Apple’s (AAPL, Fortune 500) iTunes is credited with finally getting people to pay for digital music, but it wasn’t unveiled until 2003.

In the time between Napster’s shuttering and iTunes’ debut, many of Napster’s 60 million users found other online file sharing techniques to get music for free. Even after iTunes got people buying music tracks for just 99 cents, it wasn’t as attractive as free.

and

Now just 44% of U.S. Internet users and 64% of Americans who buy digital music think that that music is worth paying for, according to Forrester. The volume of unauthorized downloads continues to represent about 90% of the market, according to online download tracker BigChampagne Media Measurement.

Matt Yglesias responds

Music industry executives can tell themselves that as long as they want. But under conditions of perfect competition, the price of a song ought to be equal to the marginal cost of distributing a new copy of a song. Which is to say that the marginal cost ought to be $0. That’s not a question of habit, you can look it up in all the leading textbooks. Of course real businesses rarely operate in circumstances of perfect competition, and record companies have a variety of political and legal tools they can deploy to try to protect monopoly rents. But this is hard to do. I think the real story with the iTunes store is that over time competitive pressure has impelled it to largely drop DRM and over time I expect we’ll see that the CPI-adjusted price of songs declines.

If you are a music industry executive, you can wait for CD sales to bottom out at somewhere close to nothing. Or you can take the initiative

I don’t know if any research has been done on this or not. But it seems to me that $1 is just too high a price for a song. At that price, a high school or college student faces the choice of transferring music from his friend for free or paying $40 to get a few albums of a new band that he got interested in. There’s no contest.

You might say that by this logic you can never win against free. You can, if you make it really easy to access and download cheap music from legal sites. If iTunes had song downloads for 10 cents you would convert a large majority of “pirates” to legal downloads.

Related posts:

1. Piracy Pulling Down Music Sales

To my mind, piracy of music:

1. Is inversely related to the chances of getting caught, which is very low.
2. Is inversely related to the punishment if caught, which is mild.
3. Is inversely related to the disapproval from friends and family who might know that you are using illegal music. This is almost non-existent.

All of these factors might indicate that piracy can’t be vanquished. But there is something that the music labels could do to start beating it back – reduce the cost of digital music dramatically.

Today the price of a song averages around $1. The marginal cost of delivering the next song is close to zero. So if you were to somehow know what the price to downloads curve might look like, all you would do is to set a price where the product of price and downloads was maximum. But of course, you don’t. Which is why the price of a song is stuck at $1.

I don’t know if any research has been done on this or not. But it seems to me that $1 is just too high a price for a song. At that price, a high school or college student faces the choice of transferring music from his friend for free or paying $40 to get a few albums of a new band that he got interested in. There’s no contest.

You might say that by this logic you can never win against free. You can, if you make it really easy to access and download cheap music from legal sites. If iTunes had song downloads for 10 cents you would convert a large majority of “pirates” to legal downloads.

Obviously, executives in the music industry have a pretty tough choice. First, they may not be able to convince all parties – Apple, artistes – to agree to a dramatically lower price. Doing it for one song doesn’t really work – it won’t change habits. They need to go the Full Monty. That’s a tough sell. Even if they managed to get that far, it is likely that revenue would plummet in the short term before it started rising again. On the other hand, it takes one bad quarter to get you fired.

The leap of faith is that reducing the price per song to a tenth of what it is today can take the share of legal downloads from 5% to 50%. Isn’t it time someone took that chance? After all, things can’t get much worse can they?

No related posts.

There are a few disadvantages of course. The biggest one is the price. At $360 or so you don’t want to leave it on the airplane! You can’t loan a book to someone else. Books with illustrations won’t offer the same experience for a while (no DC comics on the Kindle so far). You are forever tied to amazon.com as your supplier of books. Much like the lock-in that music downloads from iTunes created for the iPod until Apple also moved to mp3 downloads. Funnily, the DRM that the publishers insist on creates a lock-in that benefits the device manufacturer the most.

