Almost daily we see a press release hit the wires announcing yet another B2B exchange promising unparalleled efficiency, transparency and competition. At their best, B2B exchanges help create a level playing field by facilitating the ability of buyers and sellers to find one another in an efficient and transparent forum. At their worst, they are not really exchanges at all, but rather attempts to capture the efficiency gains from the Internet to consolidate market power and ultimately stifle competition. Though various models may proliferate over time, an independent, third party exchange is the best model to ensure the stated benefits of B2B exchanges are in fact realized.

Three aspects of the B2B marketplace are worth exploring in order to understand the core issues at play in the various B2B exchange models. First, the differing motivations of the founders of these exchanges highlight a crucial fault-line in this emerging market. Second, not all B2B exchanges are created equal and, as such, the structure of these exchanges matters. Finally, the stakes are enormously high because the "rules" associated with B2B exchanges will affect the ability of old and new market participants to capture first mover advantage in these lucrative markets.

Motivation - A Core Question

Some B2B exchanges are motivated by the desire to help level the playing field by increasing competition and transparency within a particular industry. For example, in the foreign exchange market, our goal is simple -- we believe corporations and funds should have access to the best foreign exchange rates possible and that a competitive reverse auction is the best price discovery mechanism to achieve this goal. Like most third-party exchanges, we facilitate the transaction between companies and the seller (in this instance, banks), but do not have a stake in the outcome of any single transaction.

By contrast, the motivation of B2B exchanges led by a coalition of sellers is far less clear. Though press releases may claim interest in creating a competitive, transparent process, in fact sell-side exchanges have a significant stake in the outcome of the transactions conducted on the exchange. This fact not only presents an inherent conflict of interest, but also calls into question the stated goal of creating a competitive exchange. Clearly, there is a very strong incentive on the part of sell-side exchange owners to tilt the exchange in their favor since doing so benefits the sellers directly. Conversely, establishing a more level playing field only means more vigorous competition and fewer benefits for the current market participants, a prospect that is inherently unappealing to a sell-side exchange. In this scenario, a clear motivating force for a sell-side exchange is to maintain and/or strengthen market power and avoid the increased competition that is inherent in an independent exchange.

This concern about potential market concentration (and concomitant potential reduction in competition) is further heightened in situations in which a sell-side marketplace requires exclusivity from its members. It is not surprising to see such market players join forces, but doing so under the guise of a need to "compete in the new B2B marketplace" misses the point. Independent exchanges create a mechanism for both established market players and other sellers to compete, and is a model that encourages participation by all parties. As such, there is no compelling reason for a coalition of sellers to establish a separate exchange other than to avoid increased competition.

Because B2B exchanges represent a fundamental restructuring of the marketplace - a restructuring in which customers/buyers will have better access to information -- it is not surprising to see resistance by sellers to the prospect of increasingly intense competition. However, from a regulatory perspective, this brief exploration of the motivations behind these exchanges helps answer the perennial question of who benefits. In the case of the independent third-party model, it is clear that customers and ultimately the market benefit from the increased competition and transparency that results. With regard to seller-led exchanges, it is not clear who benefits beyond the sellers themselves.

Details, Details

The FTC has rightly identified ownership and control as critical issues in assessing the implications of B2B exchanges. These factors are of particular importance because they provide insights into the incentives and opportunity to engage in explicit or tacit anti-competitive activity. Equally significant is access to the sensitive market data that B2B exchanges collect from their transaction activity. For example, in the case of foreign exchange, data on a company's trading patterns is among its most sensitive and proprietary information. Ensuring that this information remains confidential is essential, and only an independent third-party exchange has a strong incentive to protect this information.

Let's explore the issue of who runs the exchange. In the case of an exchange led by a coalition of sellers, the risks of collusive or other anti-competitive activity are much greater because there is a strong incentive to use data collected from the exchange to benefit the sellers. Because the sellers are also board members, by definition, the board member/seller has access to real-time and macro-level information (e.g. customer trading patterns, pricing, demand, trends) that could easily be used to "front run" the market or otherwise manipulate the customer and stifle competition. Sell-side exchange participants could also easily use their access regarding each other's pricing information to facilitate and enforce horizontal price-fixing agreements. An impartial exchange is run by a management team/board without an incentive to collude. In fact, the purpose of such an exchange is to facilitate a fair and open marketplace to ensure a competitive market for all parties. Though seller-led exchanges extol the virtues of firewalls, there is no firewall that can be constructed to separate board members from the information required to fulfill their fiduciary responsibility vis-à-vis the exchange.

By contrast, an independent exchange has an interest in maintaining both a balanced equity relationship with buyers/sellers as well as the confidentiality of the transaction data. In our case, we do so by ensuring that equity relationships are minority stakes, thereby avoiding the conflicts associated with board participation. This is because the inherent value of a third-party exchange is the ability to maintain independence from either side of a transaction. The exact opposite is true in the case of an exchange led by a coalition of sellers.

It is also important to examine the "rules of the game" to determine whether the exchange has imposed rules that subtly tilt the playing field in favor of the owners/sellers. For example, there are exchanges that are theoretically open to a multitude of players, but close bidding after a limited number of bids have been received. These systems thus favor those sellers with better integration into the exchange's systems, typically those with the greatest ownership stake in the exchange itself. By arbitrarily limiting bidding or engaging in display bias, such exchanges - like the airline reservation systems of an earlier generation of technology - are using the purportedly neutral "rules" to exclude potential competitors (e.g. non-exchange partners) and avoid competing on price or another objective standard.

Of course there are many other potentially anti-competitive impacts of sell-side exchanges beyond the possibility of collusion, including increased barriers to entry, leveraging effects and a net decrease in the intense level of competition that currently exists among the participating sellers. It would also be very easy for the top market players to manipulate smaller market participants by blocking access or offering access on unequal terms. Like the question of board participation, each of these present structural challenges that cannot be easily ameliorated by building firewalls or other band-aid fixes.

The independent, third-party exchange is the model that is most likely to realize the efficiency-enhancing and pro-competitive potential of B2B exchanges for consumers with the lowest likelihood of anti-competitive effects such as collusion on fees or price. Models of B2B ownership in which sellers are the controlling and operating force should be subject to careful scrutiny and viewed with an eye toward the potentially anticompetitive motivations of their owners.

The Stakes

The stakes are high. For example, in the foreign exchange market, a recent McKinsey study predicted that by 2002 electronic trading of foreign exchange is expected to rise from 25% to 75% of the daily $1.5 trillion turnover. As a result, those providing internet-based trading systems are moving quickly to capture first mover advantage in this lucrative market. As in other industries, the established players have much to lose as old advantages give way to technology that allows for a more transparent and competitive market.

The B2B marketplace has the potential to shift fundamentally the way markets operate, but right now it is only potential. However, for the benefits of B2B exchanges to be realized, it is critical to create a framework that supports the establishment of exchanges that benefit the market rather than the status quo.

In considering the rules that should govern B2B exchanges, it is important to return to the underlying market dynamics. If the internet did not exist, and dominant players in a particular industry announced plans to work together exclusively in a way that would maximize the benefits of their collective market power and reduce overall competition, regulators would not hesitate to question the effort. The existence of the internet per se should not justify allowing powerful market players to work collectively to maintain market share.

In this environment, regulators face the unique but daunting challenge of setting the rules as a market is being established. From our perspective, the choices are pretty clear. We can start on the right foot by encouraging exchanges that truly help to level the playing field by increasing competition and transparency or head into a thicket of complicated seller-controlled exchanges where the incentives for collusion/anti-competitive behavior are high and the structures themselves are difficult to monitor.

Currenex, Inc.