DealBook: In London, Nimble Start-Ups Offer Alternatives to Stodgy Banks

Hazel Thompson for The New York TimesAnil Stocker, a co-founder of MarketInvoice, a new financial firm based in London.

LONDON — When Hiroki Takeuchi joined McKinsey & Company in 2008, he had a front-row seat to the upheaval in finance.

After the collapse of Lehman Brothers, Mr. Takeuchi, a 26-year-old Oxford graduate, worked with some of the world’s biggest banks trying to figure out how to adjust to new regulations and a changed market. Then he quit.

For Mr. Takeuchi, memories of friends building successful start-ups at college outweighed the lucrative rewards offered by the blue-chip consulting firm. He joined forces with two McKinsey consultants, feverishly writing code out of his parents’ house on a minimal budget to create his own technology start-up.

The result was GoCardless, a London-based company that allows small businesses to set up monthly payments to suppliers at a fraction of the cost that banks charge. The business has secured $1.5 million in seed capital from a number of well-known investors, including the American early-stage venture capital firm Y Combinator.

“The whole idea of bank payments is broken,” said Mr. Takeuchi at the start-up’s office in a dilapidated building on the outskirts of London’s financial district. “There’s an opportunity here, and we’re looking to grab it.”

Hazel Thompson for The New York TimesHiroki Takeuchi, co-founder of GoCardless, a new financial firm based in London.

London’s fast-growing start-up scene is trying to disrupt the financial status quo. As consumers’ trust in banks deteriorates because of a series of recent scandals, young companies are pressing their newcomer advantage. Firms are offering services like low-cost foreign currency exchange and new ways for small business to borrow cash.

Backed by venture capital firms like Index Ventures, the financial start-ups are taking on entrenched incumbents by using technology to pare back costs and improve the customer experience. Local authorities do not directly regulate many of the firms, but the young companies often use traditional banks and other financial firms for their back-office functions, like processing payments, which are monitored by British regulators.

“Start-ups are taking advantage of London’s position as a global financial center,” said Adam Valkin, a partner at the European venture capital firm Accel Partners. “They are innovating in ways that banks just can’t do.”

The growth of finance entrepreneurs comes as London’s start-up community continues to flourish. Many parts of East London have transformed into a mini version of Silicon Valley, with the likes of Google opening shared office space to support fledgling companies. Finance, technology and fashion start-ups have been able to tap into the large talent pool of young, multilingual professionals eager to work for the firms.

Many companies are following the lead of Wonga.com, an online lender founded in 2006 that has sought to fill a void left by banks by offering short-term, high-interest loans to consumers and small businesses. The company has been criticized for charging high interest rates to vulnerable consumers. The typical annual percentage rate on the company’s loans is more than 4,000 percent, though Wonga.com says it only offers lending for a maximum of 30 days.

To cut down on costs, the start-up relies on publicly available online data to determine whether an applicant is creditworthy. Loans can take as little as 15 minutes to arrange, and the company has branched out from consumer lending into the small-business market as individuals look for alternatives to banks.

The tactics are paying off. Last year, the online lender reported a 269 percent rise in its net profit, to £45.8 million, or $73 million, after its loans increased fourfold compared with the previous year. Now, Wonga is now contemplating a multibillion-dollar initial public offering on Nasdaq, profiting from lending to consumers that are perceived as too risky for banks.

For many workers in London’s financial services sector, successes like Wonga have turned the idea of starting a business into an increasingly attractive option. With investment banking activities on the wane, job prospects in the industry have remained poor since the beginning of the financial crisis, and the financial sector here is expected to lose 25,000 jobs this year.

Anil Stocker has seen the layoffs up close.

Mr. Stocker, a 28-year-old Cambridge graduate, left Lehman Brothers a few months before it collapsed in 2008. A year later, he resigned from the American investment bank Cogent Partners to co-found MarketInvoice with two friends who worked at JPMorgan Chase and Goldman Sachs.

The start-up helps small businesses gain access to capital by selling their supplier invoices to investors at a discount.

“The finance industry will have to completely change, and we are just at the beginning,” Mr. Stocker said.

MarketInvoice wants to exploit an underserved market in the banking sector. As firms have pulled back on lending, small business have been denied credit because they are deemed too much of a financial risk.

To help these companies access cash, Mr. Stocker and his partners began an online marketplace where small businesses can auction their long-term supply contracts to money managers for the highest price. Many of these invoices can take up to 90 days to pay out, so companies are willing to sell them at a discount to get hold of short-term capital.

Starting the business has not been easy. It took MarketInvoice’s founders — who were still working for banks — almost a year to devise the business plan, and a further six months to raise $1.4 million from investors. The start-up auctioned its first supplier contract for £40,000, or $64,000, in early 2011, but only hit the £1 million mark nine months later.