Kindle, and hopefully other e-books, will change the economics of the book publishing industry. I can’t say if it will be for better or for worse for the publishers (probably worse) or authors (probably better). But the readers will certainly have more choice. And this can be very, very good for Amazon’s shareholders.

The marginal cost of a book is quite a bit more than a for a music album or a DVD. I would put at about 20 to 30 %. It would be somewhat less for hard covers and technical books with specialized readership as compared to paperback and popular fiction.

With e-books that marginal cost goes down to zero. This allows the price of the book to be lower, even while (I suppose) Amazon makes a higher % margin though perhaps a similar dollar amount per book. A lower price can seriously expand the market.

Then there is the convenience. To be able to instantly gratify the need for a new book can only mean more sales of new books.

The marginal cost being zero means a few other things as well. Classics whose copyright has expired are available for next to nothing. The entire collection of Dickens is available for $1, for instance. A Raja Sharma has a whole collection of summaries of classics for around a buck each. I’m sure there are thousands of high school and college English lit students who will plump for the summary.

The reason why the summaries are interesting is much more than the genre of summaries itself, which existed before the e-book. It is interesting because it totally bypasses the publisher. The author gets a 33% cut of revenues from Amazon, regardless of the price. Amazon keeps the rest. Might this become more of a trend in the future? It just might. New authors can avoid the publisher entirely with a combination of Kindle and Print on Demand. You’d have to do your own marketing, but then if you are a new author, it’s not as if the publisher is spending millions on marketing your book anyway.

Question – are summaries of books that are still copyright protected, an infringement of the copyright? Business book summaries are regularly advertised in the Economist and given that the summary almost always will eliminate the need to read the book it seems reasonable to assume that there is some contractual arrangement between the summarizer and the publisher of the actual book. On the other hand can ‘remixing’ a book be deemed an infringement?

In an earlier post Paperbacks in India I wrote about how publishers were releasing cheaper paperback versions of books in India simultaneously with hard cover releases in the US. With an e-book release that won’t be possible, which means that publishers will lose the ability to geographically price segment the market. Which hopefully means that the book will cost less everywhere. Although it’ll be a long time before e-books become a factor in India. The readers just cost too much today. But get some real competition going and the prices should come down quickly. Maybe from Sony, or maybe these guys.

No related posts.

I saw the article coincidentally when I was looking at a Zoho product after a long time. A friend in New Bombay who co-owns a fledgling, but growing business was looking for a CRM solution. I was spending the weekend with him so he and I got on the internet and started checking things out. He was already being pitched by salesforce.com. Apparently, salesforce.com has a center in India that calls out to trial users in India. He was getting ready to get salesforce.com for the low, low price of $9 per user (limited time offer) before I suggested that he have a look at 37signals and Zoho. I had never tried them but knew that they both had something on CRM.

The 37signals product, Highrise, is somewhat different from your classical CRM so that didn’t work for my friend. But he loved Zoho – especially, the price – free for up to 3 users, $12 per user after for a full-featured CRM product. I tried out the product myself and I was very impressed by it. CRM software functionality is not rocket science. It’s been done many times before. But Zoho had managed to improve on it considerably. For example the one feature that totally wowed me was how you could convert a list of contacts or leads into a Zoho spreadsheet (nice cross-integration, guys), edit it and then save it back to the CRM database. Very cool.

Back to the topic at hand. The Face Value story was about how Sridhar and Zoho were creating a new disruptive model in software based upon a dramatically lower cost of operations. Not just lower cost Indian engineers, though that probably doesn’t hurt.

If Mr Vembu still expects to make money, it is because of his firm’s frugal ways. This has little to do with low Indian wages: these are rising quickly, and most Western software firms also do much development in India. More importantly, he says, Zoho’s software and data centres are built for efficiency. The firm spends a pittance on marketing. And it uses free technology developed by others wherever possible. Its subscribers can, for instance, use Google’s authentication service to sign on to Zoho.

