Time to talk of caps and floors…of sealing wax, of cabbages and kings.
As one of the iconic companies of the internet age and the default example of the ability to create (cost-effective) markets in anything, as you might guess I’ve always been interested in eBay. But equally interesting is the fact that I have never really used their platform (despite this intellectual curiosity and admiration for what they achieved.) I have an account, but have never listed anything and have bid on only a dozen or so items over several years – including a Ford Shelby Mustang (!) – none of which I’ve won. Basically, I am fortunate in the sense that my time is more valuable than what I could save by becoming adept at trading in eBay auctions. Before you condemn that for sounding elitist, I imagine that for many – more commoditized – items this is true of very many people. And as a result it didn’t surprise me when I learned (via the excellent sramana mitra and Usuable Markets) that the proportion of fixed price purchases on eBay was growing in share:
Business Week reports that eBay’s auctions business model is being increasingly overlooked for fixed price transactions. Ease of use is a primary driver. Another is the ubiquitous presence of comparison shopping engines.
“What happened to auctions? Not only do shoppers want convenience, they’re also looking for value. And the proliferation of pricing information online has made it easier for consumers to bargain-hunt and lessened the need to risk overbidding in an auction. Hershenson recalls when a new $40 toaster could fetch $80 on eBay, thanks to a bidding frenzy. Now, a buyer can figure out the retail price with a few mouse clicks.”
Most “end users” of markets (explicitly or implicitly) want to hedge (price) risk – this is true both of corporations and individuals. Furthermore, in many (most) cases they don’t necessarily need absolute certainty, but are loathe to accept “open-ended” uncertainty ( in price or outcomes.) They are however often happy to take on some level of defined or ‘bounded’ uncertainty. Indeed, one of the oldest and most popular forms of derivative used by ‘end-users’ in financial markets are interest ratecaps, floors and collars:
An interest-rate cap is an OTC derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the “index” or “reference” interest rate) exceeds a specified strike rate (the “cap rate”). Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.
Or of course more simply calls, puts and collars. So what has this got to do with eBay?
So you want to buy a particular model of digital camera. Well you could do a search on any of a vast number of comparison pricing sites, or you could go to Amazon or eBay – probably because you have an account and you know/trust how the fulfillment process works. (This is the true USP of these two platforms imo.) Say you go to eBay. You could bid in any number of auctions – with the hope of getting a particularly good deal but the risk of spending time and energy and not ‘getting filled’, or you could ‘Buy it now’ for a fixed price. Why can’t you have your cake and eat it too? Why doesn’t eBay allow you to buy or sell options from/to them. For example let’s say the average ‘Buy it now’ price is $100. However, a number of the same item have recently sold in auctions for a weighted average price of $90, with the low being $80 and the high being $105. Instead of having either the option of paying $100 immediately, or taking the chance of bidding in multiple consecutive auctions in the hope of buying it for $90, what if you could buy a $95 strike call from them, maturing in two weeks. Obviously they would need to be able to sell this call for less than $5 (otherwise the customer might as well just ‘Buy it now’) – but given the amount of data eBay has, this should be feasible. Assume they sell this option for $2. Then eBay makes a profit if they can source the item for less than $97, which given the recent price history should be possible. This would be a good strategy for a customer that wants to buy the item but reserves the right not to (for whatever reason.)
Another possible simple strategy would be to sell eBay a put. Ie the right to sell the item to you at a set price, say in this example, eBay pays you $2 for the option to sell you the item at $90. You are not assured of getting the item but if you do it will be at the price you want and you get income in the mean time. (There is an issue here for eBay with respect to credit risk they take on by buying an option from you, however this is somewhat mitigated by the fact that it is ’secured’ – ie the loss exposure is limited to the difference between the market value and the put strike.)
So what’s in it for eBay? Well basically – besides giving buyers and sellers (you could conceive of offering the same products to sellers) an enhanced user experience – this should offer excellent potential for monetizing the what I imagine to be enormous and rich transactional data set that they own. This is effectively a form of price insurance and insurance businesses can be very profitable. Now strictly speaking, eBay is an exchange and this approach relies on taking ‘principal’ risk, effectively standing between buyers and sellers as at least a financial guarantor. There may be real issues with this, so perhaps it would be best for them to ‘outsource’ this risk management to a third-party capital provider. Of course some independent 3rd-party could probably do this independently (”an ebay broker-dealer”) but I suspect the most efficient way to implement something like this would be for eBay to build it directly into the user experience, and ‘manage’ the risk (the options book) on behalf of an indepedent risk ‘underwriter’. (This/these partners would agree the option pricing models and algorithms with eBay and ‘accept’ risk based on this methodology up to certain pre-determined limits; eBay would receive a fee for originating this risk.) Of course this approach (at least at its simplest) would only work for highly commoditized / identical items, but I suspect this is a reasonable chunk of their business, and exactly the segment where their traditional auction model is the least useful for their customers.
So what’s in it for the hedge fund providing the risk capital? Well this is where I’m shooting a bit in the dark – the numbers might not bear this out at all – but my hunch is that given eBay’s underlying liquidity and their extensive data-set, they should be able to price up and build a portfolio of options that are attractive to customers while providing an excellent risk-adjusted return (15? 30%? RoE) for the underwriter.
As a bonus, just as they spawned a generation of small (and not so small) businesses who used eBay as a platform, they might find that they add another component to their ecosystem: entrepreneurial market-makers happy to try to make a living by buying and selling these options (cyberspace ‘locals’), which of course over time would allow eBay to refine their algorithms even further… So instead of going to Chicago to trade Corn options, the next generation of option traders will be making markets on Digital Camera’s or Prada handbags!
Of course, with some adaptation, Amazon could probably do something similar – maybe even more easily as they already have a ‘prop-trading’ desk and settlements back-office…yet another reason for Mr. Donahoe to get cracking! 
