Monday, May 18, 2009

First Ever Ad Market

I was out with Josh Grotstein--CEO of Motionbox--last week, and got to talking about how the inefficient market design of our current ad exchanges saps liquidity.

OK, maybe I was talking about it.

Possibly I was ranting*.

Josh wisely changed the subject to an episode of 1987's Max Headroom, featuring the first vision of an ad exchange that we could think of, the steam-punkish Ad Market. It's not entirely clear what the underlying is in this market, since elsewhere in the episode a big advertiser seems to be using Skype to tell a network head to get the ratings up. It could, perhaps, be a pure risk-hedging derivatives market without any delivery of the underlying, which would certainly explain the show's dystopian setting.

Elsewhere in the episode, Amanda Pays makes those 80s style big-shoulder suits look pretty damn good.

* The thing about a rant is that it can't be kept in. So here it is.

Liquidity in a marketplace is generally determined by depth of limit order books. If the limit order book gets depleted, there is no liquidity. Most research on this subject focuses on the ratio of limit orders (supply liquidity) to market orders (deplete liquidity). This ratio depends on trader patience and market design.

Market design decides time to execution, the key endogenous factor traders take into account in deciding whether to place a market or limit order (mappable, perhaps, to the more classical 'waiting costs.') Variability is a function of spreads, spreads a function of liquidity, and liquidity of time to execution. Highly variable prices drive down the average price level.

In a well-designed market, time to execution can be minimized even with low volumes. Many marketplaces have historically kept TTE low by opening only for a limited period of time every day or every week. By concentrating order flow in a smaller period of time, the chance that each trade would clear quickly was increased.

Our current ad markets seem to be headed in the opposite direction. I consider these markets low-volume. But instead of working to decrease TTE by increasing the concentration of order flow, they seem to be motivated instead to decrease inventory risk by imposing a small TTE, diluting order flow. This depletes liquidity and must, in the aggregate, lower CPMs.

Of course, this is all speculative on my part, since I don't have the data to back it up. Also, this effect is probably a small part of why online CPMs are so low, the relative inefficacy of online ads being the bigger part. But liquidity is certainly more interesting to think about. It also makes me wonder what the heck Hal Varian does at Google.

Thursday, May 14, 2009

On Regulation and Innovation in the Financial Industry

Yesterday President Obama said

We started taking shortcuts. We started living on credit, instead of building up savings. We saw businesses focus more on rebranding and repackaging than innovating and developing new ideas that improve our lives.
But contrast that with this, from November of last year:

The Securities and Exchange Commission this week issued a formal cease and desist order against peer-to-peer lender Prosper Marketplace Inc.

The San Francisco company said in October that it was no longer accepting new lenders or loans as federal regulators consider the company’s application to establish a secondary market for loans made on its person-to-person lending site. That process is expected to take months.

It's easy to talk the talk about wanting innovation, but government regulation and innovation are inimicable. It's hard enough to start a new company. It's next to impossible for a startup to comply with government regulation that is opaque, one-size-fits-all, slightly different in each of the 50 states and written by lobbyists to benefit incumbents. To comply with the regulations, companies have to hire expensive, well-connected lawyers and go through a several month process. As an early-stage investor, I probably wouldn't invest in working cold fusion if it required the company to be government regulated.

I know everybody and their mother thinks the solution to all our financial system woes is more regulation, but it's worth considering that the US financial services industry is probably the most heavily regulated industry in the world (and if it's not, then it's second only to our incredibly inefficient healthcare industry.) It seems everybody and their mother thinks that if beating your head against a brick wall isn't working, well, just beat harder.

I'm not against regulation, really. I just think that if the regulation we have isn't working, we need to go back and figure out why, rather than layering on a new layer of regs. We should also go back and figure out who wrote our current regulations and burn them in effigy, to better motivate the current regulation writers. Nothing focuses the mind like a hanging.

The first principle in writing new regulations should be an explicit statement of what we are trying to achieve. And if what we are trying to achieve is that no one loses money ever, then perhaps what we want is not a financial system at all. That goal would be best achieved by returning to the gold standard and issuing safes to every home.

But whatever the goals are, one of the primary ones should be to promote innovation. And one of the primary goals of that innovation should be promoting diversity of business models. After increased regulation, the primary prescription in the mass media for the financial system is making sure that no company is too big to fail. This worthy-sounding goal is a non-starter in today's economy. Even if every financial services firm in October of last year had been split into 100 identical sub-firms, we would have had the same problems. Paul Kedrosky has talked about making sure that firms are less tightly coupled as one solution to rolling failures. While I believe this, I wonder if it's possible to implement.

But if you turn the problem 90 degrees on a completely different axis, we can address the tight coupling along functional axes: if we had many types of firms, then even if they are financially intertwined, only a small subset will fail in any given crisis. This idea--that diversity is key to the resilience of an ecosystem--is widely understood by ecologists, biologists and evolutionary scientists. The benefits of biodiversity are inarguable.

We need an appreciation of diversity in our financial services companies. We need to encourage innovative startups that try to provide crucial financial services--like converting savings into investment--in new ways. We need hundreds of them, understanding that most will fail. (Innovation is akin to an evolutionary process in this.) We need to change our regulations to encourage innovation, rather than discourage it. The president needs to stop placing blame and start planting seeds.

And we need to get over the fact that some blameless people will lose some of their money some of the time. Because with the financial services monoculture we have now, every taxpayer loses a lot of money every ten years or so.