And further,

But Mr Vembu is unfazed: “We’ve heard this before from the likes of Digital Equipment and Sun Microsystems. But look what Dell did to them.”

So while the SaaS model upends the high cost licensed software model, Zoho aims to become the cost leader amongst the SaaS business software vendors. And do what Dell did to the PC industry a decade ago.

But there are some crucial differences. The PC and hardware business is a variable cost business. Lower costs translate into a pricing advantage that leads to more sales and better margins. On the other hand, software, especially in the SaaS model, is largely a fixed cost business. Lower fixed costs don’t automatically turn into a pricing advantage and more sales.

According to the Face Value article, Zoho has wired its business so that a variety of costs are lower:

1. Fixed costs – use of open source, engineering and most of the company is in India. Almost no Marketing costs. Just word-of-mouth.
2. Variable costs – data center efficiencies. Minimal Sales costs. Service costs are presumably India based.

This is a comprehensive, across-the-board cost advantage. But what we must note is that while some things have a lower cost at presumably no trade-off, having lower Marketing, Sales and Service costs than say salesforce.com is a strategic bet. The bet is that sales can scale without them.

Does this comprehensive cost advantage automatically translate into success in the market? Not necessarily. If the lower costs enable Zoho to offer a somewhat lower price, say 15% lower, it may not matter to the customer. The design and quality of the software may matter more. Part of what makes one software product better than another is simply feature coverage, which is more a function of cumulative investment in engineering rather than this year’s fixed cost, giving incumbents the advantage. The other part of it is just how it is designed. “Code is poetry”, as wordpress.org says. Lower costs make no difference whatsoever in this regard.

In my opinion, lower costs are only part of the story here. The big bet that Zoho is making here is that there is a lot of room at the “bottom of the pyramid”. My quick assessment is that a Zoho CRM subscription is between 4 to 5 times cheaper than salesforce.com (ignoring their limited time offer). That is not a measly 15% less. That is 75 to 80% less!

At these prices, they don’t have to fight salesforce.com for customers. They are going after an entirely different market. A market that includes my friend in New Bombay and his Indian startup. Or a Chinese toy manufacturer. Or a small business in the US. You get the picture.

I’ll leave you with an excerpt from my post Go South, Young Man from two years ago.

I think the bottom of the global pyramid in SaaS (borrowing heavily from Prof. C. K. Prahlad) is a great opportunity for Indian tech startups. India abounds in technical talent but is stymied because it can’t develop cutting edge software for developed markets. Indian technologists aren’t deeply knowledgeable about business practices there and thus lose out. My contention is – forget developed markets. Go for the bottom of the pyramid. There are thousands of businesses – small and large – in China and India that need the same software that is being served up by today’s SaaS providers in the US. While these companies are trapped in their first world pricing traps, Indian companies can create similar SaaS products and target the South. These products, at first will be similar, but will eventually diverge as the needs and price points take them in a different direction from their US competitors. And that is good. It creates entry barriers for when the SaaS companies from the North wake up and realize the potential in the South.

[Update: General Electric is going with Zoho on thousands of its desktops. Clearly targeting the bottom of the pyramid does not preclude a smart player at the top of the pyramid (and they don't go any higher in the pyramid than GE). Well done Zoho!]

Related posts:

1. Piracy Pulling Down Music Sales
2. Is Offshore Services a Scale Business
3. What to do About Falling Music Sales

At the most basic level the framework says that to maximize the chances of switching you should maximize Switching Benefits, minimize Switching Costs and make Research and Trial really easy.

Maximize Switching Benefits

If there isn’t a compelling feature or two in your product that will get a large percentage of your target user base to check out your product, it won’t work. When you introduce a product, it is more important to focus on the Switching Benefits than on lowering the Sacrifice. If the Switching Benefits aren’t there, you won’t get enough people into Research & Trial. If the Switching Benefits are there but the Sacrifice is somewhat high, at least you’ll get the trials and perhaps some early adopters to switch. You might also get some parallel runs, where users use both products for a while. But most importantly, you will get feedback.

