E-liquidity.

With the number of electronic markets on the rise today, liquidity risks can only be heightened. Knowing what the risks are is the first step to avoidinq them.

"The value of an asset without cash flow is only what somebody else will pay you for it," says Peter Bernstein, the author of Against the Gods: The Remarkable Story of Risk. "That's a very risky position to be in," he adds.

The meaning of Peter Bernstein's words cannot be more far-reaching than what we are witnessing in today's dot-com community. Since the beginning of 2000, dozens of industries ranging from aerospace and defense to energy and petrochemical have announced joint venture Web sites to buy and sell goods and services online. A term that is often associated with these new markets is liquidity. It is arguably the most notable word used in e-business news coverage today.

Liquidity, as we know it in the 'old economy,' refers to an institution's ability to generate or obtain sufficient cash or its equivalents on a cost-effective basis, to meet its commitments as they fall due. In the investment industry, it is usually associated with how easy or difficult it is to buy or sell a security.

Although this definition still applies in the e-business economy, liquidity in electronic markets (e-liquidity) primarily refers to the presence of buyers and sellers in online exchanges. Recognizing that buyers and sellers together are the driving force that can transform asset into cash, or cash into asset, e-liquidity has been touted by e-business professionals as "the single greatest determinant of the relative attractiveness of a trading site.

The agora effect

An agora (a marketplace assembly in ancient Greece) facilitates the exchange of goods between buyers and sellers. In e-markets, the foundation of such an exchange is a system that exploits the capabilities of the Internet. We are all familiar with how eBay and Priceline operate to facilitate exchanges between buyers and sellers through real-time negotiations. We will soon be inundated with "industrial strength" exchanges based on the same liquidity principle in the business-to-business (B2B) market space. GE and Commerce One have recently joined forces, as have IBM, Ariba and I2 Technologies. And there are many more joint ventures to come.

What these exchanges have in common is their ultimate goal to increase liquidity through collaboration, alliances, partnerships and the like, to capitalize on the agora effect. With the popularity and increased sophistication of software agents and special search engines, it is difficult to see how price can be used as a competitive advantage to create and sustain e-liquidity. Personal shopping agents (the shopping "bots") are at your command to get you the lowest price. Some portals, such as Smartbots.com, even offer information on shopping agents from all over the world. For example, a recent startup, Perfect.com, offers an automated "request-for-quote" service to attract online participants on many factors other than price.

To create and sustain e-liquidity, there has to be an efficient interaction between price, trade and volume. In an agora, trade determines price, price determines order flow, and order flow determines price. All these have to work favourably inside the psychology of the market participants before these exchanges can flourish.

E-Liquidity risks

We see liquidity risk in e-business markets and traditional markets the same way: the failure to transform assets into cash (and vice versa) quickly, easily, and efficiently. E-liquidity is not born of "stickiness" and "eyeballs." The presence of buyers and sellers alone is not enough to generate liquidity. E-liquidity risk arises from the failure to turn "eyeballs" and "stickiness" into sales. It is also the risk of unwittingly providing a space for buyers and sellers to Just meet and get entertained, but not persuasive enough for them to act on the information to generate sales. The once feisty TheStreet.com has no problem establishing its reputation as a premier source for thousands of investors who surf the Internet everyday for stock news. This high-traffic site, however, is not yet profitable and therefore is not liquid.

What makes price, volume and trade interact efficiently depends a lot on what the customers have in their mind. As mentioned earlier, if price is no longer a differentiating factor in electronic markets, then the competitive advantage has to come from optimal service that finds the best match between the buyer and seller. E-liquidity risk is the failure to empower customers with timely decision-making information tailored to their needs during their online experience. It is customer service risk at a critical moment.

For a business Web site to be attractive, content, context, commerce and community have to operate seamlessly. This should thus prompt businesses to focus on the risks associated with continuity, efficiency, and information delivery as a bundle. Today, the technology that enables online exchanges is already in place -- and it continues to get cheaper and better. Online risks are now shifting to the reliability and availability to keep global markets humming 24/7 without a glitch.

As markets grow, scalability must be there to ensure continuity of operations. Here's an example of what could happen if the underlined risks are not properly managed. On July 26, 2000, the Federal Trade Commission (FTC) charged seven e-retailers for violating the Mail and Telephone Order Rule during the 1999 holiday shopping season. These e-retailers broke promises by failing to alert customers of their order fulfillment problems. [2] These "Holiday Hangover" and "Gripes of Wrath" were no small incidents: the FTC reportedly received more than 18,000 Internet-related complaints in 1999, up from less than 8,000 the previous year. [3] Liquidity was at an all-time high, but customer satisfaction halved. The dissatisfaction was mostly related to the risks of continuity, efficiency and information delivery: outages, weak links between the online software interface and inventory management, order fulfillment, customer service, payment and security processes. That translated into total disrespect for operational ex cellence, the foundation for cementing customer relationships. With the number of e-markets on the rise today, e-liquidity risks can only be heightened.

To avert the risk of launching an unsuccessful electronic exchange, customer service, continuity, efficiency and information delivery risks should be assessed up front. This is an opportunity to transform risk into reward. Informing customers what risks you have consciously mitigated is another way of telling customers that you care. The remaining technology risks -- including data integrity, fraud, privacy and resource skills -- must also be managed with as much rigor.

The risks that affect liquidity go beyond technology. Liquidity can be adversely affected by market swings specific to the industry, seasonal issues, uncertainty of supply and demand, nature of product and service offerings, regulatory interest, and potential displacement by other market models and more.

Implications for e-business

E-liquidity drives volumes, price, trades and most importantly, relationships. It is the greatest advantage an electronic market can enjoy. To create e-liquidity, developers must deal with the risk of launching unsuccessful e-business ventures at the concept stage. To sustain e-liquidity, such risks have to be scenario-tested from time-to-time in reality.

Somewhere between the medium and the message, there is a new force to be reckoned with. It is difficult to calculate exactly how much a company's market capitalization is directly liquidity-related, but it is substantial.

Sally Chan CMA, is senior manager of Technology, Internet & eBusiness Risk, Group Risk Management at Royal Bank Financial Group and co-author of Electronic Commerce Relationships: Trust by Design (Prentice Hall 2000). Sally than would like to acknowledge the contribution of Dave Singer, VP, Technology, Internet & eBusiness Risk, Group Risk Management, Royal Bank Financial Group to this article.

Notes:

(1.) See "Mastering Risk" from Financial Times London, June 2000.

(2.) Information Week, August 7, 2000

(3.) Business 2.0, March 2000 and July 25, 2000