Building From The Middle Out

An online exchange model that engages intermediaries is the first step to long-term liquidity

By Don Nachtwey & Ed Shields

At the turn of the 21st century, advances in information technology have created a phenomenal rise in business-to-business (B2B) exchanges. Today, more than 1,000 online exchanges trade everything from primary and finished goods to transportation; three years ago, hardly any such exchanges even existed.

Interestingly enough, 100 years ago, the significant advancement in technology at the time - the telegraph - resulted in a phenomenal decline in exchanges. The telegraph let multiple investors receive trade data and then execute their trades from remote locations. Thus, over the last century, the number of exchanges declined from almost 300 to seven. However, the New York Stock Exchange (NYSE) was able to consolidate and control the transmission of information, allowing only registered members of the exchange to gain access to the data and trading facilities. These restrictions ensured that the NYSE became the leading financial exchange in both dollar and share volumes.

The Internet has had the opposite effect on this trend. Whereas financial exchanges deal in homogeneous assets like securities and options, public electronic exchanges, such as FreeMarkets Inc. and Bid.Com International Inc., are markets for goods and services. Unencumbered by transmission restrictions, these marketplaces use technologies that create a central location for buyers, sellers, and data. The result? Commoditized, heterogeneous assets: Many buyers and sellers derive prices among themselves rather than as individuals negotiating with each other. Furthermore, industry giants such as Ford Motor Co., General Motors Corp., and DaimlerChrysler in automotive; Sears, Roebuck and Co. in retail; and Chevron Corp. in oil have overcome supply chain inefficiencies by creating their own trading hubs for sourcing supply.

With their arsenals of procurement, auctioning, and transaction technologies, public exchanges are firmly set on slashing the transaction costs applied through brokers, dealers, distributors, and other intermediaries. Buyers as well as sellers are intrigued by the possibility of finding each other quickly, cheaply, and easily. However, each side believes that exchanges have a long way to go before they can eliminate existing paper-based and manual processes, and liquidity will not be achieved until buyers and sellers commit significant resources to the exchange.

As we'll explain, an exchange model that engages intermediaries is the first step in this path to long-term liquidity. Why? Because intermediaries can be "reflexive": One day they can be buyers, and the next day they can be sellers.

The Value Proposition

As we've explained, reducing transaction costs represents the greatest opportunity for Internet exchanges. In diverse, fragmented, and disorganized markets, transaction and information costs can represent 30 to 50 percent of the total price of goods. These costs - incurred in the middle by brokers, resellers, and other sourcing intermediaries - then pass on to the buyer.

The contemporary wisdom is that the value generated through the intermediary - for example, organizing demand, sourcing supply, and setting price - can be automated in an Internet exchange environment. Suppliers can connect directly with buyers at a Web site and eliminate the historical role of the intermediary.

This erroneous thinking is the "fool's gold" of B2B e-commerce. Consider this eye-opening fact: Of the more than 1,000 exchanges that exist today, fewer than 37 percent achieve 100 or more transactions per month. Instead, most transactions that begin on the Internet are completed with a phone call, a handshake, a paper contract, and a signed check.

Many intermediaries specialize in product and service requests that comprise multiple attributes not readily handled by many of today's exchanges (for example, specific quantities, quality, delivery time, and so on). More important, intermediaries provide supporting products and services critical to closing a transaction - including physical services such as shipping and warehousing, financial services such as credit clearing and insurance, and other services that, if absent, would break a deal.

One of the key ingredients in a successful transaction is trust. Trust can't be automated. Every OEM will gladly accept a 60 percent reduction on the cost of its component parts. But every OEM will just as readily pay full price if even the slightest possibility exists that a part will not be delivered on time. You may recall the movie Back to the Future, in which the scientist played by Christopher Lloyd needed to build a "flux capacitor" by a certain time or Marty McFly, played by Michael J. Fox, would cease to exist. This life-and-death situation is the kind of pressure that an OEM faces when it risks missing a contracted deadline. Buyers that have built trusting relationships with their key brokers know they can depend on this mutual history in a crisis.

Intermediaries and the Sourcing Process

Investigating the spot market for electronic components helped us understand the role of the intermediary in fueling the supply chain. This $30 billion-dollar market includes more than 3,000 brokers with annual revenues ranging from $1 million to more than $750 million.

To put this market into context, you need to understand that the primary electronics market is tied together by contractual relationships between the parts producer, such as Intel or Texas Instruments Inc., distributors such as Arrow Electronics Inc. and Avnet Inc., and the OEM, such as Dell Computer Corp. or Motorola. These contracts specify price, production and delivery costs, and schedules.

In the secondary market, price, supply, and delivery remain unknown until demand is revealed. Once demand is understood, an informal process will source the supply while negotiations for price and delivery occur "on the spot."

In our interviews with electronics component brokers, we discovered that they devoted approximately 60 percent of their resources to sourcing inventory. This process usually begins with a fax or a phone call to an account representative with a list of needed parts. The list will consist of multiple attributes rather than a large amount of one component type. The broker will turn the order over to a purchasing representative that specializes in the "by any means necessary" (BAMN) sourcing process. When the parts are found, prices are negotiated. Finally, the supplier and broker draft a purchase order, and the broker and buyer sign a contract. In many cases, the supplier drop-ships the parts to the buyer.

On the surface, an Internet exchange seems like it would introduce efficiencies and reduce, if not eliminate, the role of the intermediary through procurement tools for order taking and systems for posting supply and finding price by auction. But brokers are still needed to manage the supply chain process and step in when bottlenecks occur.

To be successful, an exchange must introduce automation that can mimic the sourcing process, reduce the sourcing time, and maintain the relationship between buyer and seller. This automation includes multiattribute procurement, negotiation, pricing, and transaction processing. The same players that are in place today (manufacturers, brokers, and buyers) would run the exchange using the same business rules.