Getting the Switching Benefits right is half the battle – that is the innovation, the idea. But sometimes it is not big enough. For instance, the challenge that online office competitors like Google apps and Zoho face is that their Switching Benefits over Microsoft Office are so slim that most of their users continue to use Office for the most part and use online spreadsheets for shared lists or some such occasional use case. Meanwhile Microsoft keeps making progress with Office Live.

Minimize Relearning

In recent years this has received a lot of attention. Design of software particularly has now entered an era where the bar on usability and aesthetics is getting higher and higher. This is partly because of enabling technologies like Javascript, AJAX and of course ubiquitous broadband. And partly because it needs to. It has become so easy to offer new software based services over the internet that, well, people are. In droves. When many services that do very similar things compete to keep users, user experience becomes very important.

Minimizing Relearning is not just about designing for better usability and aesthetics. There are other important considerations that are perhaps more strategic. Like not making it so different from what the user is using today, that they are totally lost. Or, holding off on introducing power user functionality to when a section of users are familiar enough with the simpler workflows and are ready for the power user functionality. And when you need to make the software more complex, layer the complexity so that a new user can still achieve simple tasks quickly. Many Web 2.0 companies do this really well. The poster child (if you don’t count Google) is perhaps 37signals.

The greatest design technology, will still leave some users looking for help for something or the other. When they do, they should be able to find answers to their questions quickly and in many different ways. A service that I use (and like immensely) called Wufoo has so many different ways of getting an answer to a question that is unlikely that anyone at the end of it will actually use the email support that is also available.

Performance

In Enterprise IT products were, and in some cases are still, bought based upon a comparison of features in presentations and marketing material. Here, having a feature is more important than how well it performs. But in software targeted at the individual, for personal use or for work, try before you buy has become so common that a technology marketer cannot hide a low performance feature.

Outlook 2003 could claim that it had a search feature, but one used it only under duress. Google Desktop changed that and Search became the natural way to find old emails. Now Outlook 2007 has better search, but Google Desktop and Spotlight on the Mac, are what users use even for searching email.

Integrating with peripherals

This one is important, but brings up the rear after Sacrifice and Performance. Sometimes, you won’t be able to integrate with peripherals even if you’d like to. Apple, for years, courted application software vendors to port software to the Macintosh platform. Some didn’t. Some did, but all new releases would be on Windows only and the Mac versions would follow after months.

Now Apple makes it easier to bypass this problem by allowing users to run Windows on the Mac. As momentum shifts to the Mac, application software vendors will automatically shift (or balance) allegiances.

Research and Trial

As I said in the last post, Research and Trial is a separate kind of Switching Cost. It is a component of the total Switching Cost, but in addition, it is something like an “investment”. Regardless of whether the switch happens or not, the individual has “sunk” in this cost. Also, a successful Research and Trial cuts through all the marketing hype and the fogs of the unknown usage patterns of each individual to uncover all the Switching Costs. What is still left uncovered becomes the Switching Risk. The higher it is the less likely is the individual to switch.

Thus it is important not only for the cost of Research and Trial to be low, it must appear to be low. Very often a potential user will not even go through the Research and Trial because it appears too costly in terms of time invested.

For tangible technology products, being able to touch and feel the product is very important. I remember how intrigued I was about the Segway a few years back. I read all the press about it, but nothing could beat the 30 second trial ride at the San Jose Tech Museum. Riding it was easy as pie. It’s another matter that I and a million other enthusiasts could never figure out when or where to use it.

In the world of software, free trials are the rule. But by itself that is not enough. One shouldn’t expect users to figure out how to use your product or even the purpose of it just by downloading your software and playing around with it. Most people don’t go through all the menus and screens just to figure out how it works. They want to know what it does and how it can help them in their jobs or their lives. And they are short on time.

