Tag Archives: two-sided markets

Market-making in two-sided on-demand markets

Every on-demand market has “liquidity providers” and “liquidity takers”. In fact, the market is “on demand” only for the liquidity takers, for when they arrive at the market there are liquidity providers who are providing this liquidity. In other words, the liquidity takers’ demand is instantaneously supplied by the liquidity providers, who make sure that the market is on demand.

Now, providing liquidity is risky business. Let us look at it from the perspective of stock markets, where the concept of market making is most well established. Market makers in a stock market are responsible for keeping “live quotes” (on both the buy and sell side) at all points in time, so that whenever a trader enters the market, there is ready liquidity available for the trader to execute his trade “on demand”.

Let’s say I’m a market maker and have put out a bid (offer to buy) on a particular stock. Now, if there is a massive downward price movement in the market, my bid gets “taken out” (i.e. a counterparty takes me up on my offer to buy and sells me the stock at the price I’ve quoted), and the market continues hurtling down. Notice now that the moment my bid got “taken out”, I have a long position in the market (since I have now purchased the stock), and the continued downward movement of the market leads to a loss. It is similar if I’m making a market on the ask side and there’s a massive upward price movement.

To put it another way, the market makers (i.e. liquidity providers) are effectively “short optionality”, as they constantly need to write the option of trading at a particular price at any given instant. The “liquidity taking” side is effectively “long optionality”, since they have the option to trade at that particular instant at the price quoted by the market maker.

The question is how I as a “liquidity provider” (as a market maker I’m providing liquidity) need to be compensated for the liquidity I’m thus providing. In the American stock exchanges, for example, market makers are charged a much lower exchange fees than the liquidity takers (the opposite side which trades with the liquidity provided by the market maker). Sometimes the exchange even provides a fee to the market maker in exchange for “always being there” in the market. This is a recognition of the costs being borne by the market maker in order to provide liquidity. The question is how this can be replicated in other “on demand” markets.

It is well known that taxi providers such as Ola and Uber provide attractive “non-linear” (not directly tied to rides) incentives to drivers for being “switched on”. The economic rationale behind that is to compensate these drivers for the cost and risk associated with being “switched on” (there is opportunity cost in being switched on in terms of the driver’s time, risk of getting an unattractive ride, etc.). These incentives, are in other words, compensation to the drivers for “providing liquidity” to the market. In the long run, this gets paid out of the fees charged from the liquidity takers.

Similarly, in the electricity market (though we seldom look at it that way, electricity is the classic “on demand” market, since electricity cannot be stored and needs to be generated in response to demand), grids typically pay power producers a fixed cost to just “be there”. This is again in addition to the per unit cost of power that the producers are paid when power is actually drawn from them (this is the classic “two part tariff” that is prevalent in the electricity sector). On similar lines, think of a lower power tariff to customers who are willing to accept frequent power cuts!

In “traditional, one-sided” markets, where the seller of the good/service is also the owner of the “market” where the sale takes place, the seller usually absorbs this cost of providing liquidity. For example, your neighbourhood grocer (note that this is again “on demand” since the grocer sells you groceries whenever you demand it) provides liquidity by way of keeping his shop open (even when there are no customers) and maintaining inventory. A car mechanic provides “on demand” service by (again) keeping his shop open and having spare mechanics who can service spot demand immediately.

In a platform business (or “two sided market”, or a market where the owner of the marketplace is not a participant), however, the owner of the market cannot provide liquidity himself since he is not a participant. Thus, in order to maintain it “on demand”, he should be able to incentivise a set of participants who are willing to provide liquidity in the market. And in return for such liquidity provided, these providers need to be paid a fee in exchange for the liquidity thus provided.

Thus, the key to the success of an “on demand” marketplace is to be able to incentivise enough market participants who are willing to provide liquidity – who are willing to forego instantaneous matching, and take risk of not being matched so that other market participants can enjoy the liquidity thus provided. This process also involves the clever structuring of incentives such that such compensation to the liquidity provider is paid for by the liquidity taker – this is nontrivial since this may not be consistent with the way in which the marketplace actually charges participants!

