Tiptoeing toward B2B

Many Internet exchanges , trading everything from bandwidth to natural gas , are crying out for liquidity. Should traditional bankers answer the call?

By Hugh Fraser
February 2001
Institutional Investor Magazine

Traders will make a market in just about anything. Dealers at the European headquarters of U.S. energy giant Enron Corp. in London set spot and forward prices for executive parking spaces. During quiet moments at UBS Warburg in London, traders play spreads based on football stars, goals and number of appearances in international competition. A Lehman Brothers bond trader in New York once started a secondary market in the furniture of a beloved Wall Street watering hole that closed.

In theory, the Internet was made to order for such compulsive market makers, because nothing approaches its ubiquity and transactional power. A hospital purchasing officer in Australia, say, can go to onlineassetexchange.com to bid for surplus equipment being unloaded by a medical center in Alabama. The Net's huge business-to-business subculture even has a mantra that would be close to any trader's heart: Anything is tradable anywhere.

Consider the more than 1,000 B2B platforms currently operating worldwide. Everything from fish to telecommunications bandwidth, from leather to flowers to fuel now has its own e-marketplace (see below). "A market is a market is a market," says Frederick Varacchi, president of eSpeed, a financial markets technology spin-off of New York,based financial services firm Cantor Fitzgerald that wants to sell its infrastructure expertise to B2B exchanges. "We can do foreign exchange, electricity, bandwidth. These are just markets with different labels, and the labels have different rules."

The new marketplaces have much in common with securities markets. Imagine a hypothetical B2B exchange assembled by a group of suppliers. The suppliers post prices, which fluctuate as buyers place bids. Efficiency requires that the price-discovery system be open and fair. When there is an order imbalance, a market maker steps in to smooth it out. Credit lines or insurance can dispel any uncertainty about the ability of a given buyer to pay for , or a seller to deliver , the goods.

The same functions are performed in securities markets every day by financial institutions, their exchange and trading operations, and various settlement, risk management and liquidity mechanisms. Many investment firms routinely trade power and other commodities. And in searching for Internet-based efficiencies, major banks, institutional investors, private equity providers and entrepreneurs have backed dozens of alternative securities trading systems.

Many of the B2B exchanges, which at first did not involve financial intermediaries or other middlemen in their plans, are now looking for help to keep trades flowing smoothly and to mitigate risks. "You can,t make a market without brokers. You can,t do it," says Michael Fertik, president of TruExchange, a Lexington, Massachusetts, company that develops software for B2B marketplaces and that recently managed to raise private equity financing despite tough market conditions.

Most financial firms have been slow to apply their skills in market making, risk assessment and funding to nonsecurities exchanges. Their reluctance is understandable; many B2B upstarts have already perished, and others are hastily revising their business plans to cope with General Motors Corp. and other newcomers from the Old Economy.

Still, a handful have begun testing the waters. Among the leaders is Morgan Stanley Dean Witter, which has moved aggressively into telecommunications bandwidth trading, a hot market that had also attracted Enron, the Houston, Texas,based gas-pipeline company that has evolved into the leading B2B player. Additionally, Morgan Stanley's private equity arm and Goldman, Sachs & Co. are among the leading investors in London-based Band-X, the first neutral bandwidth exchange, which was founded in 1997. The market for bandwidth, or transmission capacity, is approaching $1 trillion in annual turnover, but the online trade is just getting started. Market research and consulting firm Forrester Research of Cambridge, Massachusetts, estimates that online utility sales, which include telecommunications, totaled about $130 million in the U.S. and Europe last year. That is a substantial portion of the $750 million in online B2B sales, which are seen rising to $1.6 trillion by 2003. As of 2000, motor vehicles and computing and electronics (including an active market in semiconductors) were the two most active online sectors, each at about $200 million in the U.S. and Europe.

