Creating Exchanges to Solve Problems: 5 Must Have Characteristics

Posted by Jeff Carter
on October 17th, 2012

It’s almost a trite saying, “there are markets in everything”. But it is one of the ultimate truths of human existence. There are in fact markets in everything. As soon as a person makes a choice, a trade off between one option and another is made. That creates the cost/opportunity cost relationship that leads to supply and demand curves. Once supply/demand curves exist, where ever they intersect is a “price”.

Many times when I listen to entrepreneurs pitch, they are actually pitching an exchange model. They are trying to create a centralized marketplace where buyers and sellers interact to create value. Sometimes, the pain point is so huge and the problem so acute that it’s easy to set up an “exchange” and solve it. The problem for the entrepreneur is setting up an efficient exchange with a compelling enough value proposition that it draws both sides of the market in.

The interesting thing about the exchange phenomena; if you get it going the exchange gets so sticky to your customers it sets up a barrier for entry that’s almost impenetrable. Exchanges that trade securities and commodities have been a textbook case for that. It’s enormously difficult and expensive to move one contract or steal a contract from an exchange. It almost never happens unless there is a technological change, or a regulatory change. That makes the desire to set up an exchange model really compelling.

In the past several years, I have spoken with a lot of entrepreneurs, and even Congressman, about potential exchanges. Sometimes they have a potential to work and actually make the marketplace more efficient. Sometimes they don’t. For example, there was an idea floated a few years ago to have a “movie box office exchange”. It was destined to fail because there weren’t natural buyers of risk. Besides, there is also a lack of transparency in movie accounting so the way this particular exchange was set up, nothing would have been accomplished.

However, there are some products where exchanges might really add value. Yesterday in Asia, Richard Sandor floated the idea of water futures and an exchange to trade water. It’s a good idea. I have heard about exchanges for biomass, for waste, for Industrial biproducts. That begs the question, “What do you need to set a good exchange up?”

Here are some core elements an entrepreneur needs to set up an exchange:

A standardized unit of measure that the industry will adopt, or already has adopted. There is a reason corn is traded in bushels.
Natural buyers and sellers. Entities that have an economic interest in trying to maximize a sale price, or minimize a purchase price.
A big enough market so daily transactions can occur. Exchanges also function as a social network for buyers and sellers to come to and meet daily.
Some volatility in the price which injects an element of risk into the marketplace.
Transparent contract specifications, settlement prices and open interest.

Once those five factors exist, an exchange model can be applied to try and create value. Too often, I think that entrepreneurs put the cart before the horse and try and launch an exchange model without examining the different ways the pieces fit together. Once the model is in place, the problem becomes chicken and egg. How it starts up can impact the business.

Entrenched exchanges have similar chicken/egg problems. It’s pretty rare when a new contract is launched and succeeds. I can make a good argument that in futures, no US exchange has launched a successful futures contract since 1982. Most successful new contracts are actually derivatives of existing contracts. The emini S+P (ES_F) is just the big S&P online. The CME did create a dairy complex. But the average daily volume doesn’t move the needle for their business. They launched weather futures which have a good economic reason for existing, but they aren’t really vibrant. In Europe, the LIFFE lost all their high volume contracts to technology and ethnocentric bias, and they created the Euribor. But it can be argued the contract is a derivative of the Eurodollar-so no real imagination there.

Entrepreneurs may have to figure out a different way to incent customers. It’s highly unlikely that they will launch their model and have it work right away. They need to get really close to customers they initially socialized the model with and find out what they really need to make them access the market. Like a good mystery novel, the key to turning on the ignition may have to be found with good deduction. Once that key is found, you’ll feel stupid because it will seem as plain as the nose on your face. The ignition will turn, the engine will run, and you’ll be on your way.

follow me on Twitter
Like PnF on Facebook

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.