Arbitrage in the Internet Age

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Simultaneous buying and selling makes the economy extremely efficient. But in our overconnected world, it may also force us into a race to the bottom. 


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If you want to succeed in an Internet-driven, overconnected world, you must arbitrage. If you don't, you will become prey to those who do. But in an Internet-driven, overconnected world, arbitrage may also force us into a race to the bottom.

Arbitrage makes the economy extremely efficient. In the commodity world, arbitrage can be a miraculous transaction, yielding an infinite rate of return. The arbitrager buys a commodity in one market and sells it instantly at a higher price in another. In a perfect arbitrage, the arbitrager collects the money from the sale before paying for the original purchase. For example, sell a bushel of wheat for $7.00 and collect the money instantly; buy the bushel in another market for $6.75 and pay later.

Of course, perfect arbitrage seldom exists. Speculators quickly root out opportunities, and prices converge. The sale price, for example, drops to $6.85 and the purchase price rises to $6.84. Of course, the sale price could drop below the purchase price to, say, $6.75, and the arbitrager would lose 9 cents on every sale.

In the past, the term "arbitrage" was used in conjunction with financial and commodity transactions, but now it is used more broadly. For instance, people talk about arbitraging labor costs, referring to using cheap labor in a distant location to substitute for more expensive local labor.

Successful arbitrage depends on strong and efficient connections. You have to be able to move products from where you buy them to where you sell them. Transaction costs and other logistics must be kept to a minimum. And in order to find the best arbitrage opportunities, you have to have good information about markets.

This is where the Internet comes in. Not only does it reduce the cost of finding opportunities, but it greatly increases the efficiency of doing so. As a result, the universe of arbitrage opportunities has expanded. Name something that can be bought or sold, and there may a way to arbitrage it: stocks, bonds, commodities, precious metals, labor costs, taxes, regulatory environments, credit card debt, retail shopping experiences.

In 2004, commenting on slow job growth in the U.S., Stephen Roach of Morgan Stanley cited "global labor arbitrage" as the main reason growth had slowed. Roach predicted that global labor arbitrage was likely to be an enduring feature of the economy. Our experiences over the past seven years have certainly proven him right.

Most people might think Roach was referring to factory workers and customer support workers in India who answer calls in heavily accented English. But because of the power of the Internet, information-intensive jobs of almost any type are subject to labor arbitrage. Teleradiology Solutions, a company located in Bangalore, reads X-rays for patients in the U.S. and Singapore. Jobs we thought were safe are safe no longer. More and more companies are employing engineers and programmers in India, Russia, and the Balkans. Businesses must either arbitrage and succumb to the unrelenting pressure to cut costs or face the prospect of becoming uncompetitive.

Non-traditional arbitrage lurks in some surprising places. Consider retailing. Physical retailers add value by providing a retail experience. Some people enjoy shopping. One of the most important services retailers provide is the opportunity to experience the merchandise. Test drive a Ferrari. Try on a pair of jeans. Then go to an online retailer and arbitrage out the added value and the local taxes as well. Many of us do this without giving it a second thought. We find what we want at the shopping center and then rush home to buy it on Amazon. If we're shameless, we do our online shopping on our smart phone a few seconds after leaving the store.

In financial markets, arbitrage has run rampant. Transaction costs facilitated by the Internet have plummeted. It has become possible to collect massive amounts of information inexpensively. As computation power has increased and data sets have grown, computers can now uncover more and more arbitrage opportunities.

High-frequency traders use computers to scan the market to scout out the tiniest mispricings. If a computer can discover an index made up of a few hundred stocks that is priced too high, traders sell the index short and buy the stocks, making pennies per share on billions of shares--pennies that add up to hundreds of millions in profits. Is it any wonder that high-frequency trading now accounts for nearly two thirds of the trading volume?

High-risk arbitrage adventures aren't just for the big guys. I was amazed to learn about credit card arbitrage. Get a low-interest introductory loan for signing up for a new credit card, invest that money in a high-interest account, and pray.

The Internet makes it easier to get around financial regulations and circumvent jurisdictions. If regulators in the UK or USA get too tough, the Internet can help: when data flows so efficiently, it's a lot easier to move the regulated entity from London or Wall Street to a more understanding jurisdiction.

If I can arbitrage a growing number of financial transactions, both low-skilled and high-skilled jobs, and then throw in retailing, what's left? A lot, as it turns out. Ask people in Hollywood about movies and recordings. Talk to the newspapers. As bandwidth increases, opportunities to arbitrage will continue to grow as well. Maybe the only things that will be safe are meals in restaurants and trips to the hair salon.

Arbitrage is an economist's dream. It squeezes out inefficiency. It creates an intensely price-competitive world. Consumers benefit big time, because they have access to high quality goods at low prices.

But arbitrage has its downside as well. I used to love to travel. I even looked forward to the flight. I could sit in peace and quiet and catch up on my reading. Today I can fly for less money, but I also fly less. The qualitative experience is so poor that it has reduced my interest in traveling.

Price is one of the most powerful motivators known to humankind. Nobody wants to pay more. When the focus is exclusively on price, qualitative aspects often suffer, and in many situations that is too high a price to pay. If only arbitragers could find a way to squeeze out costs while maintaining quality. Now that would be the perfect arbitrage.
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Bill Davidow is an adviser to Mohr Davidow Ventures and the author of Overconnected: The Promise and Threat of the Internet.

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