"Trading in bandwidth is not new," says Harold Kamins, head of the commodities department at Morgan Stanley in New York. "It's an evolution rather than a revolution. Somebody will build a transatlantic cable. They will sell capacity to a dozen different people. Those people in turn will use some of that themselves and sell the rest on. In some cases, you can identify chains of buyers that make it look just like a commodity market , like when a barrel of oil is on-sold five times."

Citibank e-Business is taking a broader approach to the needs of these exchanges. In an agreement announced in November with San Francisco,based ChemConnect, Citi is offering a package that includes everything from foreign exchange to escrow services, credit facilities, cash management, security and customer validation to more than 11,000 members of the World Chemical Exchange. Jorge Bermudez, executive vice president in charge of Citibank e-Business, sees the deal as a showcase for "how companies can transform both financial and business processes across borders and among key trading partners."

Citi is not alone in its approach. Royal Bank of Scotland's RBS Commercial Services is providing basic ledger and processing services to one fledgling B2B exchange as "a way to test the Internet market" before going further with liquidity-enhancing credit facilities, says Kim Tunesi, senior new business manager.

Other funding deals have been struck in recent weeks. Last month Point2 Internet Systems of Canada, operator of the Point2.com heavy-equipment marketplace, designated GE Capital as its exclusive financing source, serving 6,000 daily users. On January 4 San Diego, California,based Online Asset Exchange struck a deal with First International Bancorp, a Connecticut-based business lender, to enable online settlements of industrial equipment transactions up to $5 million in value. Two weeks later United Parcel Service, moving to enhance its e-commerce activities with e-finance, announced an agreement to buy First International for $79 million.

These are just first steps. And given the growing pains of B2B sites , not to mention those on the B2C, or business-to-consumer, side , it's no wonder financial firms aren,t jumping in too quickly. That,s disheartening, says Arthur Andersen consultant Waino Pihl, who produced a study in mid-2000 that criticized the financial industry for its slow response to e-business opportunities. Says Pihl: "There are those, like Citigroup, who innovate, see competitive threats to their payments and other business lines and thrive on the challenge. But too many wait because there are not a lot of easy, packaged solutions out there, and that's a bit of a downer."

The three-year-old, Boston-based PaperExchange exemplifies the liquidity and competition problems facing some of the early B2B marketplaces. The company, which serves the $500 billion global pulp, paper and packaging industry, is still standing, but it,s struggling. Controlled by Internet Capital Group, a troubled B2B venture capital and incubation company with a big exposure to e-marketplaces, PaperExchange canceled its IPO in September and laid off some of its staff. Now it calls itself a technology provider to the paper industry , slightly changing its focus, as many early players are doing.

"We have buyers and sellers, but we don,t yet have large companies putting 30 percent of their capacity through us," says PaperExchange's European chief, Colin Carroll. The company has, following B2B form, run into competition from ForestExpress, an industry consortium announced in March by Georgia-Pacific Corp., International Paper Co. and Weyerhaeuser Co. Carroll concedes that PaperExchange's original business will eventually get squeezed.

Going up against many of these early start-up ventures are industry leaders who can bring their own liquidity and see no need for third-party operators. The most prominent example is Covisint, which links the major auto manufacturers , led by organizers DaimlerChrysler, Ford Motor Co. and General Motors Corp. , with thousands of parts and materials vendors in a potential $240 billion marketplace. This was just one of the powerful consortia that emerged over the past year in such areas as retailing, electronics and petrochemicals, in the process squeezing out independent ventures. The doomed have included Chemdex, a life-sciences marketplace, and Promedix, its specialty medical products counterpart. Their owner, Mountain View, California,based Ventro Corp., announced in December that they would be closed. Like PaperExchange, a repositioned Ventro is now billing itself as a supplier of e-commerce technology and other support services.

