‘What is a B2B exchange? It’s a Web Site and a dream.’– Douglas Gardner, eSpeed
MicroExchange: A revolutionary style of lightly staffed, technology-driven marketplace bringing together buyers and sellers in key niche commodity markets, reducing costs, improving returns, and facilitating trading in all sorts of commodities, physical and intangible.
The strategy of bulking up to create cross-border and even pan-continental trading exchanges is firmly in vogue in many parts of the world. As a result, most people’s attention is firmly fixed upon the large multinational end of the exchange business, where household names such as Deutsche Börse, Euronext and NYSE attempt to be predatory – providing their shareholders and regulators permit them. However, somewhere far below the radar of the massive legacy exchanges with lengthy histories is a small but growing number of tiny marketplaces. Christened ‘MicroExchanges,’ they tend to operate in very modest niche areas of markets where large exchanges cannot find the scope to merit taking the risk.
Put simply, a MicroExchange is like any other exchange mechanism, but smaller. It operates within a niche which is too small for existing large exchanges to exploit profitably. By taking advantage of new technology, and maintaining a modest executive, MicroExchanges are set to revolutionise the way producers and users do business in all sorts of commodity markets throughout the world.
Mircoexchanges tend to have three core characteristics:
- A very modest secretariat (somewhere between a handful of people and a dozen is best for many such markets).
- A niche product (a world annual market of over a billion dollars for a commodity remains well below what ‘legacy’ exchanges require to justify listing a contract).
- Trading carried out predominantly via the Internet.
The barriers to entry for MicroExchanges are low, with regulatory cost often being one of the highest factors. This low cost of entry also leads to an intriguing dichotomy. While the world of ‘grown-up’ exchanges is starkly falling into three core groups of Predators, Prey and Road Kill, rationalisation (in all forms) will reduce the number of ‘legacy exchanges’. However, the total number of exchanges world wide is likely to reach unprecedented levels as the MicroExchange boom continues.
MicroExchanges exist thanks to cheap network technology, which makes increasingly powerful price discovery possible in almost any kind of asset, no matter how intangible. In that respect, the exchanges have a huge potential to create price transparency in areas where the economics of larger exchange markets simply would not permit it.
MicroExchanges have often grown out of niche markets as a result of anomalies in pricing or government intervention. Perhaps the poster child of the MicroExchange revolution was the agricultural arm of the South African Futures Exchange, SAFEX. SAFEX itself was a model legacy exchange, created almost on a ‘micro’ basis with a mere 26 staff operating a fully fledged electronic exchange and clearing house for futures and options. However, its agricultural arm was initially the work of just one man, Rod Gravelet-Blondin. The aim of the SAFEX agricultural futures product was to help reduce the cost of direct subsidy to farmers. In South Africa, the now defunct government Maize Board had a frictional cost of up to ZAR150 or every tonne of maize it handled as the central counterparty to that market. The SAFEX agricultural derivatives market reduced that frictional cost to ten cents (i.e. ZAR). Thus, a classic MicroExchange was born and indeed a super niche market has succeeded which allows farmers to hedge their crops more easily, buyers to have a clear price and government to save money. On such a basis many more MicroExchanges will be borne in due course. Some, like the SAFEX exchange itself,will ultimately become so successful that they are bought by a large legacy exchange, in this case the Johannesburg Stock Exchange.
Many MicroExchanges have a developing country element to their presence, although they are not necessarily restricted to operations in the emerging markets. A leading developer in the space for MicroExchanges is COMDAQ, a British company with outlets in various parts of the world and a team of developers in Pune, India.
The markets developed by COMDAQ have covered a variety of commodities including a coffee exchange in Karnataka state, as well as a metals market, the world’s first essential oils exchange, as well as www.exname.com, an exchange for World Wide Web domain names. The core COMDAQ internet platform is developed in .NET and has been utilised for everything from simple commodity transactions through to complex swaps. MicroExchanges may be small but they are not necessarily technologically undeveloped!
When it comes to developing MicroExchanges, there remain stumbling blocks. Clearing services are often difficult to obtain, although MicroExchanges can provide a fertile new source of business for those clearing houses which can provide a suitable scalable model for their business. Meanwhile, COMDAQ has developed its own online escrow service in association with Fortis bank for its commodity markets in the absence of a CCP solution.