Again 37signals and Wufoo do a great job here. They have Free Trials of course. But also product tours, video tutorials, FAQs, testimonials, forums…you can research their product any way you like.

These two posts turned out to be much longer than I thought they would. I hope I have done justice to the topic, at least what you might expect from a blog. But the downside of long posts is that you keep putting it off for when you have a stretch of free time from work and family commitments. In the future I’ll have to think about how to tackle deeper subjects – maybe break them into more posts.

Related posts:

1. Open Toolbox
2. Paper Problems

When writing with a fountain pen, the kind of paper you write on is very important. It has to be of a certain quality, otherwise the nib snags or the ink blots. I don’t believe you are supposed to write on both sides of the paper, but I do. So for me, the thickness and quality of the paper is even more important.

I do most of my writing when I am traveling – in meetings, on planes, on phone calls – whenever it is inconvenient to fire up the old laptop. So I need a light notebook.

Unfortunately, you don’t get light notebooks with high quality paper. I have tried Moleskine. Very high quality paper. Looks good. But with 192 pages and a hard bound cover, it adds many ounces to my already heavy laptop bag.

Last week I was in Mumbai. Before lunch with a friend we had some time and stepped into Rhythm House, a favourite haunt of ours when my wife and I lived in the city. I saw some notebooks on display. Most of them were thick with colored paper which weren’t interesting to me.

Then I saw this slim notebook, just 80 pages, with a cover that was made of craft paper. Good quality Very simply designed but with just a few stylistic touches to make it stand out. The price at Rs. 80 is a steal compared to the Moleskine prices.

I bought a notebook. The product is from Rubberband Products. There is a design studio, Ajay Shah Design Studio, behind it. Goes to show that good design can breath life into every day products that are almost commodities.

Now I’m in Chennai. I wish they had an outlet here. I would have stocked up before I left for the US.

No related posts.

One of the (many) problems with modern day drug discovery system is that it is driven completely by a template that provides no incentives to discover naturally found active ingredients with therapeutic properties. Discovering new drugs is an expensive process requiring tens of millions as investment before the drug can be commercially exploited. Most drug candidates don’t make it. If you amortize the cost of these failed drugs over the few successful ones, the costs multiply rapidly. The entire edifice of the pharma industry rests upon the ability of companies to successfully exploit a successful drug through patent protected pharmaceuticals. The problem with naturally found active ingredients is that a patient can get the cure without buying the pill.

I believe that there are many, many cures to diseases as well as ways to stay healthy (nutraceuticals) that can be found in natural substances. Ayurveda is entirely based upon finding remedies in natural substances rather than man made molecules. Unfortunately, to take Ayurveda from what some might call ritualistic mumbo jumbo to authentic medicine requires investment – to isolate active ingredients, do pharmacological testing and clinical trials. How does one justify this investment if at the end of it, the remedies will still be available freely?

Tough problem to crack. Somebody needs to come up with a business model that allows them to justify the required investment. I don’t think this business model can emerge in the developed countries where the powerful pharma industry will snuff it out. But in a country like India, there is still hope.

No related posts.

An individual can start and run a company all by herself. There is nothing new about that. What is however changing is just how much that company can achieve with a small team. A few individuals can create a company with millions of dollars in revenues and tens of millions of dollars of value.

The photo-sharing site flickr is one such example. Caterina Fake and Stewart Butterfield created what is today the leading photo-sharing service on the internet with just a few developers. It took in no venture capital and sold itself to Yahoo for an estimated $30-35 million.

An extreme case of a one-man company already looking at a billion dollar plus valuation is a site called Plenty Of Fish – an online dating site. They just hired their first employee – a customer service rep!