For all of these operators, the priorities were to lower purchasing costs through auctions or other online negotiation methods and to improve the supply chain by disintermediating middlemen, strengthening communications among buyers and suppliers, shortening inventory cycles and maximizing shipping efficiency. But as market participation increases and transactions multiply, liquidity needs become more important, particularly for actively traded commodities such as bandwidth. "Market makers are necessary to tamp the volatility and create liquidity by bridging the gaps in supply and demand and counterparty risk," says Julian Bond, chief technology officer at Netmarkets Europe, a London-based research and education group for e-marketplaces. "Chasing disintermediation is a mistake in most Net markets. In fact, they would do well to create systems that actively support the middlemen."

TruExchange president Fertik says that his company has differentiated itself by seeking out markets with established intermediaries, such as the semiconductor arena. TruExchange's first customer, Canadian B2B semiconductor brokerage Dynasty Components, which plans to start an online semiconductor exchange sometime in the first quarter, is a natural. That, Fertik explains, is because semiconductor suppliers and buyers have long turned to brokerages to unload or obtain extra chips. Just as a stock trader carefully works large orders to keep them from being noticed and distorting prices, a computer maker selling chips prefers that competitors know nothing about it.

Fertik concedes that transparent marketplaces are not for everyone: "Who doesn,t like the process of commoditization? Suppliers. Samsung has spent a lot of money becoming Samsung, and it doesn,t want to see its product become a commodity just like one made by anyone else. Who loves it? The guys at Morgan Stanley and Merrill Lynch. Trading is their lifeblood."

Products need finite and standardized attributes to facilitate trading and price discovery. Mortgages could be securitized because they have those characteristics, notes Fertik. Semiconductors are defined by 30 principal attributes and are easily tradable. In contrast, sophisticated medical equipment has too many variations from product to product to trade readily, he says.

To date, Enron is the one company that has successfully navigated the liquidity problems common to the nascent exchanges. Through the end of December, $330 billion worth of deals in multiple markets had flowed through EnronOnline since its November 1999 start. On an average day that month, Enron's site saw 3,800 transactions with a notional value of about $3 billion.

The seed for EnronOnline was planted in early 1999, when Louise Kitchen, a trader in Enron's London office, initiated a project to move gas trading operations onto the Internet (see below). That became a platform for Enron to handle other core trading operations, such as bandwidth, and eventually to diversify more adventurously into things like weather derivatives. EnronOnline is now said to be the world's largest B2B e-commerce trading site.

What separates Enron from the run-of-the-mill B2B operators is its balance sheet: $46 billion of assets that enable it to provide liquidity in any market it chooses to enter. "In every transaction we are principal. A lot of people talk about neutrality, but we are willing to buy or sell at a known price not knowing who the other party is , that's neutrality," says Bruce Garner, a London-based vice president of the EnronNet Works subsidiary.

The bulk of Enron's trading profits come, as in the offline world, from selling derivatives and risk management hedges, which can be highly targeted. One product especially useful to aluminum smelters is based on an index of power costs in relation to aluminum prices. It also offers swaps between petrochemicals and such plastics as ethylene and polystyrene. Indexing is made easier by the deal flow and price transparency of the active online operation.

"How many trades can a trader make in a minute on the fax and phone? When trading goes online the number of deals multiplies," says Garner. "Our model is different from B2B matching [of buyers and sellers], which doesn,t have a continuous pricing system. On a B2B exchange you can have lots of bids and no offers. If you take our metals business, we now have a transparent market with continuously updated prices. We are the only people in the world showing two-way [bid and offer] prices in hot rolled steel."

Garner boasts that no one matches Enron's ability in its chosen markets to "offer continuously updated prices and hedging. In our experience, liquidity begets liquidity."

Like the industry consortia, Enron could spell trouble for the less liquid. In November it opened Clickpaper.com, coming into direct competition with the beleaguered PaperExchange. Both offer reverse auctions and online negotiations, but Enron alone offers a way for customers to negotiate deals and hedge them in one place.

