Communications of the ACM

Communications of the ACM

What Drives Market Transactions in B2B Exchanges?

By Andrea Ordanini
Communications of the ACM, April 2006, Vol. 49 No. 4, Pages 89-93
10.1145/1121949.1121953
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The failure of many digital marketplaces in recent years reflects how difficult it is for managers to exploit the potential of digital interconnections between businesses. The vast majority of newcomers fail to achieve liquidity in their target markets no matter how long they stay in business, and few exchanges are able to manage a consistent flow of activity in business-to-business environments [4].

Data from a survey I conducted in 2003 on a sample of 45 European Union exchanges culled from the emarketservice.com directory reveals a strong positive relationship between the revenue of a B2B exchange and the share of that revenue derived from transaction fees; at the same time, a marketplace that counts mainly on other revenue sources (such as subscriptions, advertising, and non-exchange services) faces yet more difficulty on the path of growth. In this sense, the choice of revenue model directly affects revenue (see the table here).

The revenue model is concerned with value appropriation decisions, namely the modes in which a business model enables revenue generation. But revenue model decisions also derive directly from business model features; in this case, successful marketplaces reflect certain distinguishing characteristics compared to other B2B exchanges. In this way, researchers focusing on the digital exchange environment exercise their creativity by identifying new business models [5, 10]. Their thinking is generally inductive; business models are designed using a set of qualitative variables, and categories are created from scratch, sometimes taking a successful initiative as a reference point.

Even from a theoretical point of view, there is no consensus on the meaning of the term "business model," which has different connotations in different contexts [8]. Here, I employ it in a more deductive sense, as a "set of descriptors" for more-or-less successful initiatives. Since the term refers largely to the internal rules employed by firms doing business in the digital environment [1] or to the architecture these firms leverage to organize activities in the value network [11], I considered an e-business model as a framework consisting of three layers [2]:

• Content, or market positioning, of an exchange in terms of what is being exchanged and, above all, who are the target customers;
• Governance, or the rules and incentives provided by the various shareholders; and
• Structure of the market, or the mechanisms and services enabling it to function.

Findings from my 2003 survey, which was sponsored by Bocconi University, reveal that in each layer, a successful marketplace can be expected to exhibit distinguishing features with potentially important technical and managerial implications.

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Empirical Evidence

The emarketservice.com directory includes more than 1,000 exchanges worldwide, from which I selected the 45 European operators focusing on B2B and with commercial offices in more than one EU country, thus skipping the much less active domestic exchanges. Of the 45, I chose a sample of 32 and collected data through a questionnaire I devised and emailed to CEOs, as well as by looking at their Web sites. I used the customer target as a proxy to represent the content dimension of the business model, particularly whether an exchange had a specific orientation emphasizing small and medium enterprises (SMEs).

I investigated the governance dimension through the relative percentage of shareholder control, such as whether established firms were involved as shareholders or financial shareholders controlled the exchange.

I analyzed structure issues through the presence of dynamic or static exchange mechanisms, focusing on the presence of auctions in the offering (see Figure 1). Figure 2 includes the empirical evidence—the relationships between an exchange's ability to perform intermediate transactions and the choices its management might have made in terms of customer targets, shareholder structure, and the presence of auctions in the offering.

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Customer Focus

The choice of target customers is a distinguishing feature of the most vital exchanges. In particular, the inclination toward emulating a small-business environment is an obstacle to growth, and the survey's results tend to confirm the effects of business models and small-business design.

B2B exchanges that do not view SMEs as their primary target market get a larger share of their revenue (46% as opposed to 15%) from transaction activities, while small-business-focused initiatives must target other non-exchange revenue sources (such as advertising and service fees) for which the digital dimension is significantly less compelling.

Early B2B exchanges were largely inclined toward the needs of SMEs, feeling that the digital marketplace model was the best fit for fragmented markets where the buyer-side of the exchange suffers from market opacity. But the stronger counterpart—the seller—had no incentives for participating in a game where bargaining power represented the jackpot. Participation in a B2B exchange required two notable capabilities only rarely present in SME firms:

• Strong integration between transaction activities and complementary processes that are costly, time-consuming, and risky for many small firms; and
• Some IT capabilities and learning capacities that have a positive influence on B2B exchange participation and for which small firms traditionally lag behind [6].