There is a long-term trend that is playing out, especially in certain sectors like IT, gaming, media and entertainment – entrepreneurs are able to go much further with very few employees and very little capital. What is common across all these sectors is that what they produce is an “information product” not physical goods and services. And what provides this leverage to innovation and talent is the availability of cheap, simple, pay-per-use technology and the internet as a low-cost channel for marketing and distribution. Open source software, Cloud Computing, viral internet videos and many other things are today changing the rules of the game in industries that produce information products. And this is just the beginning.

How will all this play out? Differently in different industries. The music industry in the west is in the early days of what could be cataclysmic change. The need for capital in the music industry was primarily for marketing and distribution. That need has come down to zero for well-known bands like Radiohead, who create their own buzz. Radiohead has decided to put up its new album for download, without any DRM at all. In an amazing twist, to download the album, you simply pay what you would like to pay for the songs. Even though you can download it for free, most people pay something (figure that out, Mr. Rational Economist).

Obviously, Radiohead isn’t stupid. They have a gameplan. They are betting that the economics of the music industry are better if you give away your music and sell your concerts high. Selling the music at a high price, on CDs and as digital music with DRM, is an exercise in futility. If it was just rogue websites you were fighting you might still be able to shut all of them down. But you just can’t win against peer-to-peer file sharing technologies like BitTorrent.

Radiohead isn’t the only mainstream band having second thoughts about the artist-label relationship in the current structure of the music industry. Madonna, recently signed up with Live Nation a concert producer for both concerts and albums. The deal is quite different from what Radiohead is doing here, but it all points to one thing – there’s going to be a new structure in the music industry emerging soon, and the balance of power is going to shift slowly but surely towards the artists.

In the software industry something similar should be expected. Hosting services, open source software, SaaS and outsourced services – all enable an innovator to think up something new and build it on the cheap. For a consumer internet business, marketing too requires innovative approaches rather than millions of dollars in TV advertising. Enterprise IT still requires capital to build a professional sales force, but even here travel is becoming less and less necessary. Webex type screen sharing technology makes the sales process more productive.

What all this means is that there has never been a time when the leverage to innovation and talent has been this high. A startup essentially is becoming a zero-distortion amplifier for an innovative idea. It thrives or dies on the merit of the idea and its implementation as a product. An innovator with an idea and the skills to bring it to life are all that it takes to make a successful large business.

Related posts:

1. What to do About Falling Music Sales
2. Piracy Pulling Down Music Sales

I got an invite for Joost and tried it out yesterday. It rocked.

Joost, for those who haven’t heard about it yet, is basically internet TV. Full screen, high(er) quality, mainstream TV content streamed to your computer over broad band. The guys behind it are Janus Friis and Niklas Zennström, the same duo that did Kazaa and Skype. With their backgrounds you have to take Joost seriously.

And it doesn’t disappoint. Yesterday, I downloaded the beta version of the client software and settled down to try it out. My verdict – this was vastly superior to any other video on the internet and ‘acceptable’ when compared to regular TV. Every program started with a few seconds of rickety video but once the buffering kicked-in, it was smooth sailing from there on.

The content was not great, but there is frenetic deal-making going on to bring in content. The user interface is slick and easy to figure out. Overall, I quite liked it. The video quality isn’t as good as TV (regular, not high-def) but the ‘anytime, anywhere’ advantage more than makes up for that.

Other commentators have found the video experience less than exciting. It could be because of some technical problems that Joost had, that have since been fixed. It could be that I am willing to settle for less in exchange for anytime, anywhere. Or it could be that in the Bay Area the P2P infrastructure offers many nodes in my near vicinity.

Joost runs largely on peer-to-peer technology infrastructure though it does us some server/CDN infrastructure as well. P2P technologies like BitTorrent work best for popular downloads that have peak download periods. That’s when their advantages over regular server/CDN infrastructure are most evident. On the other hand, they don’t do very well for ‘long-tail’ downloads. It would seem then that the user experience on Joost should improve, at least for popular programs, as they sign up more users.