Cross posted from LinkedIN

Fragility of two-sided markets

Two-sided markets are inherently fragile for participation of each side depends on a certain degree of confidence in participation on the other side. Thus, small negative shocks can lead to quick downward spirals.

Following the ill-advised ban on Uber and other taxi aggregators in four Indian states (Delhi, Karnataka, Andhra Pradesh, Telangana), business for drivers who ply their services via such apps has dropped significantly. While on first inspection you might expect it to go to zero (given their services have been banned), the fact that enforcement is tough (there is nothing to identify a cab as “belonging to Uber”) means that apart from Delhi (where Uber has pulled its services) these cabs continue to ply.

In the days after the ban, various news reports have interviewed drivers who ply for Uber who complain about drastically reduced services. While numbers vary from report to report, the general sense is that so far the number of trips per driver per day has fallen by half. And I expect this to fall further unless drastic steps are taken – such as issuance of new regulations or removal of the ban.

In a “normal” market (where the owner of the market is also a participant), when demand for a particular good drops, price is expected to fall and availability is expected to increase. If demand for a particular item that you have in stock drops, you need to take steps to get rid of the excess inventory that you have. You are most likely to indulge in discounting or other such promotional activities, in order to make it more attractive for the buyers to buy, and thus take the inventory off your shelves.

In a “two-sided market” (one where the owner of the market is not a participant), however, things work differently. It is a popular saying that in such markets “demand creates its own supply”. A corollary to that is that “lack of demand creates lack of supply”. Let us take the case of Uber itself. Over the last few days, irrespective of whether the ban on the service is official or not, legal or not, the number of people who have been requesting for the service has dropped.

Now, if you are a driver using the app, you realise that your potential revenues and profits from continuing to use the app are not as high as they used to be. Thus, if there are other avenues for you to make money, you are now more likely to take those avenues rather than logging on to Uber (since the “hurdle rate” for such a switch is now lower thanks to lower Uber revenues). As many of you take the same route, the availability of cabs on Uber also drops – something that I’ve seen anecdotally over the last few days. And when availability of Uber cabs drops beyond a point, I start questioning my trust in the service – a week ago I would be confident that I would be able to hail an Uber from anywhere in Bangalore with very high confidence; that confidence has now dropped. And when my trust in the service drops, I start using it less, and when many of us do that, drivers see less demand and more of them pull away from the market. And this results in a vicious cycle.

Notice that things would work very differently had Uber been a “traditional” taxi service which owned its cabs and employed its drivers. In that case, falling demand would have been met with a response that would have made it easier for customers to buy – price cuts, perks, etc.

The point is that platforms or two-sided markets are inherently fragile, and highly dependent on confident in the system. I leave my car at home only if I have enough trust in the taxi platforms that I’ll be able to get a cab when I need one. A driver will forsake other trips and switch on his Uber app only if he is confident that he can get enough rides through the app.

The same network effects that can lead to a rapid ramp-up in two-sided markets can also lead to its downfall. All it takes is a small trigger that leads to loss of confidence in the service from one side. Unless that loss of confidence is quickly addressed, the “positive feedback” from it can quickly escalate and the market grinds to a halt!

Another good example of lack of confidence killing two-sided markets is in the market for CDOs and associated derivatives in 2007-08. There were standardised pricing models for such products and a vibrant market existed (between sophisticated financial institutions) in 2007. When house prices started coming down, some people started expressing doubts in such models. Soon, this led to massive loss of trust in the pricing models that underpinned such markets and people stopped trading. This meant companies were unable to mark their securities to market or rationalise their portfolios, and this led to the full-blown 2008 financial crisis!

So when you build a platform, you need to make sure that both sides of the market retain confidence in your platform. For in the platforms business loss of confidence can lead to a much quicker fall than in “traditional” markets. This dependence on confidence thus makes such markets fragile.