Secondly, the gestation of MicroExchanges tends to be either very rapid or painfully slow. The fast developments are usually when somebody has the resources (especially the finances) in place and is ready to go. In this case, with essentially turnkey software on offer, it only takes a matter of installation time and some customising before a web-based MicroExchange can be yours.
Alas, on the other hand the stifling factor in the development of these markets is often the management of the venture. Ironically, extracting a budget from somebody spending 100,000 dollars may be much more difficult than trying to get a hardened investment banker or experienced exchange official to sign off an amount many times that for an internalisation/ECN or exchange matching engine. Longstanding exchange software vendors mutter darkly that they might not even be able to afford the plane ticket to visit a prospect at these sorts of software budgets.
In a world of increasing commoditisation, large scale players will need to continue to work on substantial scalable software projects that can deliver mind-blowing daily matching, Then again, it is also true that comparatively ‘simple’ software packages will continue to be created (and priced at levels that large vendors may find eye-wateringly cheap) to provide simple commoditised trading services. In that respect, there are more than sufficient exchange software creators who can provide the technology.
From all remarkable hype of the B2B internet boom has emerged a tenable example of B2B e-commerce through the MicroExchange – although ironically it may not be all that ‘e’. For with many MicroExchanges, the key to success is in fact a modicum of good old fashioned intervention. In this case the activity is known affectionately as ‘broker assistance.’ True, many may be aghast at the concept of intermediation playing a role in electronically broked markets, but the fact is that when you don’t have the sort of wondrous continuous order flow possessed by those leviathans of the legacy exchange business, then truly you need a little bit of judicious intermediation to make the process work.
‘Broker assistance’ can involve around several possible processes. In almost all markets, the early stages of MicroExchange development require a fair amount of broker input to help customers understand how to use the exchange and indeed ‘hold their hands’ as they go through the process of making their first trades. This is commonplace, and often the burden decreases as more customers become used to what is happening. Nevertheless, where liquidity is not effective in a continuous market, the skills of a broker to try and help position order flow in the market can be a key issue for fledgling MicroExchanges. In this respect, a little judicious addition of value can be achieved from human intervention!
Currently most MicroExchanges are in the low volume commodities that are simply too small to place on a larger scale platform as operated by a legacy exchange. A good example in this regard is the Essential Oils Exchange (EOEX), created by amongst others the author of this article over the past few years.
Essential oils are highly concentrated volatile substances extracted from a single or multiple plant part such as the petals of the rose or the wood of the sandalwood.
Throughout history, plant extracts have been used for their smell, taste, industrial and medicinal characteristics. In the modern age, the drive towards holistic treatments and alternative medicine has helped promote a massive revival of the essential oils industry. In major markets such as Australia, Germany, the UK and the USA, essential oils have gained in prominence in recent years, now being used in cosmetics, foods and a variety of applications, as well as being sold in their natural state.
At present, growers tend to only get around 40% of the sale price of their oils to corporations which use the oil in their products. Yet, buyers frequently complain that they simply cannot gain access to product, despite there being some 300 middlemen traders in the industry.
EOEX created an auction platform for essential oils in partnership with COMDAQ with the simple concept of removing the middlemen and thus enhancing the supply chain for the buyer and seller by both enhancing their prices and ensuring more regular sourcing of supply. Essential oils may not register on the radar screen of the large commodity markets, but as a USD2bn business world wide there is ample scope for improving returns.
In a MicroExchange such as this, revenue, as with most exchanges, is derived principally from transaction commissions. While the scope for data sales may initially be small (or impeded by the fact that many transactions are kept opaque at the request of the counterparties), there is scope for making modest incremental fees from the brokerage of additional services such as transportation.
EOEX, like all MicroExchanges, can be described as providing the following benefits for buyers and sellers.
