do it. My competitors make their moves along with everyone else.

I can do all this because I have cash. My competitors all listened to your advice about copying the average. Not only am I the only one with funds to execute my strategy—I’m the only thinking of a unique strategy.

The CEO continued, “they often didn’t even get it. They couldn’t recognize a bad model when it slapped them in the face like a dead fish.”

Q. Who’s right?

A. The CEO—hands down, a no-brainer.

Q. How could the bankers so spectacularly miss something so obvious?

A. The blinding power of an unchallenged paradigm.

Q. And what paradigm would that be?

A. Ah, that’s the big question. Is it:

  1. Youth is arrogant
  2. Business has become overly quantitative and analytical
  3. Finance has triumphed over marketing and production
  4. Paris Hilton was somehow involved
  5. We are killing off strategies and relationships for the sake of transactions.

I vote #5—death by transactions.

The history of capitalism is one of scale economies, enabled by parceling out pieces of work to others. Every time you do that, you gain scale—and you create a transaction.

This trend has accelerated: more chunks of business are being chopped up and parcelled out—both in space and in time.


  • Modular software
  • Mortgage (and other asset) collateralization
  • HR competency models
  • Outsourcing
  • Globalized sourcing

This habit is reflected even in meta-patterns of business thinking—how to tackle a problem? Break it up, break it down. Analyze it. Measure it. Parcel it out. Track it. Install rewards. Repeat at one level of detail lower.

Every time you break up a function and parcel it out to more people over less time, two things happen. Greater efficiencies—and less relationships.

Repeat infinitely, and you get people who think about business like tinker-toys—models to be constantly assembled and re-assembled.

That way of thinking fosters neither strategic or relationship thinking.

It is also impossible to think ethically when there are no relationships to be harmed, and no timeframe in which to be held accountable.

But the biggest irony is: it doesn’t work anymore. The chop and parcel game has been played out. The returns are beyond diminishing; the cost of the transactional mindset is exceeding the savings of scale. The game has turned dysfunctional.

Death by transactions.