If Joost becomes successful it can change the rules of the game in the television industry. Here are some observations on how its impact might be felt:

• Joost’s ‘anytime, anywhere’ benefit is far greater than what a DVR like TiVo can give you. In my house, there is practically no TV that is watched live except for the occasional NBA game. Everything is recorded on DVRs and watched later. There are millions of households like ours. Some of them will trade-off an inferior video experience in Joost for the luxury of not having to program recording. Or have accidents like this.
• We also watch some stuff on Comcast OnDemand, which unfortunately has very little programming. OnDemand, in concept, is pretty close to Joost but with far better quality. If OnDemand could crank up the content, it could probably cut Joost off at the pass. But current cable technology is probably going to slow them down if not make it impossible.
• Joost will feed on the global appetite for high quality TV programming. In this, it will compete against internet video, basically YouTube and its ilk, and will deliver a higher quality user experience for commercial programming (not user generated video).
• Joost has ads (what did you expect – free TV and no ads?). At this time they show about a minute of commercials every half an hour. These cannot be fast forwarded, unlike on a DVR or even OnDemand. And they cannot be ignored like text ads on YouTube. In fact because watching TV on a computer is a different setting than watching TV, I think these ads will receive more attention even compared to live TV ads. This is good news for advertisers.
• There is more good news for advertisers. Because Joost knows my profile (Male, 42, live in CA etc.) and the kinds of programs I watch, it can help advertisers direct more relevant ads to me. The ability to target ads combined with the greater attention paid by viewers to non-forwardable commercials should make advertisers very happy. Rates per ad served should be much higher. This will allow Joost to keep minutes of advertising low. It will also be better for consumers who are sick of broadcast ads that are not relevant (women’s fashion to men), are constantly repeated (how many times will you show me the same ad in a game?) and are so numerous they crowd out the real program.
• Studios should also be happy. Making their programming available ‘anytime, anywhere’ will cut down illegal downloads on P2P networks. And ultimately, anything that the advertisers like, the studios like.

Joost is a big play. There are big risks – will the technology hold up, will the networks and studios license their content. But a business model which works for the content owner, the advertiser and the viewer (just), is as good as it gets. With broadband connections around the world growing rapidly, Joost is playing to where the “puck is going to be.”

No related posts.

My interest in this episode is in connecting it with other recent developments in text analysis based algorithmic trading to see what this might augur for the future.

Algorithmic trading has been around for a while. From its early days when computers would look at arbitrage opportunities (between say an index and its underlying stocks) algorithmic trading has become very, very sophisticated on the quant side of things. Recently, the interest has now been shifting to text analysis of breaking news and opinion on the internet.

Reuters recently announced a product called Reuters NewsScope which analyzes news items as they are breaking and assigns them sentiment scores (good news/bad news). These sentiment scores and the associated tickers can then be fed into a computer which based upon pre-programmed rules can straightaway place trades. All this happens in milliseconds, well before human readers can read and act upon the news.

So what happens when a news flash like the one Engadget broke hits the blogosphere in a market full of “algos”? Within milliseconds (not six minutes) the stock will drop as the computers place their trades. This particular news was bad, but not life-threatening for Apple. But in other cases – say a pharma company’s blockbuster drug candidate fails the clinical trial – it will go all the way down, in pretty much the same time frame – milliseconds. If the news is false and planted, as it was in Apple’s case, seconds later, the bad guys are a good bit richer than they were.

This puts enormous responsibility on the shoulders of both established media as well as bloggers to verify authenticity of breaking news. The problem with this is that breaking news doesn’t stay “breaking” if somebody else breaks it first.

A very interesting conflict of interest here is that in a world where bloggers get paid on advertising which is directly proportional to eyeballs (unlike subscription based newspapers), the incentives are stacked in favour of “post first and verify later”. Unless, of course, they care for something called “reputation”.

Related posts:

1. Insider Trading