Monday, July 31, 2006

Spot lead pricing

When prices look wrong there are two possible explanations, either the market is wrong or you are wrong. Bully for you if you can pick which!

Across the lead generation business I see an interesting phenomenon which is worth investigating. Large volume suppliers are paid more (per lead) than small volume suppliers. Additionally, large volume buyers pay more for their leads than do small purchasers. At initial glance this looks very wrong - as arbitrage profits can be made by buying small amounts of leads, bundling and then selling as large lots. Are leads a Giffen Good? No, but I think three factors come into play when modeling this situation: Cost allocation, quality and a risk premium.

Examining the supplier side we can easily see how these three factors may come into play. Lead aggregators (or exchanges, for that matter) have certain fixed costs associated with each participant. On the supplier side, there are the costs of technical integration, support and initial marketing expense which all have fixed components. Thus, on a per lead basis, leads from a small supplier are more costly than those from larger suppliers. Additionally, large supplier have more to lose if they were to provide poor quality leads in the exchange and it is common to see a higher return rate with smaller suppliers than for larger suppliers. These returns are costly for the aggregator and are thus reflected in the price paid to smaller suppliers. Both cost allocation and quality are factors that are readily understood in this industry, however the risk premium is not often voiced.

Dealers take a profit for providing two key services, price discovery and liquidity provision. The risk that they face is one of spread risk. In other words they make money, but are exposed to the risk of holding an unbalanced book. Before the modern era of financial engineering, where dealers (and others) can structure positions to offset spread risk, dealers would just bump their prices to cover this risk. So if a large market order came in, which would take liquidity from the market, the buyer would have to pay a 'liquidity premium' to cover this. This still happens today in the world of large block trades, but not to the same extent as in the past.

A quick point that I would like to make before returning to the lead risk premium is the difference between liquidity and volume, which I notice are often used interchangeably, especially in lead markets. Volume is simply the number of things bought or sold on a market. Liquidity, however, speaks to how easy it is to buy or sell on a market. Imagine a market with sellers providing exactly one million widgets per day, and buyers wanting exactly one million widgets. The volume of this market is one million widgets, which for the sake of argument, we will call 'large'. However, if the sellers represent all the producers of widgets and there are no more widgets to be made, a new buyer wanting to purchase 50 widgets would not be able to do so at the current market price. Those 50 widgets would have to come from the requested quantity of an existing buyer and this should only happen if the new buyer is willing to pay more. In this market we have large volume but little liquidity.

In general, market orders or offers, which demand an instantaneous purchase or sale at whatever price the market can bear take liquidity away from the market. Limit orders which set the price at which they are willing to trade provide liquidity. A market with a large number of limit orders is said to be deep. Limit orders can have two types of fill policy: all or nothing, or partial fill. If the orders for the million widgets were 100 all-or-nothing orders for 10,000 widgets each, then the market order for 50 widgets would have to pay at least 200x the per widget price of the larger all-or-nothing limit orders.

What does this mean for a small volume lead seller? Recall that small sellers are paid less for their leads than large sellers. The best way to think of this is in terms of spread risk, or the cost to an aggregator of keeping an unbalanced book. Leads are provided by suppliers in real time, whereas orders are pre-existing limit orders. If a single small sellers leaves the market there is little impact on the balance between supply and demand. If a large seller were to leave the market, a large number of orders may go unfilled. And although buy orders are mostly of the partial fill variety, if you start supplying only 100 leads to an order for 1,000 it is likely that either the order will become smaller or the buyer will leave the market. Both situations require a chunk of sales capital to bring the volume back. To prevent this from happening it is wise to pay your larger suppliers more to minimize the chance of them selling their leads elsewhere. If this indeed is the case, a portion of the premium paid to large suppliers on the spot market represents an incentive for future behavior.

Likewise, when a buyer buys 100 leads today they are making a statement that they are likely to buy 100 more tomorrow and they are paying for the probability of extracting liquidity from the dealers book in the future.

This is interesting. Without the mechanisms afforded by futures contracts, participants face differential pricing in the spot market contingent on beliefs about future events.

At ROOT Exchange I am working on developing contracts and other futures products to help better serve the needs of natural participants and speculators. Hopefully when I get some time away from working on that, I will be able to share some more analytical detail about my thoughts on these premia embedded in spot prices.


Blogger Dave said...

wow, that was some good sh*t.

please sir, could i have some more?

(nice post)

9:46 PM  

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