DM University: Arbitrage
If you’ve ever taken an economics class, in all likelihood you’ve come across the term, arbitrage. If you paid attention at all, you’d have learned that arbitrage is the practice of taking advantage of the state of imbalance between two or more market prices for a given product (e.g. currency, apples, leads/RFPs). Essentially, arbitrage is exploiting that imbalance or discrepancy to gain a profit.
If, for example, Google stock can be purchased in New York for $389 a share and sold in London at $390, a keen arbitrageur may simultaneously purchase Google stock here and sell the same amount in London, making a nice profit of $1 a share, minus expenses (e.g. transaction costs). While arbitrage is generally associated with trading financial instruments, such as bonds, stocks, derivatives, and currencies, it can also be applied to certain practices within the online advertising realm.
Affiliates, performance based ad networks, and lead aggregators alike, engaged (whether directly or indirectly) in the practice of matching consumer interests to online ads, are in essence, arbitraging. Let’s take for instance, a lead aggregator who has an interest in pushing a CPA product, such as EZ Mortgages (a fictional mortgage product). By promoting EZ Mortgages, the lead aggregator will earn $10 per lead in the backend from merchants, in this case from the mortgage lenders, seeking leads (i.e. contact info of prospective homebuyers).
At the same time, the lead aggregator will pay out $20 to publishers for each lead they can generate. Of course, the lead aggregator won’t get very far by paying out more per lead than they earn from distributing it to mortgage lenders. Spending $20 to earn $10 isn’t a sustainable or recommended strategy. Fortunately, for the lead aggregator, such an imbalance in payouts creates an arbitrage opportunity.
For example, let’s say that the majority of users coming through the path flow will, on average, submit a lead (via a one form submission) to three various mortgage lenders. If such is the case, on average the lead aggregator will earn $30 ($10 payout to the lead aggregator x 3 lenders) minus $20 (payout to publisher per generated lead). Thus, the lead aggregator is banking that users will submit leads to at least two different lenders, so that at the very least, it can break even. If the user submits to more than two lenders, the lead aggregator earns a profit and is “in the money”. Needless to say, a lead aggregator interested in maintaining profitability or staying out of the red would find it quite advantageous in figuring out the average amount of leads generated by users coming through the path flow.
Lead aggregators aren’t the only entities in the online advertising industry engaged in the game of arbitrage. Let’s take for instance, affiliates who profit from the state of imbalance that stems from the disparity between the CPC and CPA costs in converting a given offer. Search engines such as Google and Yahoo employ an auction style bidding system to work out the price of a word on a CPC basis, so whenever a user clicks, the advertiser pays. When affiliates arbitrage for merchants, affiliates pay a CPC to the search engines, while the merchants pay a CPA to affiliates for every sale that is made by their efforts. Affiliates assume the risk for merchants by buying ads on a CPC basis, while being paid on a CPA basis.
Thus, if the affiliate intends to make a profit, it must earn more on a CPA basis (paid by merchants), than it spends on a CPC basis (paid to search engines). Affiliates spend a good amount of resources on testing and optimizing their ads, both of which the merchant does not necessarily have to deal with. By utilizing a legion of arbitrage affiliates, merchants significantly reduce the risks and costs for their online advertising and search engine campaigns.
In 2005, search engines such as Google and Yahoo, implemented changes that have notably altered this game of arbitrage played by affiliates and merchants alike. In an attempt to eliminate duplicate listings and improve relevancy for their users, Google’s affiliate policy allows only one ad per search query for affiliates and parent companies sharing the same website address to display. Yahoo Search Marketing enforces “direct path” requirements where the website listing must be the advertisers own site.
Consequently, merchants seeking low cost channels of customer acquisition via arbitrage must now encourage their affiliates to be more creative in delivering customers. Affiliates must now allocate more resources and time in working with merchants, as well as building unique landing pages. Presumably, this may have a considerable effect on the low costs and time efficiency required to make arbitrage work, negatively affecting the bottom line of arbitrage-based affiliate programs.
While affiliates may profit from the discrepancy between CPC and CPA costs in converting certain offers, performance based ad networks likewise, may profit from the differences between CPM vs. CPA costs. Many ad networks for instance, buy media on one price point in the form of CPM banners, and then strategize on how to earn twofold of whatever they paid by showing the best rotation of CPA ads. Established ad networks can leverage their size in buying high volumes of media, which typically warrants discounts or exclusive rates, while also doing enough volume to warrant a more attractive CPA.