“No one wanted to be the first company to use our system,” Mr. Stocker said. “At the beginning, you live or die by your reputation.”

London’s finance start-ups also are attracting entrepreneurs with a technology background.

Taavet Hinrikus, a 31-year-old Estonian who was Skype’s first employee, dreamed up his business while still working for the Internet calling service. In 2006, the company moved him to London from Tallinn, Estonia, where he rose to become Skype’s director of strategy. But Mr. Hinrikus grew frustrated after losing 5 percent of his salary to bank charges every time he moved money from Estonia to Britain.

After meeting fellow compatriots in London who wanted to transfer cash back Estonia, Mr. Hinrikus created a system in which individuals could move money to each other’s accounts. By agreeing to swap currencies at a set rate, Mr. Hinrikus said he saved thousands of dollars in bank fees.

“We had to find our own way to avoid the charges,” he said.

With his business partner, Kristo Kaarmann, a former management consultant, Mr. Hinrikus built a Web site that connects people looking to exchange British pounds with euros. Their start-up, called TransferWise, acts as an intermediary for the money transfers and has expanded into other European currencies.

Not everything has gone to plan. The start-up had to wait 18 months to receive its license to operate from British regulators.

Yet in its first 12 months, Mr. Hinrikus said TransferWise has helped people to exchange around $10 million of foreign currencies that has avoided costly bank charges. The start-up also has raised $1.3 million in seed capital from investors, including PayPal’s co-founder Max Levchin.

“Banks aren’t doing a good job at innovating for consumers,” said Robert Dighero, a partner in the London-based venture capital firm Passion Capital. “Start-ups are nibbling away at some of their most profitable businesses.”

DealBook: Trying to Be Nimble, Knight Capital Stumbles

As the leader of one of the largest brokerage firms in the nation, Thomas M. Joyce has been an unapologetic advocate of electronic trading and one of the most vociferous critics of companies that struggled to keep up with the ever-changing stock market.

Now, Mr. Joyce, a longtime trader who seized the reins of the Knight Capital Group in 2002, is fighting for his company’s survival.

In a bid to keep a grip on its customers, Knight pushed to introduce a new system that would position it competitively amid market changes that took effect on Wednesday, according to people briefed on the matter. Unlike rivals that hesitated, Knight Capital’s presence on Day 1 would ensure bragging rights and extra profits.

But in the rollout of the system that morning, Knight created a blizzard of erroneous orders to buy shares of major stocks. The orders caused wild swings that affected the shares of more than 100 companies, including Ford Motor, RadioShack and American Airlines.

While the companies quickly recovered, the 17-year-old Jersey City firm was left reeling. Knight will lose $440 million in selling all the stocks that it accidentally bought on Wednesday — more than its entire revenue in the second quarter of this year, when it brought in $289 million.

Mel Evans/Associated PressKnight Capital, in a bid to keep a grip on customers, rushed to introduce a new system that would position it competitively.

On Thursday, rattled customers like Citigroup, Fidelity Investments and Vanguard took their business elsewhere. Knight shares plunged 63 percent, to $2.58. The fallout prompted the company to contact JPMorgan Chase and other big banks for emergency financing.

The company is also facing an onslaught of regulatory scrutiny. The Securities and Exchange Commission’s enforcement division is examining potential legal violations, people briefed on the matter said.

As it faces the flight of confidence, Knight is desperately seeking potential buyers for parts of its business. On Thursday, Knight’s senior executives reached out to hedge funds and rivals like Citadel and Virtu Financial, according to people briefed on the matter. But by day’s end, interest was uncertain and there were questions about whether the company would collapse into bankruptcy.

“With the events of yesterday, you have to question if this is the beginning of the end for Knight,“ said Christopher Nagy, founder of the consulting firm KOR Trading.
Knight Capital declined to comment.
Within the company, the mood grew grimmer as hopes for a recovery dwindled, according to traders at Knight, who were not authorized to discuss the matter. Some employees slept at the company overnight on Wednesday.

“I am grateful that at this point I still have my job,” one trader said.

Originally named Roundtable Partners, in a nod to Arthurian legend, the trading company rose to prominence with the proliferation of high-speed electronic trading. In the first half of the year, Knight accounted for 11 percent of all stock trading in the United States, according to the TABB Group.

The pressures to stay competitive, however, meant that the time between developing new trading software and putting it in use became shorter and shorter.

On Wednesday, the New York Stock Exchange began a program intended to loosen the stranglehold that brokerage firms like Knight had over retail investors. Under this program, trades from retail investors now shift to a special platform where trading houses compete to offer them the best price.

