Financial innovation is on the menu at Hotel Chocolat

On the playing-field of UK start-up businesses, one that I particularly admire is Hotel Chocolat. Started in 1993 by Angus Thirlwell and Peter Harris, it has grown to open 44 stores worldwide by providing a product of superb quality and developing a brand that is modern, decadent and personal. Their products are innovative (I particularly like the super-thick shelled Easter Eggs); their marketing is democratic (customers can submit ratings of each chocolate); and thanks to free samples and a friendly team of sales assistants the shopping experience at their stores is always a pleasure.

When it came time to raise finance, then, is was only natural that the Hotel Chocolat entrepreneurs would find a novel way to do it. Conventional options would include selling equity in the company, which would dilute the owners’ stakes, or taking out a long-term bank loan, which could have a high, variable rate of interest. Instead HC gave their customers a chance to invest in the business. In exchange for a lump sum of £2000 or £4000, the customers will receive “interest” paid in regular deliveries of boxes of chocolates.

A £4000 “chocolate bond” yields 13 boxes of chocolate each year, with a retail value of £18 a box, equating to £234 p.a., or 5.83% net interest (7.29% gross). For customers who are already paying cash for the monthly boxes of chocolates, this is a potentially attractive investment opportunity: to swap capital expense for reduced cash outflows in future. For HC they are locking in the value of those future sales as capital – which they can then earn a further return on.

Looking, for a moment, with a critical eye, I expect the transaction costs of this deal are fairly high (although partly offset by free publicity received). And there is no guarantee that the target customers will take up the offer. Furthermore, the investors are putting their capital at risk, as unsecured creditors, and would be left with a big loss if HC went into liquidation. So as with most forms of innovation, it comes with a certain set of hard-to-quantify risks.

Perhaps the most exciting message from the Chocolate Bonds project is that financial innovation is not dead. Financial innovation has taken a beating in recent years due to the mis-selling of complex mortgage instruments and derivatives, which allowed one party to exploit another. This looks like something refreshingly different: a genuine win-win scenario for HC and their customers.

Liquidity – at what cost?

Last week I read an interesting definition of arbitrage: "making money by buying and selling something without adding value." Those last three words began a train of thought that led to a conversation that led me to conclude that the world probably has too many arbitrageurs, and too many financial traders in general. Probably.

The primary purpose of financial instruments used to be for large companies to raise finance (through debt or through equity) and to hedge risk (through derivatives). Now it seems like their main purpose is to allow hedge fund managers and bank’s proprietary traders to make large profits.

In most industries, making a profit is achieved by adding value to some product or service and selling it at more than the cost of delivering it. The value added usually corresponds to a direct benefit for society – think of a baker turning flour into bread or a bike mechanic making a broken bicycle usable. One person’s effort allows them to earn a living while benefitting another person.

With the trading industry it is much harder to see who are the net beneficiaries - but they do exist. Speculators and arbitrageurs create liquid markets for financial instruments, which are important for companies to be able to raise finance with which to grow. Growth allows economies of scale, and public listings create a certain level of discipline amongst corporate management.

Having said this, I would argue that there are probably more people working in speculation and arbitrage than are required to make the financial markets liquid. The cost to society of the additional liquidity is that the people working as traders could have otherwise been adding value to society through industry or entrepreneurship. In this trade-off of the allocation of talent, there must be an optimal level of trading activity – enough to make financial markets work, without damaging other industries by sucking up too much brainpower – and I don’t think we are there.