How might the more successful B2B markets evolve? Most experts are watching bandwidth trading to see which strategy , and which participants , will thrive. Enron has made a major push into this market. Its own broadband business in the third quarter of 2000 produced $135 million of revenue and an operating loss of $20 million. Enron has invested in 13 pooling points across the U.S. and in London, providing an infrastructure for switching bandwidth capacity between carriers that buy and sell network capacity.

As a big-impact player, Enron commands attention, but the company wasn,t the first to move in. Marcus de Ferranti's Band-X was. A former Royal Air Force fighter pilot, de Ferranti founded Band-X almost four years ago. Several others followed, including Arbinet-thexchange of New York and RateXchange Corp. of San Francisco.

De Ferranti cobbled the first Band-X Web site together on his home computer. Today buyers and sellers physically connect their networks through the Band-X routed exchange. Last year more than $80 million worth of bandwidth changed hands through its reverse auction process. Band-X is still losing money, though it generated about $1.5 million in commission and other revenues in December.

One reason for Band-X's survival and for the bandwidth boom in general, de Ferranti says, is that transactions can be completed instantaneously over the routing network. That's ideal for a true spot market. By contrast, exchanges dealing in physical goods struggle mightily with fulfillment and delivery logistics.

Bandwidth markets also fill a void. No telecommunications company as yet owns a global network. And deregulation around the world is giving birth to new carriers, which only increase the market,s fragmentation. Telecom providers sift through a plethora of options to fill gaps in their global networks. When they entered Band-X's online exchange in December, for example, the telecoms could choose among such "switched minutes specials" as 42 pence per minute in Afghanistan, 17.77 in Djibouti and 10.24 in Guatemala. De Ferranti argues that Enron will find it hard to replicate its energy and electricity successes in the bandwidth realm. "We will never run out of [bandwidth], and there will never be more than a temporary shortage. Anyone who thinks about it in terms of traditional commodity trading is likely to be disappointed," he says.

Enron obviously disagrees, and so does Morgan Stanley's Kamins. "Our forte is price-risk management," he says. "So if Marcus is right that nobody wants to buy price risk here, then I,m wasting my time." But Kamins is convinced that it's no waste, and Morgan Stanley has "done some business over the past several months." He is not specific about volumes and the number of traders committed.

Because businesses and telecoms lease capacity for one to 20 years, bandwidth also has characteristics similar to those of derivatives. "All the time, buyers are making the decision about how far forward they want to buy the capacity," says Kamins. "Some will buy a certain capacity now and have the right in two years, time to upgrade to a higher level of capacity. That,s an option."

David Prior, a telecommunications analyst with Phillips Group, a London-based consulting firm, believes that the active participation of investment banks like Morgan Stanley will stoke price volatility. When electricity trading began, he recalls, people expected prices only to drop. In fact, there have been huge price swings, as is painfully evident from the current capacity crisis in California.

Kamins says that forward-pricing uncertainty is already a given. Even if everyone generally agrees that bandwidth will be cheaper in two years, nobody knows by how much, and volatility begets derivatives pricing.

Another bandwidth-market reality is that telecom capital is harder to raise , a sharp reversal from a year ago, when the sector was in favor. "We,ve already proven that these companies are highly at risk to the price of bandwidth. The carriers should want to manage their risk," says Kamins.

Credit risk may be greater, but so are techniques for managing it in large and liquid online marketplaces. Enron offers an evaluation of trade credit risk expressed as an interest rate on 10,000 companies, through EnronCredit.com. With this information it creates a "bankruptcy swap" for mitigating trade risk. Credit risk in one company, for instance, can be spread across a portfolio of companies. John Sherriff, president and chief executive officer of Enron Europe, says Enron and its customers can thus monitor and mitigate credit risk in real time. "As the deal flow accelerates, you can,t stop the process of electronic orders and send it to the credit committee to await a decision in two weeks, time," Sherriff says.

