Commercial Trade Exchanges, Their Present Limitations and Potential Future

Commercial Trade Exchanges, Their Present Limitations and Potential Future

[This is a draft chapter for a forthcoming book. Draft of August 5, 2007]

By Thomas H. Greco, Jr.                  

Commercial trade exchanges, often called “barter exchanges,” provide services that enable business-to-business trading (1) outside of conventional marketing channels and, to some extent, (2) without to use of conventional money. These two elements together constitute the value proposition that is offered to trade exchange members (clients), and for which they pay sizeable cash fees.

This industry has been growing and developing over a period of more than three decades and has become a significant force in the global economy. According to the International Reciprocal Trade Association (IRTA), the hundreds of commercial trade exchanges operating in various parts of the world now collectively enable annually billions of dollars of sales between their members (Over 8.25 billion dollars in 2004), a figure that is growing at an estimated annual rate of 8 percent, which is significantly faster than the growth of GNP in most countries. IRTA further estimates that “over 300,000 business firms — most of them small businesses, but including a large and growing number of well-known larger firms — will use the services of commercial barter companies this year (2002).”

In the early days, many so-called “barter exchanges” sprung up, thrived for a season, and then passed from the scene. Most of those that failed were ill conceived and/or mismanaged, many being operated by entrepreneurs who had little understanding of the business and even fewer scruples. The industry has matured a great deal since then and those exchanges that remain are, for the most part, reasonably well run and profitable. But the industry seems to have reached a plateau, and there is a rising discontent that it is not thriving as it should. I believe that most of those who currently operate commercial “barter” exchanges have neither fully comprehended its main value proposition nor the enormity of its potential market. There is a great deal of complacency among those who have established exchanges that have achieved some moderate size and profitability, and they are reluctant to risk making any change in the way they do things. Further, there are some practices still widespread within the industry that have been limiting and counterproductive. In the following paragraphs I will offer an assessment of these limiting perceptions and practices and provide some recommendations that I consider necessary to the continued success of the commercial trade exchange industry, recommendations that, if followed, can enable it to achieve unprecedented levels of service and prosperity.

Here, below, is a summary of the limiting factors that pertain to current commercial trade exchange operations; these will be addressed in order:

1. Limited scale and scope of membership
   1. Inadequate number and diversity of member businesses.
   2. Limited geographic coverage.
   3. Failure to penetrate all levels of the supply chain (almost exclusive focus on recruiting members who operate at the retail level).

 

1. Failure to perceive and promote the real value proposition inherent in credit clearing services, which is the most distinctive feature of trade exchange operations, and over emphasis on the marketing advantages of membership.

 

1. Certain clauses that are commonly included in their membership agreements that result in conflicts of interest with their members and debasement of the value of their internal trade credits.

Limited Scope and Scale

The vast majority of commercial trade exchanges are small local operations that average between a few hundred to a little over one thousand members. In most cases, the bulk of the member businesses offer services or “soft goods” rather than “hard goods” like manufactures and commodities. Media, advertising, hospitality, tourism, and entertainment comprise a large portion of the offerings in many trade exchanges. These and other business lines that have prices that are negotiable rather than fixed and advertised are usually well represented.

Further, trade exchanges have been limited by their almost exclusive focus on the retail level of business-to-business trading. While retailers and service providers are the most readily available client prospects, the greatest potential lies in connecting suppliers and customers throughout all levels of the supply chain (More about this later).

Value Proposition

Trade exchange operators generally recognize that the main value propositions which they offer to their members consist of:

1. the competitive advantage of having privileged access to a group of potential new customers,
2. the active brokering of trades, by which they help their members to find customers for their offerings and suppliers of their needs and wants, and,
3. the ability to pay for purchases using internal trade credits instead of cash.

However, the emphasis has been primarily upon the marketing advantages represented by the first two of these rather than the financial advantages of having a cashless payment alternative and an interest-free or low-cost line of credit.

Many exchanges intentionally limit the number of members in a particular line of business that they will accept in order to assure them a competitive advantage. This makes sense if one sees the marketing advantages as the main value proposition provided to exchange members, but if the main value proposition of exchange membership is the cashless clearing of purchases and sales, then “the more the merrier.”  The value and usefulness of a credit clearing network, just as any other network, grows geometrically as the size of the network increases. Grounds for exclusion need to be carefully reconsidered. Credit clearing can work for everyone.

Operations and Agreements

Certain clauses that are commonly included in their membership agreements have jeopardized the viability of trade exchanges and retarded their growth. Specifically, these are clauses related to the trade exchange’s own trading account and its ability to participate as a member as well as a service provider. But, such a dual role can easily lead to serious conflicts of interest.

