Reaction Wheel

I was out with Josh Grotstein–CEO of Motionbox–last week, and got to talking about how the inefficient market design of our current ad exchanges saps liquidity.

OK, maybe I was talking about it.

Possibly I was ranting*.

Josh wisely changed the subject to an episode of 1987’s Max Headroom, featuring the first vision of an ad exchange that we could think of, the steam-punkish Ad Market. It’s not entirely clear what the underlying is in this market, since elsewhere in the episode a big advertiser seems to be using Skype to tell a network head to get the ratings up. It could, perhaps, be a pure risk-hedging derivatives market without any delivery of the underlying, which would certainly explain the show’s dystopian setting.

Elsewhere in the episode, Amanda Pays makes those 80s style big-shoulder suits look pretty damn good.

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* The thing about a rant is that it can’t be kept in. So here it is.

Liquidity in a marketplace is generally determined by depth of limit order books. If the limit order book gets depleted, there is no liquidity. Most research on this subject focuses on the ratio of limit orders (supply liquidity) to market orders (deplete liquidity). This ratio depends on trader patience and market design.

Market design decides time to execution, the key endogenous factor traders take into account in deciding whether to place a market or limit order (mappable, perhaps, to the more classical ‘waiting costs.’) Variability is a function of spreads, spreads a function of liquidity, and liquidity of time to execution. Highly variable prices drive down the average price level.

In a well-designed market, time to execution can be minimized even with low volumes. Many marketplaces have historically kept TTE low by opening only for a limited period of time every day or every week. By concentrating order flow in a smaller period of time, the chance that each trade would clear quickly was increased.

Our current ad markets seem to be headed in the opposite direction. I consider these markets low-volume. But instead of working to decrease TTE by increasing the concentration of order flow, they seem to be motivated instead to decrease inventory risk by imposing a small TTE, diluting order flow. This depletes liquidity and must, in the aggregate, lower CPMs.

Of course, this is all speculative on my part, since I don’t have the data to back it up. Also, this effect is probably a small part of why online CPMs are so low, the relative inefficacy of online ads being the bigger part. But liquidity is certainly more interesting to think about. It also makes me wonder what the heck Hal Varian does at Google.