Other credit risk innovations could come out of the emerging-markets sector. DealCommodity, an online exchange in London, must cope with the fact that cotton producers in the former Soviet Union "require cash in advance to fund production. America is cash on delivery. Who is going to bridge the credit gap?" asks Patrick Lynch, head of business development at DealCommodity. The firm is talking to the trade finance departments of a number of banks to see if they have answers.

ChemConnect and Point2 Internet were in business five years before striking their financial relationships with Citibank and GE Capital, respectively. Iber-X, a Spanish bandwidth exchange that is mapping a major expansion into Latin America, moved faster. In November, a year after its founding, Iber-X enlisted Banco Español de Crédito to operate an online, real-time transaction settlement system. The companies say that the system could easily be extended to other B2B marketplaces.

Mesania.com, an exchange serving 15,000 European housewares retailers, took the unusual step of bringing a bank in on the ground floor. Named after an Italian market town from Roman times, London-based Mesania was set up in August by two Americans, Mary Cagliero and Susan Arndt, with $13.4 million of venture capital from Internet Capital Group and others. The organizers decided that trade credit belonged in their value chain, which led to their discussions with Royal Bank of Scotland.

RBS's Tunesi wants to size up the operation before taking on credit risks. "If we are going to fund a debt, we look for a very good paper trail," she explains. If there is a dispute about delivery, "we need our clients to produce documentation to support the debt. In an e-commerce scenario, the Web site is a trading place and the goods will be going from a third-party supplier to a third-party customer. It,s all a bit remote, and before we put any finance in, we want to make sure that procedures are in place."

Such bankerly risk aversion seemed out of place amid the Internet speed of the late 1990s. Now, given the disasters in B2C and the problems that beset early B2B participants, it's looking a lot more sober and sensible.

"It's still a relatively small number of banks that are seriously trying to enter the B2B space," says Nicholas Viner, head of Boston Consulting Group,s payments industry practice. "They are right to think about how to retain customers, build liquidity and create a growing business around these services. They should want to provide financial services to these exchanges and protect their payment system positions. There is still quite a long way to go."



Hides , and seeking fortunes

On any given day a million head of cattle bite the dust. A cow's meat might end up as a sizzling porterhouse in a Chicago steakhouse, while its hide could emerge as a pair of Prada pumps in a Tokyo boutique.

Attempting to sort out what part of the cow goes where , and at what price , is Barcelona,s leatherXchange. It's one of hundreds of business-to-business marketplaces that have sprung up where old , well, hidebound , processes intersect with the new efficiencies of Internet connectivity (story).

José Suarez, leatherXchange's Cuban-born, U.S.-educated founder, gained experience in leather and electronics as an import-export specialist between Eastern and Western Europe in the 1990s. The 40-year-old latched onto B2B technology as a way to pull together the highly fragmented $85 billion leather market and its estimated 170,000 buyers and sellers worldwide.

"In March 1999 I read an article about PaperExchange and thought, ,Wow, this is exactly what I,d like to do with the leather world,," says Suarez.

He started the company eight months later, and the trading site went live in August 2000, three months after leatherXchange raised E11.5 million ($10.8 million) in a financing led by Netherlands-based Gilde IT Fund, Amadeus Capital Partners of the U.K., and Banco Santander Central Hispano of Madrid. Last year the exchange generated commission revenues of about $500,000. This year it began charging a $2,500 membership fee plus an additional $70 per price quote. Such aggressive pricing might raise eyebrows in certain e-commerce circles, but Suarez believes that users will prefer paying for this service to dealing with the high costs of travel and seeking the same information from conventional offline sources.

Suarez needs the revenue to overcome the challenges of introducing technology into a highly traditional industry. His up-front costs include sending representatives out to customers to take them step-by-step through the transaction process. He says potential customers have to see the system work about five times before they are comfortable enough to buy in.