In addition, many small firms usually find it to their advantage to establish a network of long-term relationships with a few key suppliers based on mutual trust and cooperation, rather than try to pressure suppliers. This behavior is inconsistent with the goal of transaction cost reduction in arm's-length relationships [5].

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The negotiation mechanism is the main aggregating factor in today's digital marketplace.

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From the technological side of B2B exchange operations, the superiority of large firms as a target would involve reconsidering large standardized software platforms that were once criticized as inflexible. These platforms positively affect the process phases of an exchange by reducing time and resources and are well suited to large firms whose internal processes leave room for efficiency gains.

Small firms have not been an especially lucrative market focus for B2B exchanges, especially for those oriented toward providing transaction benefits. On the other hand, paying attention to the issues of large firms has a positive effect on potential profitability.

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Shareholder Structure

Another characteristic of most dynamic exchanges is their governance structure. The results of the survey reveal how B2B exchanges with financial shareholders receive a lower share (16%) of their revenue from transaction activities, while the corresponding share in the private/consortia marketplace is 42%. Even so, some marketplaces unable to realize digital intermediation are forced to identify and pursue other revenue sources involving lower potential profit margins to sustain their revenue flows.

Many exchanges in the early wave of B2B development were newcomers; their start-up capital was provided by venture capitalists and financial institutions interested in a mid-term stock price increase in exchanges with the potential for quickly transforming themselves into publicly held corporations. Unfortunately for these initial investors, the exchanges in many cases failed to provide or transfer specific knowledge and expertise regarding the businesses in which they would operate. Without such knowledge, the exchanges had difficulty making themselves attractive to firms looking for better ways to do business; they had even more difficulty providing services that would improve transaction conditions in specific contexts. Marketplaces involving a significant percentage of financial shareholders are more likely to be service providers than true exchanges.

The most direct way for a digital marketplace to achieve specific knowledge has been to become an exchange sponsored by an established firm with a relevant position in the market. These operators, called private marketplaces or consortia when the sponsor is an industry association, are biased in the sense that they serve only the buyer-side of the transaction and usually involve only one or several big purchasers (generally the shareholders).

The presence of user firms as investors in these exchanges sought to improve the efficiency of transactions in specific business environments, drawing from their day-to-day experience and knowledge. In addition, partner firms that are also shareholders are traditionally more patient than their purely financial counterparts, helping align the time horizon of expectations of both investors and managers.

Even if these private exchanges are viewed as e-business support for their shareholders, they have progressively opened their activity to other buyers, reducing the share of intermediation associated with captive businesses. Thus, the inclination toward neutrality, which supported the early B2B exchanges, should be reconsidered—a situation that reveals how a winning technological solution reflects a high level of customization and flexibility by the main users and owners of an exchange. The level of customization reflects the integration process of an exchange's software platform and the user firms' business processes, thus requiring adaptation of existing routines. In this way, successful platforms (in terms of both traffic and revenue) appear to be standardized (in terms of process automation and customization); that is, they are deeply integrated into the business process of user firms.

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Dynamic Negotiation and Auctions

The third characteristic defining the capability of intermediate digital transactions is the use of tools for dynamic matching, particularly for auctions. Dynamic tools allow the simultaneous interaction of supply and demand, adjusting negotiation conditions in real time; static tools permit only transactions on predefined terms [9].

The empirical evidence from my survey indicates that the auction provides the only discriminating item for the transaction capability among the services an exchange can provide. This means that the negotiation mechanism is the main aggregating factor in today's digital marketplace. In fact, the survey showed how B2B exchanges that provide auction services retain a greater share of revenue derived from transaction fees—42% as opposed to 17% for exchanges that do not offer such service.

In this sense, it seems that only dynamic tools provide a real and complete reduction in transaction costs for the exchange, due to the fact that a significant portion of these costs appear after the transaction has been realized and cannot be captured through static mechanisms.

