An interesting debate took place at last week’s Cloud2020 gathering regarding the viability of futures markets for cloud computing capacity. I’m firmly at the skeptical end of the spectrum as the title of this post will attest. However, I had not given enough thought as to the reasons for my skepticism. Having reflected on it a little I’m more convinced than ever that any attempt to create either primary or secondary markets in cloud commodities is doomed. In short the lack of friction and a lack of volatility in matching cloud computing supply and demand means there is likely no window for 3rd party market makers to insert themselves into this value network.
I am neither and economist nor do I have any experience in the financial markets. At best I’m an informed observer. My opinions are therefore not based on any particular expertise in this domain. That withstanding my views are based on my observation that the basic nature of cloud computing production, delivery and consumption is unlikely create the opportunity for the emergence of primary and derivative markets.
A 'Market' in its most simple form is a mechanism for matching buyers and sellers of goods, services or information. The market acts as a means of matching supply and demand and therefore arriving at the optimal price at which goods will be exchanged. The more buyers and sellers there are active in the market — allowing for perfect sharing of information across the market — then the closer the market will get to providing the optimal exchange of value between buyers and sellers.
More formally; 'Markets' create local minima in complex trading networks that minimize the amount of energy that needs to be expended to trade by maximizing the amount of information available to market participants. This is the reason we have fish markets.
Consumers of fish do not have direct access to the resource themselves. Fish must be harvested with considerable effort in time, energy and personal risk often far away from where the fish will be consumed. The most efficient means of matching buyers and sellers is for them both to congregate in a location that maximizes the efficiency of all actors. Therefore it’s far more efficient for fish to converge on Billingsgate market in London than it is for the concentration of buyers in London to visit all the ports where fish are landed. The same dynamics are certainly not at play in the cloud computing.
Accessing cloud services requires little expenditure of energy on the part of the consumer — no more than a few clicks of the mouse. There is also very little effort required to find multiple suppliers of cloud services — Google «Cloud hosting services.»
As Zysman and I wrote in our recent position paper for the Transatlantic Policy Network that cloud is unique in being at once a competitive service, a dynamic enhanced utility, an ICT infrastructure/platform and innovation eco-system, a marketplace, and a production environment. The cloud is its own market.
Advocates for the creation of new primary markets for cloud services will argue that a lack of standardization in cloud computing resource definitions creates an opportunity for markets to arise. There is no benchmark today against which cloud services from different providers can be compared: There is no cloud equivalent of West Texas Intermediate crude. This makes it very difficult for consumers to price compare across cloud providers. This information asymmetry should create the opportunity for a market based on common benchmarks for cloud resources.
I completely agree that the lack of standardized — comparable — cloud resource benchmarks is a problem. The question then becomes how much value could a 3rd party market maker extract based on that information asymmetry. My view is not enough to be viable.
If benchmarking standards become a consumer requirement then cloud providers will adopt them, but the energy expenditure by consumers to compare costs is just not that great. Now I have to click three times rather than just once. Or more realistically volume consumers of cloud services will programmatically make three API calls to obtain the current benchmark spot price for the resource they need.
The opportunity for 3rd party market making in cloud resources is so small as to be essentially non-viable. As a consumer there’s just not going to be enough value in the service for me to accept the market maker’s vig on the transaction.
The internet has been the great disinter-mediator across many industries. The retail supply chain — with lots of actors between suppliers and consumers — has been completely disrupted by Amazon and their direct to consumer model. Intermediate actors in value networks create information asymmetries — each actor has access to unique information on the buy and sell side of the transaction and these asymmetries create sub-optimal exchange of value between the producer and the consumer.
The cloud business models of Amazon, Google, Microsoft and others are premised on having the shortest path between supply and demand. None of these companies is going to willingly permit the insertion of a 3rd party market maker and no rational consumer would want that either. A for profit 3rd party market ultimately reduces margins for producers or increases prices for consumers — or both. It cannot be any other way.
Secondary — derivative — markets emerge when there is uncertainty about either supply or demand i.e. there is imperfect information about the state of the primary market or information asymmetry between buyers and sellers. This uncertainty can be traded or arbitraged. Traders in derivative markets are betting that they have better information about future supply and/or demand than other actors in the market.
Futures contracts allow buyers and sellers to hedge risk driven by volatility in either supply or demand of a particular commodity. In essence the contract allows you to fix the price for future delivery of a commodity. The contract itself can then be traded based on whether other actors believe the actual market price — supply or demand — will be higher or lower than the contracted price. The more volatile a market is the greater the opportunity there is for arbitrage.
Wheat futures contracts have a straightforward economic rationale. Volatility is largely driven by the unpredictability of seasonal weather patterns. Supply — crop yields — can vary dramatically based on whether there is a particularly hard or long winter, a snap hard frost late in the spring etc. Both farmers and breakfast cereal manufacturers use futures contracts to lock in prices and hedge risk for their individual rationale. Derivates traders make a living by trading on the lack of perfect information on either future weather or consumer consumption patterns.
Trading in petroleum products adds additional factors which drive volatility. Crude oil — what comes out of the ground — is 'cracked' to make make many different products; petrol, naptha, diesel, heating oil and feedstocks for a wide arrange of industrial chemicals. The efficiency with which crude can be turned into these products depends on its 'quality' i.e. how heavy it is and the level of contaminants — sulfur etc.
Petroleum based futures contracts are based on standard quality benchmarks — West Texas Intermediate being but one. Out of the ground crude production is fairly predictable at a macro level — OPEC sets production quotas for their producers. The volatility which drives the rationale for futures contracts is based on variation around the quality benchmarks, seasonal demand for petrol, heating oil etc. based on weather patterns and economical cycles driving macro demands for industrial chemicals and lubricants etc.
The problem as I see it for anyone wishing to create a futures market in cloud resources is where’s the volatility?
There has to be some driver of volatility in either supply or demand for there to be an economic rationale for futures contracts. Unfortunately for nascent 3rd party market makers there is no indication at all that the market for cloud resource provision shows any meaningful volatility.
On the macro demand side of the equation there is little or no volatility. We’re at the start of the adoption of cloud computing and consumption demand shows only one trajectory: up. There is no volatility on the supply side either. The major providers of cloud services — Amazon, Google, Microsoft, Rackspace and others — all build far ahead of the demand curve. They also have almost perfect statistical insight into demand patterns driven by data from millions of direct consumer relationships. There is little or no information asymmetry in this value network.
Of course it would be correct to point out that individual cloud providers do see changes in demand over varying time horizons. The demand for cloud resources powering online commerces peaks during the christmas holiday season and tails off during the summer. But the cloud providers themselves already leverage these demand fluctuations by providing spot pricing for their resources.
Consumers can contract for the provision of a certain amount of compute capacity at a fixed price if they are willing to be flexible about how long it takes for the capacity to be made available. Its likely that all cloud providers will eventually offer the same. This example again demonstrates that the cloud is its own market and that there will be very little — if any — opportunity for 3rd parties to insert themselves between suppliers and consumers.