Like other B2B entrepreneurs, Suarez assumes that transaction revenues , the commodity operation , will not necessarily be his main source of future earnings. He expects that financial and other value-added services will increase both fee income and the desirability of membership. Suarez sees leatherXchange evolving into a platform for selling the independent examination and grading of hides before they are shipped. Up to a third of conventional orders are subject to costly disputes about quality on delivery.

"Anyone from Portugal to Siberia can get in touch with us, and we will grade their shipments hide-by-hide. This is a huge cost saving. We call it the killer application," he explains.

EnronOnline: Tapping the energy within

Louise Kitchen didn,t get much encouragement when she first told Enron Corp.'s senior traders and technical advisers about her proposal for online natural-gas trading. "We had a very nice meeting where they all said, ,Oh yeah, that would be great,, but nobody thought that we would actually do it," she recalls.

Even within a company that embraces change, Kitchen's plan seemed a bit aggressive. As it turned out, the skepticism was misplaced.

Seven months after that April 1999 meeting, Enron,s e-trading site, EnronOnline, went live. No one at the company has looked back since. As of last month, EnronOnline was offering 1,200 contracts , not only in core products like gas, electricity and fiber-optic bandwidth, but also in data storage, metals, petrochemicals, plastics, sea freight and weather risk.

EnronOnline handled more than $330 billion in trading volume between its November 1999 start and the end of 2000. About half the company's trading is now done online.

Houston, Texas,based Enron, a once-staid gas-pipeline operator functioning largely in regulated energy businesses, has become the world's most formidable competitor in business-to-business electronic commerce. Last year the parent company,s revenues topped $100 billion, up a stunning $60 billion in just 12 months. Almost all of the growth came from its trading operations. (Aside from its B2B initiative, the company benefited mightily from higher energy prices.) The majority of its $1.3 billion of profit from continuing operations came from wholesale energy trading (both online and traditional), as well as other services that have taken it well beyond its original role as a utility.

Enron boasted a recent price-earnings multiple of 56 and a market capitalization of $60 billion. Those are numbers that all but a few dot-com entrepreneurs would die for, and they,d like the corporate culture, too. Enron wants innovations to bubble up from employees, and it supports them in bringing their ideas to fruition. In his recent book, Leading the Revolution, strategy consultant Gary Hamel calls that quality "a genius for innovation," stemming from Enron's response to deregulation in the 1980s. Initially, chairman Kenneth Lay and president Jeffrey Skilling stayed close to their energy roots by expanding internationally and moving into power plant construction. But their breakthrough was the trading of energy-related commodities. Skilling set the tone with his idea in 1988 to create a market-making "gas bank" that smoothed order imbalances in energy trading.

EnronOnline began with Kitchen, 31, a senior gas trader in Enron's London subsidiary, in early 1999. She brought John Sherriff, president and CEO of Enron Europe; and Greg Whalley, head gas trader at the Houston headquarters; into her scheme. "We talked about it a lot in a general sort of way," says Kitchen. By that April "we decided that we would really do something. I had a conversation with John and Greg on a Thursday and left for Houston on Friday. Life didn,t calm down until about three months ago."

Neither Lay nor Skilling, who takes the Enron CEO title from Lay this month, were briefed about EnronOnline until two months before it was formally launched. They had questions but encouraged the initiative. As many as 350 Enron employees worked on the implementation. One key decision was not to buy off-the-shelf technology. Says Kitchen: "Our prices change 100 times a second. No system that would deal with those price changes existed."

To Kitchen, now EnronOnline's Houston-based CEO, the benefits of the innovation are obvious. As she notes, a trader who formerly worked the phones feverishly to handle ten customers at a time can now deal with thousands. Prices are posted on the Web site, and customers can click and buy.

"Ten years ago you wouldn,t launch a company without a telephone," says Kitchen. "Now you wouldn,t launch one without a Web site. Our site goes one step further because it puts the whole center of our business , wholesale trading , online."