There are two types of transaction costs [8]: ex-ante for searching counterparts and coordinating exchange procedures and ex-post arising from opportunism and adverse selection. Static mechanisms affect the ex-ante dimension, since they can help reduce the marginal costs for searching for and identifying counterparts through various aggregation mechanisms. However, they do not affect the ex-post dimension; those effects start to appear only during negotiation.

Dynamic tools for negotiation work only when ex-post transaction costs begin to appear. For instance, a reverse auction can affect motivation costs, shifting the inertia of the exchange from seller to buyer, rebalancing bargaining power, since sellers are forced to reveal their strategies. In this sense, sellers' potentially unfair behavior and the probability of selecting an ineffective partner are reduced.

This way of countering sellers' behavior requires that the auction enable many participants to join the negotiation on the seller-side. It is most likely to happen when the auction offers real opportunities for sellers to increase their sales through deals otherwise impossible even to contemplate. This is precisely what happens when the buyer is a large firm, the average value of the auction is relatively high, and auctions are held frequently.

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Implications

Successful B2B exchanges are able to profit from transactions, focusing on transaction fees as a main revenue source (see Figure 3). The business models for such exchanges exhibit three distinguishing characteristics:

• Large firms as main customers (content);
• Incumbent firms as shareholders (governance); and
• Auctions as the main mechanism for realizing transactions (structure).

In terms of content, aiming for large firms seems the optimal choice for the exchange, since it reduces the aggregation effort, amplifying the benefits from individual deals. This business strategy suggests a rethinking of B2B exchanges as a solution for fragmented markets and as a driver for SME firms seeking to rebalance their bargaining power toward neutrality. In this way, successful exchanges function more as tools for standardizing processes and gaining efficiencies for large organizations than as mechanisms for guaranteeing more flexibility to (already flexible) SME firms.

Regarding governance decisions, exchanges with an industrial foundation, where manufacturing firms are relevant shareholders, emerge as more buoyant. The success of private or consortia exchanges sheds new light on the role of neutrality in digital markets and suggests that financial shareholders may play a significant role only in the earliest stages of an exchange's development.

In addition, captive marketplaces are more likely to exhibit deeper integration of technological solutions and business processes, leading to superior performance, sustained by shareholder/customer sunk costs.

Lastly, regarding a market's structure, exchanges with dynamic tools for matching buyers and sellers (such as auctions) are more attractive to participants looking for reduced ex-post transaction costs. In this sense, the true exploitation of the potential of a digital relationship would focus mainly on the negotiation attributes of digital platforms.

What are the implications of this analysis? First, a successful marketplace appears to polarize and reinforce previous differences in the market, rather than function as an instrument for rebalancing the relationship between buyers and sellers. If the dominant model, at least among the exchanges in my 2003 survey, is that of a private marketplace leveraged to improve the purchasing decisions of large firms through reverse auctions, the diffusion of B2B exchanges works to support already strong operators from the buyer-side, providing them cost efficiencies. These exchanges do not rebalance bargaining power within existing vertical relationships but strengthen the transaction capabilities of their already strong counterpart buyers and sellers, giving them new business opportunities.

Also notable is that a successful business model does not consist of independent decisions but of a series of complementary choices along all relevant dimensions, where the choice in any one dimension reinforces the other dimensions. The emerging picture, based on my survey, shows how the success of any B2B initiative is a blend of market positioning, governance structure, and services offered. These three features should, from a participant's perspective, also be used to address the decision of whether to participate in a B2B exchange and how to choose among various potential operators.

From the exchange point of view, successful software platforms should combine three items:

• Standardization features to guarantee efficiency gains;
• Business process integration to address users' firm-specific efficiency problems; and
• Negotiation tools to allow the active participation of counterpart buyers and sellers before, during, and after transactions.

To succeed, Internet-based initiatives in the B2B environment must be linked to incumbents' needs; only exchanges that reflect the business strategies of established firms may concretely exploit the opportunities of digital transactions, even if these opportunities do not represent an exchange's exclusive business arena. This conclusion is consistent with the vision of B2B exchanges as architectural innovators, bringing new ways to realize inter-firm transactions in the marketplace. They must therefore focus on the profitability of participating firms.

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The Digital Library is published by the Association for Computing Machinery. Copyright © 2006 ACM, Inc.

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