In which we are the protagonists in the low comedy of our economy

This morning I was rereading Merton and Bodie's "A Conceptual Framework for Analyzing the Financial Environment" in The Global Financial System: a Functional Perspective, published in 1995 but still immensely interesting*. This passage, though, ended the paper:

In the traditional bank arrangement, there is a mismatch between the liquidity of the deposits issued by the bank and the loans backing those deposits. Indeed, it is this mismatch in liquidity that is often cited as the root cause for banking panics...

The current environment of low and secularly declining transactions costs for securitization supports a hierarchical and incremental chaining approach as an efficient means for providing liquidity. Liquidity is enhanced whenever a collection of assets is "repackaged," and the resulting collection of assets created have a smaller bid-ask spread than the original assets. Thus highly illiquid and opaque assets can be financed with short-term debt instruments. Portfolios of the more liquid of those securities, in turn, can be used as assets to back other securities that will have even greater liquidity, and so on.

Thus, at each link in the chain, the differential in liquidity is relatively small. Cumulatively, it is possible to create virtually perfectly liquid securities while minimizing the danger to the system of ever experiencing a "crisis" because of a mismatch between the liquidity of an intermediary's assets and liabilities.

The idea is appealing on the face of it, but we can't, obviously, still believe it. If I was going to criticize, I think I would start with how the authors seem to be confusing instrument-level liquidity with institutional-level and how these could be quite different markets. But this is pretty unsatisfying, if only because these institutions are just collections of individual assets anyway.

I think the better answer may be that it wasn't securitization at all at fault in the recent difficulties. Of course, at the rate we're ruling out causes, we may eventually have to accept the sole remaining explanation for the near-seizing up of our vaunted financial system--no matter how improbable it may be: collectively we're no smarter than a troop of chimpanzees.

OK, maybe it's not that improbable.

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* We're having a contest to see who can have the most boring Saturday. I'm winning.

If the ad exchanges aren't exchanges, what are they?

I should note that I don't claim to have had an original thought in my post yesterday on why ad exchanges are not like financial markets/exchanges*. In addition to Huayin Wang's insight in the comments, @jonathanmendez points me to a Cogblog post touching on this, and Jordan Mitchell of Rubicon mentions his own post from several months ago.

I love this stuff, excellent reading.

Keep in mind, though, that exchanges are only one type of market. Most commodities are not traded on exchanges. Most things are not bought and sold on exchanges. So, while I defend talking about the stock market as an analogy and as a way to think about what ancillary companies can exist in the ecosystem and how important they will be, maybe it would be useful to specify what the marketplace for ads is, not just what it is not. I'll try to blog on that next week.

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* My ex-trader friend, mentioned yesterday, scoffed at my use of the word "exchange" in our conversation, saying "if it's an exchange, then the CFTC would like to talk to you."

The limits of the exchange analogy in the ad marketplace

huayin commented on Open source the ad exchange just now on an issue that has been top of my mind for a while. He says

We need to be cautious of the limitation of any analogy... In my 2c, Ad Exchange marketplace is an order of magnitude more complex than NYSE! The current ad buying/selling ecosystem already underscores this intrinsic complexity...

He's right, of course. There's a sort of intellectual shorthand (laziness?) in equating the financial marketplaces and the ad marketplaces. It's not just me; my friend Roger Ehrenberg, who knows the financial markets inside and out, also makes this analogy. But it's a useful tool in predicting and shaping the future.

Ads aren't commodifiable in the sense that, say, soybeans are. I talked about one reason (among many) for this in Information and markets 2. Ads right now, especially with the BT, CT and other data layered on top, are way too varied to be traded on exchanges like commodities. But the ad marketplace is also not as bazaar-like as eBay. Nor is it as consumer or producer dominated as many commodity spot markets (live cattle, say, or soybeans) which are not on exchanges*.

The stock/commodity exchange ecosystems are large, high volume, complicated, economically significant and there are a lot of people who would spend a lot of money for the slightest edge. There is also a ton of public information on what works, how well it works, and its the economic effect. Try finding that for the live cattle market, which may in some respects be a better comparison. Centuries of central clearinghouses, risk sharing, information transparency, spot vs. future markets, intermediaries, analytics, etc. can teach us some useful lessons. Not to mention the reasons and limitations on the evolution of markets from haggling to fixed-price to auction to exchange to derivatives. This history deserves some thought as we try to build a coherent ad marketplace.

I think there's a better way of doing things in the ad market. There has to be, it's such a mess right now. So, despite the limitations of the analogy, it's better than starting from scratch.

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* I was talking to a ex-trader friend of mine this morning about this very subject. I asked him why the CBOT had spot markets in butter (note the trading hours: 11:05-11:15am, M-F) but not soybeans. He said it was for sentimental reasons. He also said that the betting among the traders about how many minutes the butter spot market would take to clear (7 minutes vs. 8, say) exceeded the dollar amount of the actual trades in butter.

