My friend Tom Corddry recommended Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives.  Since Tom knows more about this stuff than anyone else I know, I expected great things, and I was not disappointed.  Note that this is a book about social networks, not social media.  While much of the information can be applied to on-line communities, the book is not about them in isolation.  If you are looking for something about Facebook, keep going.

This fascinating book provides a lot of insight into phenomena that are otherwise difficult to understand.  For instance, the authors demonstrate that the motivation to vote derives from social networks.  From a purely rational, economic perspective, it does not make any sense to vote.  Let’s say you would pay $1,000 to be the only person who chooses the winner in an election.  An economist would say that by voting you are buying a lottery ticket with a potential payoff to you of $1,000.  You “win” the lottery only if there is a tie between the candidates and your vote becomes the deciding vote.  Guess how often that happens?  Given situations like Florida 2000, you might think it happens from time to time.  Well,  it has never happened even once in any election, Federal, State or local, during the entire history of the United States.  This is a lottery that you have no chance of winning.  Economically, it is literally not worth the gas to drive to the polling place.  So why do people vote?  The authors suggest that citizens know something instinctively that economists do not.  They know that by voting, they will influence others to vote as well.  As a result, there does not have to be a tie in order to win the lottery.  Voting is, to some degree, contagious.  It turns out that this is the case with most things, whether it is the urge to yawn, one’s emotional state, disease, weight gain or loss, attitudes, information or an idea.

The authors call the likelihood that the act of one person will influence others “amplification.”  In the case of voting, a conservative voting might inspire a liberal friend to vote because the liberal friend might want to “balance” his conservative friend.  Not surprisingly though, amplification works best in networks of relatively similar people.  A single liberal voting will influence many more liberals to vote than conservatives.  The distance and rate at which things spread through a network are a function of the network’s structure — how “transitive” the network is.  In networks with high transitivity, most of the members know most of the other members.  In networks with low transitivity, most of the members only know a few of the other members, but all are still connected — just in a more linear way.  You might think that things travel farther and faster through networks with high transitivity, but the authors state that is not the case.  Highly transitive networks can have insular clusters where individual participants can’t influence individuals in other clusters of the network.  People who are more moderately transitive are more likely to act as bridges between clusters in a network.  In other words, transitivity needs to be just right.  When you have the right mix of amplification and transitivity, the results can be dramatic.  The authors talk of voting “cascades” where one voter influences hundreds and ultimately perhaps thousands of others to vote.  This is possible because you can be influenced by people in your network that you don’t even know.  You may have a friend A who in turn has a friend B whom you do not know.  Friend A is apathetic about voting, but friend B votes and, as a result, friend A feels that the act of voting is more important than before.  Friend A communicates this new attitude to you, and you run down to the polling place to vote because of the influence friend B exerted upon you.

The potential applications are many.  Consider this recent Bloomberg story on how the SEC is deploying novel techniques to identify insider trading:

[T]he SEC began using computer software about two years ago to sift hundreds of millions of electronic trading records, known as blue sheets, attached to the stock exchange reports about suspicious incidents, according to people familiar with the project. By looking for patterns in the library of data, they identified groups of traders who repeatedly made similar well-timed bets.

Once investigators find a cluster of correlated trades, they tap other sources of information to unravel how its members obtain and share tips, the people said. For example, if a group profits on trades before a series of corporate takeovers, the SEC may check so-called league tables listing which investment banks or law firms advised the deals. If one firm was involved in all of them, an employee there may be the source of the leak.

Can you find more customers the way the SEC is finding inside traders — using their social networks to detect them?  Even better, can you create a cascade of new customers voting for your product or service by finding more effective ways to influence them by understanding the structure of their social networks?

Seth Godin has a great post this morning called True believers (and the truth).  At some point in every young company’s life, it must make the transition from selling to early-adopter customers who “get it” to the much larger group of prospects who don’t.  This also applies to certain product launches by more established companies.  I have been working on a post or two about this theme, so Seth’s post resonated with me immediately.  More to come on this topic.

David Weild and Edward Kim, NASDAQ veterans and long-time equity market players, recently released a paper that is a must-read for anyone who cares about companies going public (or small companies that already are public) entitled “Market structure is causing the IPO crisis.”  In the paper, they argue that we have been in an IPO crisis that began during the dot-com bubble.  The crisis was obscured in its early years by the large number of Internet-related IPOs during the bubble, but the underlying causes of the crisis were operating even then.  As evidence, the authors cite that IPOs of less than $50 million have essentially disappeared from the modern landscape even though they consistently exceeded 250 deals per year before the bubble era.

