What Capital Markets Already Know About Collaborative Consumption

by Gint Rudis
February 22, 2013

For all you MBAs, CFAs, CPAs, investment bankers, and finance professionals, the Capital Market Line is not a foreign term.  For the rest of us mortals, the capital market line is a very powerful concept with deep implications for the collaborative consumption economy.  It is an obscure, esoteric idea whose Wikipedia page (http://en.wikipedia.org/wiki/Capital_market_line) doesn’t even really explain what it is unless you ALREADY have a finance background.  For our purposes, consider the capital market line this: it is a qualitative model that captures the tradeoff investors experience between risk and return.  The theory states that the more risk an investor is willing to bear, the higher the return they should expect to receive.  Or, in laymen’s terms, “no guts, no glory.”

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What does this mean for collaborative consumption?

Many new startups in the collaborative consumption space rely on a 2-sided P2P market.  That is, they need both the supply of something to be met by peers, as well as the demand.  Airbnb needs people to put their apartments up for rent; TaskRabbit needs rabbits with free time; Zopa needs people with money to lend, RelayRides needs people with cars, etc.  The difficulty in getting a supply into the marketplace in this manner is incentivization.  Why would anyone put their spare bedroom up for rent on Airbnb?  The simple answer is money.  But how much money?  Well, it depends.  It depends on what?  It depends on where somebody falls on the capital market line.  A host on Airbnb must feel as though the money they receive from the rental is sufficient to compensate them for the risk of letting a (near) stranger into their house.  For some people, that’s $25 a night or less, but other hosts charge $500/nt +. 

Now, much of the pricing has to do with the size and quality of the accommodations.  Obviously the Park Avenue penthouse is going to be more expensive than the couch in someone’s den.  But it’s really the same underlying dynamic still at play; the theoretical downside of someone damaging your Park Avenue penthouse is much worse than that same damage visited upon your exurban row house.  Owners must be sufficiently compensated for the risks they bear.

 

How do you quantify the risk?

That’s a tricky question.  And the answer varies widely by individual.  P2P marketplaces are still just that: marketplaces.  And in a marketplace, the price of something is not REALLY dictated by the seller; it is dictated by the market.  If an Airbnb host decides that they are willing bear the risk of renting out their studio apartment in Peoria, but in exchange they require $500/nt in compensation, they won’t get very many bookings.  When comparable apartments can be had for $50/nt or less, the market is dictating the going rate and, subsequently, what the host can reasonably expect to get for their apartment.  Now it is up to the host to decide: given the risk, and given the compensation, am I willing to participate in this transaction?  Do I want to risk my apartment for ~$50/nt?  If the answer is no, then the person can try to charge a little bit more, but more than likely, will not become a participant in this market.  If the answer is yes, then the host is effectively saying “I fall on a point on the capital market line for which $50/nt is acceptable compensation for the risk I bear in renting out my apartment.”

 

The trust adjustment

OK, so let’s say our theoretical host in Peoria has realized that $500/nt was indeed a little steep for his studio and, after looking at the market, he is willing to bear the risk of letting a stranger stay there for the market rate of $50/nt.  For the sake of this exercise, let’s assign numerical values to his risk, as well as his reward.  In this example, we are saying he is willing to let a complete stranger (we’ll assign a complete stranger a risk factor of 10 out of 10) stay in his apartment for $50.  So if the risk factor is 10, the host’s required return is $50.  Now let’s say that it’s NOT a complete stranger who wants to come stay.  In fact, let’s say it’s the host’s mother.  Let’s assign her a risk factor of 1/10 (she is, after all, a loving mother who is more likely to clean and vacuum the apartment than trash it).  Is the host going to require the same level of return from his own mother?  Is he going to charge her at all?  Maybe.  But probably not.  And if he does, he certainly isn’t bearing the same risk as letting a complete stranger stay in his apartment, so he shouldn’t require as high a return, if any.

In reality, assume a spectrum of trust with a complete stranger on one end and someone’s own mother on the other end.  Trust is the primary determinant of risk in this marketplace.  Theoretically, the more you know and trust someone, the lesser the risk they pose.  So if our theoretical host requires $50/nt from a stranger with a risk factor of 10 and $0/nt from his mother who is no risk at all, he will likely put everyone else somewhere in between.  As Rachel Botsman speaks about so eloquently in her TED talk titled “The Currency of the New Economy is Trust” (http://www.ted.com/talks/rachel_botsman_the_currency_of_the_new_economy_is_trust.html), people can go from being complete strangers with risk factors of 10 to “near” strangers; people who have profiles that contain accurate personal information, photos, and reviews from other hosts and travelers.  “Near” strangers, through their previously established credibility, may only warrant a risk factor of 8, or even 5.  Now our host sees that he never need bear someone with a risk factor of 10; he can limit rentals to only those he judges less risky.  Perhaps if he was unwilling to rent his studio for $50/nt to a risk 10, he WOULD be willing to rent for $50/nt to a risk 7.  Suddenly, he has found an acceptable place on the capital market line at which he feels sufficiently compensated for the risk he bears.

 

The dynamics of T.R.I (Trust, Risk, Incentive)

In the new economy of sharing, collaborative consumption, and P2P marketplaces, this slightly novel dynamic of T.R.I (Trust, Risk, Incentive) emerges.  And I do really mean SLIGHTLY novel.  The dynamics of risk and incentive (or risk and return, or risk and reward, depending on your preferred nomenclature) have long been established, understood, modeled endlessly, quantified, studied, studied some more, and implemented across the financial as well as all other industries ad infinitum.  The introduction of trust into the equation is the slightly novel part.  Again, trust is the primary determinant of risk in this marketplace.  While trust is NOT the same as risk and it does not completely encompass all the risks (even your own mother may accidentally burn your house down), much of the risk of P2P transactions can be assessed, analyzed, and even mitigated based on the trust upon which the transaction is entered into.

“Buyers” in the new economy must realize that their reputation and trustworthiness dictate where they fall on the capita market line of Risk v. Reward and being better transactors makes them less risky, which in turn gives them additional opportunities to transact more frequently and possibly under more advantageous terms.

“Sellers” in the new economy must recognize the risks they bear, determine the incentive they require in exchange for bearing those risks, and determine if they are in line with the marketplace.  If not, sellers need to be content receiving less of an incentive or bearing more risk.

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As P2P marketplaces become more and more efficient, they begin to look more and more like other efficient markets.  The modern capital market is one of, if not the most efficient markets ever created in the history of humanity.  Applying some of the lessons we have already learned through capital markets to make P2P marketplaces as efficient and well-functioning has hugely powerful implications and can help catapult the collaborative consumption movement into the mainstream.

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