Apple acquires Quattro

A couple of months ago I said Apple had to acquire some advertising DNA. Now they are, by buying Quattro Wireless.

I'm not sure why Google, Apple and Microsoft all need to compete in all of each others' lines of business. It seems to me that Apple's incipient stranglehold on the mobile internet put Google into a "the best defense is a good offense" mode. This, in turn, caused Apple to respond in kind. In some more rational world, Apple would provide the platform, Google would provide ad services, and a million developers would provide content. I assume that someday we will arrive at that point, but the path to get there is murky.

One point I made two months ago bears repeating. In mobile advertising on the iPhone, Apple has something that nobody else does: they know who you are. They have software on your computer that connects to your phone and to the internet. They also probably have your credit card number and address. They can link behavior between your mobile, your web and your real life*. This puts everyone else trying to target ads at a massive disadvantage. It is also a privacy nightmare.

[Update: Read Greg Yardley's take on the deal.]

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* I don't know if this is true or not of Google on Android devices. Anyone?

Open Source the Ad Exchange

My last post, long and long-winded and written when you should all have been out celebrating, sent more traffic my way than any other post in this sleepy blog's history. I think the prospect of a new year and (in a sense) a new decade, makes us all a bit introspective and open to thinking the why about our path through the world. I'm glad people found it worth a read.

But it's January now, and Monday. Back to work.

*****

My work thesis since I left Omnicom in 2001 was that the advertising ecosystem was stuck in the 1970s without even the consolation of the three-martini lunch. Ad agencies--and thus advertisers--seemed to be following a rather indirect path towards connecting the right person with the right product. Efficacy was low, efficiency was poor and ROI tracking was primarily hand waving. "One to one marketing", an idea that the internet could make real, was still used as an exciting cliche in pitch decks and book titles, but never implemented in actual marketing campaigns.

So I spent my time investing in and starting companies aimed at changing that. From early (too early, it seems) location-based marketing in Platial and exchanges in Root Markets, to tracking in Pinch Media, to data targeting in 33Across and Domdex and to demand side platforms in CPM Advisors.

But when Google launched their Ad Exchange four months ago, I decided the thesis was played out. An open marketplace can be the apotheosis of efficiency and efficacy. And if Google is putting its muscle behind that, then the rest is just filling in the blanks. While filling in the blanks is probably a better investment philosophy in the short term, it's not the right place for investors like me who are putting smaller amounts of money to work for longer periods of time.

Then Google acquired Teracent. Then it was said that Google was looking to acquire a demand side platform. I also heard that Google was restricting sellers' agents from working with AdX.

The key to making the exchange-as-platform useful is making it a platform. If the New York Stock Exchange owned a brokerage firm, that would be a problem. If they owned a research firm, or an underwriter, that would be absurd. But Google is, in essence, trying to do all these things. The strategy seems to be to make the exchange easy to use for advertisers and consumers because those are Google's real customers.

This is a bad long-term strategy. Small producers of say, soybeans, are not equipped to show up on the floor of the CBOT and sell their September crop in open-outcry. And you and I are not prepared to go up against Goldman Sachs in selling our shares of GOOG on the Nasdaq. In both cases, we'd get taken. That's why there are intermediaries. If Google doesn't allow outside firms to be intermediaries then small producers and consumers will get arbitraged, and the information generated by the market will be poor quality. The hoped-for efficiencies will not appear.

Google knows this, of course. So why are they doing it this way?

In 2008, the NYSE Euronext Group had revenue of $4.7 billion and operating income (backing out one-time impairment charges and merger expenses) of about $1.1 billion. In 2008, the CME Group had revenue of $2.6 billion and income before taxes of $1.2 billion. The stock and commodities markets are each a couple of orders of magnitude bigger than the advertising market. Even if the ad exchanges facilitated the introduction of derivatives, like ad futures and the like, the future of ad exchanges are companies with a few hundreds of millions of dollars in revenue.

Being an exchange is not where the real money is made in the stock and commodities markets. The big money is made at places like Goldman Sachs. This is not to downplay the central importance of the exchanges: Goldman would be a much smaller and less profitable company if there weren't exchanges. The ad markets will end up similarly, with exchanges that are crucial to the ecosystem but not that big financially, and much more profitable firms that use the exchange platforms.

Historically, exchanges have been cooperatively owned entities, in existence to facilitate the business of their members. Google, with AdX, is in the wrong side of the business. The best move, for them and for the markets, would be to spin AdX out into a Mozilla-like non-profit foundation and then work on the hard problem: figuring out how to use the newly generated information and efficiencies to make advertising more useful.

I jumped the gun. In this sector, there is a lot more to do.