The paper does a good job laying out the causes of the decline in small IPOs, many of which will be unfamiliar to many readers.  Unless you are a market structure wonk, you may be surprised to learn that things you may never have heard of such as the odd-eighths collusion settlement, the Manning rule, the order handling rules and decimalization have had such dramatic impacts and unintended consequences.  I would also add that these same things that have led to the drought of smaller IPOs have also decimated market liquidity for small cap stocks generally.  All  of those changes, along with several others, have had the effect of making markets in small cap stocks uneconomical for the brokers that traditionally were responsible for maintaining a liquid market.  The authors state that the potential consequences of this are many and severe:

Lower U.S. economic growth — U.S. economic growth will be lower as returns languish without a functioning IPO market and investors allocate less money to venture capital as an asset class. The venture-exit time frame currently exceeds eight years — an all-time high — extending the return horizon and lowering the internal rate of return.

Entrepreneurs take a beating — Investors are already cutting back funding to entrepreneurs in this country. Venture capitalists, in order to make up short-falls in returns, will dilute entrepreneurs even more. The incentive for Americans to leave well-paying jobs and risk everything will be less. Suffering from a lack of support, the IPO takes a beating.

U.S. vulnerable to outside threats — The U.S. will lose its competitive advantage in developing, incubating and applying new technologies. Technologists are already returning to foreign jurisdictions like China and India where government has devised an increasing array of economic and capital markets incentives to compete.

Loss of American prestige — The ability of the markets to support IPOs once made the U.S. stock markets the envy of the world. Our system was so effective that the French government, concerned that the United States would trump France in the then-emerging biotechnology industry, launched the “Second Marché” in 1983 as a feeder to the Paris Bourse.

Capital markets infrastructure continues to erode — The United States enjoyed an ecosystem replete with institutional investors that were focused on the IPO market — active individual investors supported by stockbrokers and a cadre of renowned investment banks, including L.F. Rothschild and Company, Alex. Brown & Sons, Hambrecht & Quist, Robertson Stephens and Montgomery Securities, that supported the growth company markets for many years. None of these firms survives today. Firms have attempted to fill the void and have found that the economic model supported by equity research, equity sales and equity trading no longer works.

Individual investors are left holding the bag — Traditional forms of capital formation (e.g., underwritten IPOs and marketed follow-on offerings) no longer work well for small cap issuers. As a result, investment banks have developed a series of financing structures that distribute shares exclusively to institutional investors (especially hedge funds) and generally dilute the ownership interests of individual shareholders disproportionately (e.g., PIPEs and Registered Directs) by placing discount-priced shares exclusively with institutional investors.

The solution proposed by the authors is to create a separate public equity market for smaller cap issuers that would look very much like the one that existed in the early 1990s.  Most notably, electronic access would be limited and spreads would be maintained at 10 cents for stocks under $5.00 per share and 20 cents for those priced higher.  Orderly liquidity would return to this market because there would be economic incentives to provide it.

While there is no doubt that such a market would represent an improvement, I don’t think that this is a viable solution.  First of all, there does not seem to be any realization on the part of most politicians and regulators that the provision of liquidity is a legitimate service that should result in compensation.  Narrow spreads are pretty much universally regarded as good things, not bad.  Furthermore, many of the changes were put in place because the old market making structure was less than ideal in many respects.  Cost of execution was difficult to determine and abuse was not uncommon.  There will be major political resistance to any effort to throw out reforms that were ostensibly put in place to protect the small investor, even if the reforms in question did no such thing.

The changes that we have seen in equity market structure over the last several years have sparked tremendous amounts of innovation.  Some of this innovation has resulted in good things and some in bad.  To date, none of it has resulted in a better-functioning market for small cap stocks.  Still, I think that the answer will come from new ideas rather than a return to old ones.   For instance, a public execution venue could have a different pricing structure to provide larger rebates for providing liquidity in small cap stocks.  Currently, this would be difficult to implement because there are low barriers to entry in the ECN/ATS space which leads to very low pricing power.  Still, if one were able to devise some basis for differentiating the service, it would be possible within the context of today’s market environment.