The world’s top investment banks, meanwhile, profitably peddle tens of billions of dollars’ worth of complex financial instruments, such as synthetic securities and derivatives, every year. Even sophisticated customers, such as Fortune 1000 companies and hedge funds, are often understandably reluctant to take a chance on new financial instruments. So the banks now give their customers the same computerized “wind tunnel” and “stress testing” algorithms that their own quantitative analysts have used to design the products in the first place.
“In the early days, we would run simulation after simulation demonstrating that our instruments would help them better hedge their risks,” acknowledges one former Goldman Sachs and Salomon Brothers executive. “But, frankly, they didn’t fully trust either us or our simulations. It wasn’t until we started giving them the simulation tools we used ourselves that they took us seriously.”
These free simulators proved to be the most profitable innovation that the Goldman Sachs derivatives group launched. Soon, clients began asking for custom derivatives and other tailored instruments. “Without the simulators, customers would never have known what to ask for, and we would never have thought to ask,” recalls the bank executive. Yet, despite its success, this innovation appeared nowhere in the bank’s R&D budget or prospectus. It was only a tacit, not an explicit, locus of value creation.
Of course, many companies resist the idea of bringing in customers as innovation partners. Eric von Hippel, head of the Innovation and Entrepreneurship Group at the Massachusetts Institute of Technology Sloan School of Management, hypothesizes that internal innovators frequently view customer innovators as rivals who might undermine their creative role.
Professor von Hippel recalls a chemical company that devised a software program to calculate which forms of plastic were most appropriate for packaging such different foods as strawberries, fresh meats, and frozen vegetables. “I told them that they should share that program with a few of their customers to see how they used it,” he recalls. “They immediately said no. I think they were afraid that it would put their customers in a better position in negotiating with them.”
But in practice, companies that externalize internal tools typically acquire greater external influence. Moreover, the ongoing digitalization and virtualization of design-and-test innovation tools ensures that a wealth of externalization options will grow. The business goal, however, is not to make a profit by selling internal techniques; it’s to alter the innovation ecosystem, making it easier, safer, and more advantageous for suppliers and customers to take a chance on one another’s work — and to learn far more about each other, and themselves, in the bargain.
To externalize innovation, organizations must add value to tools they’ve already designed, developed, and deployed. To do this, companies need to audit the very tools they most take for granted and see how — or whether — they should be externalized. That kind of introspection may be the most customer-oriented innovation a company can make.
Michael Schrage (firstname.lastname@example.org) is the codirector of the MIT Media Lab’s e-Markets Initiative, senior advisor to the MIT Security Studies program, and the author of Serious Play (Harvard Business School Press, 1999).