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As new electronic markets arise, the market makers or industry organizations themselves often must build the rules of conduct. eBay, for instance, has had problems with shill bidding (in which sellers utilize phantom buyers to inflate bid prices). When eBay, through monitoring, discovers such unethical trading activity, it gives first offenders a thirty-day suspension, and repeat offenders are permanently banned from the market. Regulating markets is challenging when markets cross judicial and geographic borders and as electronic markets become more complex. Often technical innovation in markets outruns consensus on the principles of regulating them. But failures in (self-)regulation can be very costly, as exemplified by Enron in December 2001.
Managing online trading risk
Risk management services insure transactions and provide information to help the buyer and seller deal with price, delivery, theft, and other risks. As e-commerce proliferates, a number of insurance companies are beginning to offer insurance services to mitigate these risks. Similarly, many credit card companies limit consumer liability for online fraudulent credit card use.
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Risk mitigation for buyers and sellers is often achieved through third-party services, which are linked to the trading site. For example, From2.comacquired in March 2000 by Arzoonassesses and insures shipping risks. Similarly, Tradecard.com provides insurance for international freight. Escrow services also facilitate trade at a distance. Escrow.com, for example, intermediates electronic market transactions before payments are released to the seller to ensure that a satisfactory product is delivered. As online trading expands, the risks to both buyer and seller must be met through the expansion of such services.
Influencing online and offline behaviors
Rules are meaningless if they cannot be enforced or if market participants cannot be influenced to conform to them. One way in which electronic auctions have succeeded in regulating their participants is through feedback, in which buyers and sellers rate and post comments about each other. The comments typically describe the particular transaction as well as the registered user. In most cases, customers will avoid sellers with bad ratings and reputations.
Business-to-business commerce uses similar rating systems. For instance, Open Ratings, an online service partnering with Dun & Bradstreet, asks purchasers for feedback on their experiences with particular vendors and rates them according to the speed of delivery, the quality of services, and the integrity of the products themselves. The information is aggregated so that buyers can compare the performance of multiple vendors. Not only does the information help buyers, but it provides an incentive for sellers to meet commitments and behave ethically. Market makers can also suspend buyers and sellers who don't follow the rules and deny them future trading rights. Such rights of exclusion are practiced by markets ranging from eBay to Nasdaq.
Facilitating dispute resolution
Efficient dispute-resolution mechanisms also reduce the costs of market participation. Generally, disputants can resolve their problems through direct negotiation or through lawsuits and third-party interventions. A number of third-party services are emerging to support online dispute resolution. Settle Online, for instance, provides confidential Internet-based dispute-resolution services. SquareTrade provides an online arbitration service.
As new electronic markets arise, the market makers or industry organizations themselves often must build the rules of conduct. |
Ajit Kambil |
Some markets also establish their own in-house dispute-resolution mechanisms to avoid the high costs of court-ordered resolutions. As electronic markets proliferate and transcend traditional legal jurisdictions, however, market makers will need to develop more complicated dispute-resolution systems, ones that can be enforced as efficiently as those in courts of law.
As market makers transition from place to space, they have to design new trade context processes appropriate to cyberspace. In contrast to basic trade processes, which are rapidly improved by technological innovations, trade context processes are transformed more slowly by technology. Indeed, new trade context processes require broad social consensus among participants for successful adoption, from a new XML specification of a messaging standard to market rules that set behavioral norms. This need for social consensus makes changes in these processes more difficult and leads to slower adoption than changes in basic trade processes.
From virtual processes to decentralized markets
The transition from place to space makes it possible for core market processes to be decentralized. No longer do market processes, such as logistics and pricing, have to be co-located. Instead, thanks to efficient communications and computing processes, they can be decentralized.
The decentralization of markets follows the overall decentralization of computing and communications capabilities that has occurred over the last decade. Traditional phone systems, for example, began as a hierarchical system, one with a central office and trunk switches. Hierarchies were great at conserving scarce intelligence and bandwidth. As LANs (local area networks) emerged, they formed a new "peer-to-peer" communications architecture, one in which routing was not centralized. Rather, every personal computer connected to a LAN was a repository of intelligence, listening for relevant messages on the shared communications pipeline. Similarly, in peer-to-peer computer architecture, individual computers in a network interact without the need for a central server or "hub." In the most decentralized markets, similarly, trading applications interact directly, without having to go through a centralized hub.
The Nasdaq market and emerging Electronic Communications Networks, or ECNs, are examples. The Nasdaq computer systems broadcast the lowest offers and highest bids to more than 360,000 terminals, and orders entered by market makers are matched against offers and executed as trades. Meanwhile, the advent of ECNs, which were started in 1997 to increase competition among the exchanges, enables an even more decentralized form of trading. ECNs are electronic communications applications that allow participants to trade shares directly, without having to use the services of Nasdaq market makers.
ECNs give members new flexibility in directly negotiating prices and spreads. ECNs also route orders not directly fulfilled within the ECN network to the Nasdaq system, thus taking advantage of the availability of market markers. ECN networks have proliferated rapidly and now account for 35 percent of all trading in Nasdaq-listed stocks. Examples of ECNs include Instinet, Island, Bloomberg Tradebook, and Archipelago. The shift of trading away from the Nasdaq reduces the spreads and profit opportunities available to traditional Nasdaq market makers.