Knight sought to stay nimble. Over the last several weeks, the company tweaked its computer coding to push itself onto the new platform.

Two competitors who declined to be named because they didn’t want to publicly criticize a rival said that they took a more measured approach, choosing not to create new software to coincide with the debut. Some also questioned Knight’s aggressive approach.

“The time between the approval of the software and the time it was implemented was incredibly quick,” said a head of equity trading at another firm.

The errant trades on Wednesday quickly seized Wall Street’s attention. Within seconds of the New York Stock Exchange’s opening bell ringing at 9:30 a.m., Knight’s computer coding malfunctioned.

The code was supposed to direct the firm’s computers to react to trading. Instead, it placed its own runaway offers to buy and sell shares of big American companies, driving up the volume of trading to suspicious levels.

Officials at the exchange began noticing an enormous spike in volume shortly after the opening bell. Exchange officials soon touched base with the S.E.C. in Washington, where an internal e-mail system alerted regulators to the problem. A regulator stationed in the agency’s market watch room sent out regular alerts to senior agency officials.
Within minutes, the authorities traced the problem to Knight.

Yet even after that detection, the New York Exchange had limited authority to take action. Most measures that curb erratic trading are tied to wild swings in stock prices, whereas the problem at Knight was initially tied to the volume of trading and not the price of shares. In addition, circuit breakers that halt individual stocks do not work during the first 15 minutes of trading.

About 45 minutes into the debacle, the exchange shut down Knight’s trading.

By the end of Wednesday, there were winners and losers.

Many big investors cashed in on the market volatility. They saw what was happening when the surprisingly large trades began to register, and they quickly moved to profit from the disruptions.

The winnings were spread from individual traders to proprietary firms that use specialized computer algorithms to spot and profit from market aberrations, including the DRW Trading Group. Hedge funds and other asset managers that trawl the market looking to profit from abnormal pricing also won big.

But while many institutional traders managed to profit from the fiasco, individual investors did not fare as well.

“It’s the retail investor that gets hurt because they are not sitting in front of a computer watching the market all day,” said Scott Freeze, president of Street One Financial, a trade execution firm.

In the aftermath of the bruising day, the S.E.C. is taking a closer look at Knight’s decisions. The agency is examining whether Knight properly tested the coding change — and whether it had sufficient internal controls to avert such a disaster. Some regulatory officials, however, commended Knight for steering customers to other brokerage firms.

On Thursday, S.E.C. examiners remained on the ground at the brokerage firm. Mary L. Schapiro, the agency’s chairwoman, spoke with Mr. Joyce Wednesday afternoon.

Ultimately, the debacle is a significant blow to Mr. Joyce, 57, whose ambition came to define the rapid rise of the firm.

Mr. Joyce, who made his name at Merrill Lynch and Sanford C. Bernstein & Company, was a trusted ambassador of electronic trading. On June 20, he testified before a House Financial Services subcommittee, arguing that the booming business democratized a stock market once dominated by a handful of Wall Street firms.

He was also seen as an eager critic of other firms’ missteps. In recent months, he excoriated Nasdaq for bungling the stock market debut of Facebook, which cost Knight $35.4 million.

“This was arguably the worst performance by an exchange on an I.P.O. ever,“ he said in an interview in May with CNBC.

When Mr. Joyce took control of Knight in 2002, he was tasked with cleaning up the firm.

In 2004, Knight agreed to pay $79 million to the Securities and Exchange Commission to settle accusations that it “defrauded” customers. Knight did not admit wrongdoing.
Just last month, however, some outside traders indicated they experienced problems when routing trades through Knight Capital. Craig Warner, head of trading at Capstone Investments, a research boutique firm, said that a few weeks ago an order he placed with Knight went wrong. The trade was supposed to be spread throughout the entire day, but a half-hour before the market close, the remainder of the trade was executed all at once.

“It was alarming because if the stock had been really moving, it could have been a big problem,” Mr. Warner said. “After having the issue I had last week and with the issue yesterday, I lost a lot of confidence in them,” he said, adding that he was no longer using Knight to clear trades.

Even on his first day at Knight, Mr. Joyce was greeted by irregular trading. On June 3, in 2002, the company’s stock was suspiciously trading at 14 cents, after a software malfunction misread a Knight trader’s order. Instead of placing an order to sell roughly one million shares of a penny stock, the system sold the firm’s own stock.

In an interview with Institutional Investor magazine, Mr. Joyce recalled getting on the intercom that day and introducing himself to his staff. “I’m Tom Joyce, he said, “and yes, I know that our stock is trading at 14 cents.”

Azam Ahmed, Michael J. de la Merced and Nathaniel Popper contributed reporting.