Trade exchange operators must avoid any possibility of conflicting with their clients’ (members’) interests. They must earn the trust of their clients and have a responsibility to not put themselves into competition with them. There are two major conflict-of-interest issues that have arisen in the management of a trade exchange. The first is called “cherry picking,” which is the ability of a trade exchange operator, based on its insider information and prior knowledge, to acquire the best offerings of its members before the other members even get to know about them.

The second derives from the “borrow and spend” clause that is typically contained in trade exchange membership agreements. This clause grants to the exchange account a virtually unlimited credit line that allows the exchange management to (1) out-compete other potential buyers in the system and (2) to spend beyond its means.

The resultant ballooning of debt in the system account results in the debasement of the value of the internal trade credits and the loss of confidence in the trade exchange management. Even if members are denied access to definitive information about the extent of these practices, their effects will be “felt” in the internal marketplace as trade credits become harder to spend. As a result, members may seek ways to differentiate their cash prices from their trade credit prices, or may require a blend of cash with trade credits when they sell something within the trade exchange.

How might these problems be remedied? I suggest that the first could be handled by limiting both WHAT the system can buy and WHEN the system can buy. The system should NOT be allowed to buy anything for the purpose of resale, but should be restricted to buying those goods and services that it commonly needs to conduct its business operations, i.e. to provide services to its members. Further, it should not make any purchase until the offering has been made generally available to the entire membership for some reasonable period of time.

With regard to the line of credit allocated to the system trading account, it should be determined on the basis of the same qualifying criteria as any other account, i.e., it should have no special privileged access to trade credit. Ideally, the credit allocation process should involve broader participation by the members and be based on objective criteria, primarily, the internal trade credit earning history of each account averaged over some reasonable period of time.

In regard to these practices, some trade exchanges are better managed than others, but the limitations proposed above need to be formally specified in the membership agreement. A draft of such a proposed membership agreement is provide in the Appendix. If exchange operators do not voluntarily discipline themselves, they will eventually see that discipline imposed on them from outside by government regulation. But, more importantly, by adopting these measures and making prospective members aware of them, I think they would gain a big competitive advantage over other trade exchange operators that are more closed and inclined to exploit their members. Exchange owners that subject themselves to such restrictions can still be active traders, and by the quality and volume of trading they do become living examples to their members of the advantages of cashless trading without risking debasement of their internal currency (trade credits). Industry trade associations, like the IRTA (International Reciprocal Trade Association), also can, and do, foster such standards of practice through their own certification and branding programs.

Thinking Outside the Box

I submit that the most important value proposition that trade exchanges can offer to their members is the cashless clearing of their transactions, that is, the operation of mechanisms that enable the members to use their sales to pay for their purchases. In accounting terms this means the use of their accounts receivable (A/R) to offset their accounts payable (A/P). The market for such clearing services is virtually unlimited and worldwide, but to tap that market it will be necessary for exchange operators to think outside of the conventional “box.” What are the necessary actions required to realize that potential?

The short answer to that is that credit clearing exchanges need to attract a much larger, more diverse membership base. As pointed out above, the value and usefulness of a credit clearing network, grows geometrically as the size of the network increases. The obvious way of achieving that is to make joining the exchange easy and inexpensive. Existing pricing schedules for trade exchange services needs to be completely reviewed and revised. Trade exchange operators need to find ways of reducing the costs of participation in order to make membership more attractive.

It is said that “nothing succeeds like success,” and the challenge is to find the right combination of services and implementation strategies to get the success spiral started. During the early stages, it has been appropriate for trade exchanges to emphasize “competitive advantage” and brokering services, but as the size and diversity of the network is increased, the financial advantages of membership become more significant and obvious.

Another aspect of member diversity has to do with the supply chain. The membership in a clearing exchange must include ALL LEVELS OF THE SUPPLY CHAIN — not only retailers, but also wholesalers, manufacturers, basic commodity producers, and ultimately, independent professional service providers and employees. Trade exchange operators must actively solicit membership down through the supply chain. If a trade exchange has a retail member, it should try to recruit the wholesale companies that supply that retail member, then try to recruit the manufacturing companies that supply those wholesalers, then try to recruit the basic commodity producers that supply those manufacturers, and so on, down through the supply chain until the loop is eventually closed by recruiting the employees/customers who are supplied by the retailers.

This may take a trade exchange far afield from its local base of operations, since many suppliers will not be located within the local area in which the trade exchange operates. That implies the need for exchanges to operate over a wider geographical area, or perhaps more importantly, to have effective reciprocity agreements with other trade exchanges in other regions. The vision of a global network of independent trade exchanges that could result from such agreements is an attractive one.