Naturally this has not gone unnoticed, and traditional market makers have been complaining about the fragmentation of markets as well as the challenges posed to customers, who now must comb multiple ECNs and the Nasdaq to find the best price. As traditional market makers lose market share, they are calling for a centralized system to record all limit orders across networks, allowing market makers to see all orders and thus compete more effectively with ECNs. As a result, technology-enabled decentralization can have major impacts on where transactions are conducted and who can profit from market making.
Driven by the peer-to-peer model, some market software providers like Netrana are breaking from the centralized B2B model. The primary characteristic of such markets is the elimination of the centralized intermediary. In its place, traders post their bids on the Internet, using peer-to-peer software that communicates to other traders. When matches in prices, quantities, and other details are reached, the trades are made. Advocates of such structures note that since the middleman is eliminated, the costs are lower.
Although peer-to-peer markets may increase in the future, pure forms of these models are likely to be rare. For one, they will probably work only where the trading parties have already established trust and a long trading history. Furthermore, peer-to-peer will succeed only in situations where the peers have agreed on such critical functions as authentication and logistics. They will also have to agree on directory services (so that peers can find each other), standards for interconnection to legacy applications, security, and regulation to remedy breaches of trust. For these reasons, we expect that peer-to-peer will be the most usefully employed as independent componentsspecializing in auction services and other market processesas they are built into the more conventional electronic markets.
Seven questions for Ajit Kambil
Q: What are the main characteristics of a successful electronic market?
A: A successful electronic market creates tangible new value over existing trading methods for suppliers, buyers, and the market intermediary. This can include access to new suppliers, expansion of the buyer base, new efficiencies in basic trading processes such as search, pricing, logistics, payments, and related services. Successful electronic markets can also generate valuable information for participants about price.
Q: What causes electronic markets to fail?
A: Electronic markets like real markets are often "fragile." They fail because they do not create enough new value for all participants--buyers, sellers, and market makers. Second they fail because many markets do not quickly achieve liquidity or a critical mass of buyers and sellers. Buyers will not participate if they do not find an adequate number of sellers, and sellers likewise will not participate if there are insufficient buyers. Thus market makers need to invest early in a number of strategies to create critical mass.
Markets also fail because many market innovators fail to correctly design and implement new markets well. For example, when some markets tried to go electronic they also maintained a concurrent physical market. In the physical market the traders had more social interaction and information such as the body language of key traders than they did in the electronic market. Thus traders were very reluctant to switch to an electronic system. Similarly you cannot directly, touch, smell or taste the items being traded. Thus market makers have to create ways of informing and assuring the buyer about the features and quality of the product despite the limitations of the media.
Finally markets fail when they do not maintain trust. Market makers can create real value by enhancing and ensuring trust among participants.
Q: What has been the most successful electronic market to date, and why?
A: E-bay has been one of the most successful electronic markets in recent time. It initially enabled diverse users to trade all kinds of unique items, and provided a simple auction mechanism to set a price for the items, and provided a simple mechanism for rating the reputation of traders to create trust. But today eBay is moving from a "perfect flea market" to a "perfect mall" where many businesses both small and large can reach over 45 million users. It becomes a mechanism to clear excess inventory, and provides an infrastructure that supports multiple pricing mechanisms to trade with existing and new customers. E-bay has also become a cyberlab to learn the preferences of different customers for various fashions and goods, and drive new product development.
Q: Given today's environment, is it realistic to expect that electronic markets can be left to self-regulation? What's the danger of government regulation?
A: Ultimately the best markets will use a combination of self regulation and government regulation. Market makers have an interest to self regulate and maintain ongoing buyer and seller trust participation in the market place. Electronic markets can also create reputation mechanisms to certify the participants, and even deny access to those who engage in unethical behaviors.
Given the recent failures of Enron and WorldCom, governments must play a role in ensuring proper corporate disclosure. They must also ensure that their accounting standards or regulations do not themselves create incentives for trading arrangements that artificially inflate revenues or game the system.
Q: From a management standpoint, who inside an organization should be responsible for electronic market initiatives? Do businesses need to create a VP of Electronic Markets?
A: Businesses do not need to create a VP for electronic markets--but VPs for Sales and Marketing, Supply Chains and Procurement, Human Resources and Information Technology should take ownership of designing and using markets strategically. For marketers, e-markets and auctions are now becoming a vital channel to customers. In the supply chain, markets and auctions are emerging as critical ways for procuring materials and collaborating across the supply chain. For human resources and knowledge managers emerging electronic markets will be a vital way of sourcing expertise. The IT manager will have to provide these infrastructures to the firm.
E-markets should also be on the CEO agenda. As companies like GE uses more auctions for procurement, CEOs of suppliers will have to rethink their firms' offers and positioning vis a vis different clients. As we describe in our book, smart CEOs will also use markets within the firm to provide inputs into decision making and improve resource allocation.
Q: What are the main benefits that electronic markets--auctions and exchanges--provide for companies that do them right?
A: There are just a lot of different types of benefits: lower costs in procurement and distribution, revenue growth from accessing new customers, insight into customer preferences and needs, better forecasts, and more efficient resource allocation are some of the benefits.
Q: Are there some types of companies or industries where electronic markets are not a good fit?
A: As electronic market technologies become cheaper and easier to deploy technically, they can be applied in nearly every industry. Initially the applications will range from markets and auctions to source critical resources, distribute products and services more efficiently. In time they will be applied to improve decision making and resource allocation within a firm.