Buyers:
- Quality, independent data on the state of the market (knowledge)
- Wide choice of suppliers (flexibility)
- Year round sources of supply (reliability)
- Instant shipment upon payment (cash flow)
- Choice and flexibility in products, suppliers and quality at the best available prices when they wish to order (profits)
Sellers:
- Direct access to leading global buyers providing higher returns than using a middle man (price, flexibility and cash flow)
- Rapid and efficient clearing mechanism (cash flow)
- Choice and flexibility of chosen purchaser and delivery arrangements (flexibility)
- Reduced requirement to market leads with greater concentration on growing product (profits)
The essential oils industry presents a fascinating opportunity in terms of applying transparent pricing. The industry is global, with both developed and developing countries having equal importance. Such a broad sweep of operations of course makes it difficult to discover the best price, or even secure supply of essential oils on a regular basis. The aim of the MicroExchange is to help resolve these problems, bringing buyers and sellers together on a scale previously unprecedented in the relevant business sector. As mentioned above, the exchange can generate a ‘win win’ proposition for both buyer and seller.
While many MicroExchanges have begun in the commodity markets, they can be applied to anything that can be traded. In fact small cap stock markets are a rich and fertile ground for MicroExchanges. Angel Bourse is a platform for small companies, including start-ups, and other modest ventures who are seeking to raise money. Actual secondary trading remains relatively modest currently but the company has a strong track record in raising funding for companies. With a string of successful fundings in the million pound region, the Angel Bourse concept neatly demonstrates how MicroExchanges manage to create a very cohesive community. In this respect, MicroExchanges are rather like the original coffee shop trading culture, albeit in virtual form. This of course allows investors (and issuers) to engage in the process of business expansion while not necessarily being in the same time zone or country, and much more easily than can often be effected through the largely local linkages of, say, individual stockbrokerage offices.
Moreover, the capacity for such micro markets to create value for all parties is enhanced by the fact that in online markets the paperwork can be harmonised (and electronic forms utilised liberally), thus making the process as homogeneous as possible. Of course, the biggest challenge to equity MicroExchanges remains regulation. A light touch from regulators is a prerequisite for allowing these markets to survive, as often the cost of compliance is the largest factor in the overall cost chain.
Naturally, as with all markets, the network is key and in this respect we are talking human interaction rather than internet technology. The key to a marketplace is its participants and in that respect once again broker assistance is vital. While databases can be most effective, the human touch in trying to create deals and knowing the sorts of deals certain investors may do is indispensible. With Angelbourse, a strong regional presence in parts of the UK some distance from the City of London’s financial centres creates a powerful deal flow network.
Other small capital stock markets are springing up. As COMDAQ Chairman Colin Howard notes: ‘We are creating equity markets providing an incubator environment for embryo and emerging listed entities.’ Howard has been a prime mover in a new venture, www.AESX.com. ‘The Alternative Electronic Stock Exchange’ is opening the Dutch Caribbean Stock Exchange (www.dcesch.com, with the Central Bank of Curacao as a market maker). Another offshoot, www.regsx.com, is being launched as a trading area for regulation S stocks. AESX has significant ambitions in the world of small/micro cap equity markets world wide including various countries across the EU and many developing markets.
This of course raises another interesting area for clearing and settlement. It is clear that the market is developing for a proper Micro-Depositary for small companies and indeed many, even unquoted companies, may find it attractive to have their shareholder registers electronic. Such Micro Clearing applications will be a key feature of the future development of Micro Cap Stock Markets.
Overall, the MicroExchange revolution has barely begun. New markets will continue to arrive, although a great many more will probably be stifled by creators who lack the nerve to actually push the button. Even within conventional commodity markets, opportunities abound while few if any really small cap stock markets actually manage to work under the strictures of large stock markets. Then there are new product markets which may not find an opening within the largest exchanges. In this respect, the process of securitisation is in its infancy.
The prospects for such markets are immense. Future sports stars have already been accepting current investments against their future career earnings to give them a chance of making it into the big league. Realistically, this is a process which ought to exist on an exchange with a simple commoditised offer document/prospectus and a possibility of some secondary trading too.
This is just one of a plethora of potential markets. It seems likely that both fine wine and bulk alcohol ought to find their way on to MicroExchanges soon, especially given the growth of online ‘en primeur’ advance sales which are effectively wine forwards if not futures contracts. Similarly, www.exname.com, the online domain names exchange, is a good example of how just about any asset can be applied to the MicroExchange model. Niche sports trading exchanges and a host of other applications mean that whereas B2B has become a somewhat discredited concept as a result of the dotcom bubble, MicroExchanges which can be B2B, B2C or C2C applications have the potential to radically reshuffle not just the way business is transacted but also the world of exchanges.