Finally, each member of a trade exchange should be allocated an interest-free line of credit because it is these lines of credit that constitute the “money supply” within a credit clearing circle. It is necessary, at any given time, for some members’ balances to be negative (in debit) in order for other members’ balances to be positive (in credit), and the total of all account debits should always equal the total of all account credits, making the overall system balance equal to zero. The interest-free feature follows the usual and long-standing business practice of trading on “open account” and is crucial in tapping the huge market for cashless clearing services. System revenues should be obtained on a fee-for-service basis, relying mainly on transaction fees, brokerage fees, advertising revenues, and risk premiums.

The issues that are raised in regard to lines of credit are (1) how to determine an appropriate debit limit for each account, (2) how to assure performance of contract on each account, and (3) how to cover the inevitable “bad debt” losses.

Conventional business, especially banking, has answers for all of these questions. Those answers could be directly applied, but some are in need of improvement so they should be looked at anew. The detailed consideration of each of these questions is beyond the purpose of this book, so I will simply summarize my own conclusions.

On the first question, a rule of thumb that has been derived from past banking experience, says that a reasonable limit for a line of credit, which can be looked at as the allowable extent of the credit or currency issuing power, is that it should be no more than the expected trade credit revenue for that account over about a three month period. Thus, if a member has demonstrated the capacity to earn 10,000 trade credits a month, that account should be allowed to go negative to the extent of 30,000 credits. These lines of credit should be regularly adjusted based on actual performance. It is also prudent to consider the other indebtedness and overall financial condition of each member in arriving at their credit lines. Initial allocations of credit lines in a new start-up trade exchange should, however, be more modest than the maximum amounts given by the above rule of thumb. The suggestion is to start slowly to assure that necessary adjustments can be made and that problems do not become overwhelming.

With regard to the second question, there is a trade-off between stringency in preventing losses through defaults, and the ease of credit creation that is necessary in maximizing the amount of desirable trading that can be mediated within the trade exchange or credit clearing circle. On the side of the former, one might require the pledge of some valuable assets as collateral. The value of the collateral should provide only surety of contract and not be used as the basis for deciding the amount of the credit line allocated to that account. The reason for this is a solid banking principle that says that only goods that are in the market or on their way to market should be used as the basis for issuing currency (and trade credits can be considered to be an internal currency).

If credit is created in proportion to the value of, say, real estate that is pledged as collateral, as is often done in conventional banking, that will likely be inflationary, since the real estate is not going to market to be sold, leaving the new credits to compete with the existing stock of credits for the goods and services that are in the market.

With respect to the charges that trade exchanges impose on their members, it is very important to distinguish between “interest” and “fees.” All trade exchange revenues should consist of “fees for services” rather than “interest” on account balances. The bulk of system revues will thus derive from those members who obtain the greatest benefit from their membership, which are those who are able to clear more of their transactions through the system, so fees charged on transaction services are quite appropriate. They cover the costs of operating the clearing system, including a return to the exchange operators and owners. An insurance fee applied to balances is also appropriate in order to establish an “insurance fund” against which defaults can be written off. This fee should be only as large as needed to cover prospective bad debt losses, and should not be allowed to grow and morph into an interest charge. Any resulting buildup in the amount of the insurance fund beyond the amount of reasonably expected losses, should be periodically returned to the members.

A further important feature is transparency in the operation of the exchange. Full and timely disclosure is necessary for participants to evaluate the soundness of the operation and the value of their trade credits at any point in time.

An Eventual Cashless Trading Network

Trade exchanges must eventually associate into a network that will enable cross-system trading. This will add tremendous value for their respective members. But any network requires adherence to standards. The electricity grid is one good example. Any individual or company is at liberty to produce electricity in any form it wishes for its own use or distribution within it local isolated domain. But if it wishes to connect to the power grid, it must conform to the established grid standards. In North America, for example, the electricity one produces must be 110 volts, 60 cycle, alternating current. Nothing else is acceptable. Standards need not be imposed by any political authority, but can be worked out by voluntary agreement among those players who have the greatest interest in the development and use of the network.

So, such a network of credit clearing exchanges must be founded upon standard procedures, protocols, and ethical standards that each member exchange agrees to adhere to as a condition of participation in the network. Primary among these would be the procedures for allocating credit lines to members and the way in which the system account is managed. By way of comparison, one might consider the conditions that apply in order for any particular bank to issue transaction cards under the VISA or MasterCard brands. If a bank wishes to issue cards under one of those brands, it must do it in a way specified by the entity that manages that brand.

Cashless payment based upon direct credit clearing amongst buyers and sellers is a revolutionary innovation in reciprocal that might be compared in importance to the development of aviation. The achievement of manned powered flight has in just a few decades brought drastic changes in the way we live our lives. Cashless trading has, over the past 30 years, gone through a stage of experimentation, trial and error, and small scale application similar to the stage of development of aviation one hundred years ago. The principles of credit and exchange are now better understood, and as they are more effectively applied, the tremendous possibilities will become generally apparent, enormous amounts of resources will be allocated to their further development and implementation, and the world will be forever changed.

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