What does it take to create a market?

Joel Podolny: In reading about the markets all of you have been associated with creating, I've been impressed by the degree to which there seems to be a very strong vision that each of you has about what the market will look like and what role the market can play in, for lack of a better way to say it, making the world a better place. Is vision that central to the way you think about it? What do you do to move from vision to reality?

Rob Glaser: I'm happy to start. One of the reasons that the markets are interesting is because of the interaction between the role of vision and the role of pragmatic reality. I think that, if you don't have a vision, unless you want to be the proverbial "monkeys typing Shakespeare," you're unlikely to actually try something very different from what's been tried before. But the market system that we have, certainly in entrepreneurial cultures, actually subjects you fairly early on to a feedback loop that causes you to understand, first, whether the unsated need or the opportunity to create a new compelling experience that you thought was there is actually there. And if it isn't, then obviously you aren't very likely to create a market. If it is there, you get a set of feedback as to what the likely economic structure is going to be, which in my experience in the technology realm, is almost always different in the specific from what you think it will be. You create a good business if it turns out that the characteristics of the market that actually develops are favorable. And they may end up being more favorable than you expected. To me, the prime examples of that are eBay and Google, which were involved in creating new technology that ended up being associated with massively, explosively large markets. But if it turns out that the market is a lousy market, you can end up having launched a revolution but being a catalytic element sitting at the bottom of the glass, rather than a participant in that market.

So the role of vision is phenomenally important in getting things going. Then the reality of how the economic value chain develops is often quite different from the concept or the vision that started things off.

Richard Sandor: From my point of view, I distinguish between an institutional framework and a new product. In our case, it required both setting up a new exchange, and that has all kinds of execution risks, etc.; a new spot market, which has regulatory implications; and a new futures exchange. Then there is the separate question of a new product.

So I would bifurcate it into issues of a) new products, and b) what is the framework for the introduction of those new products? Does it require, as with eBay, just simply a technology, or does it require some kind of institution building, such as exchanges? Very often we in the economics profession assume there's a market. Really, the big challenge is the execution and building of that market, which involves a whole range of players and disciplines including trade associations, accounting, and legal, as well as educating the press and academics, and building human capital — all of those things. So I have a similar viewpoint as Rob's, but I think there's added institution building that's critical.

Bob Shiller: I'll launch off on the same question. For me, a vision — of course I'm an academic — comes from various theories that have the potential to improve human welfare, but have a long way to go. I'm thinking, first of all, of basic economic theory and the idea that there are non-traded goods and the welfare implications of that. Going beyond that, risk management theory tells us that markets for risk are fundamentally important. And beyond that, to agency theory, which is a theory of how to motivate people and which can be combined with risk management theory. So if you have a risky and uncertain environment, how do you incentivize people to do good work? And then, beyond that, there's behavioral economics, which talks about the real human condition and why some of these theories are difficult to bring to fruition.

All those theories, to me, represent the real vision that I have, and that many of us have, for improving the world. What these give us is a powerful technology for improving human welfare. And that is an exciting mission, I think, that people involved in the creation of markets have. It's not like developing a cure for cancer, because we don't have all the grateful people who've benefited in a concentrated way. The benefits are spread out over the world. But I think it's in a similar direction of importance.
Podolny: Bob just alluded to the importance of theory in laying the foundation for his vision. Rob, where do you get your vision from? Is it the theory you learned when you were in school?

Glaser: Certainly some elements of it. I have a partial academic background in economics. I may be a babe in the woods compared to the distinguished other members of this group, but I certainly developed a point of view in thinking about certain concepts. Game theory is one that I've found myself applying frequently. And when we launched RealAudio and invented internet streaming, there was this technological underpinning, which was the belief that the digitization of media was an inexorable trend, and once there was a standard dial tone, an interconnectivity method for all of the digital devices in the world, which I came fairly early, I guess, to believe was going to be IP, or the Internet Protocol, that there would be an inexorable trend towards more and more media flowing over that protocol, connecting more and more consumers in more and more ways, and that there was a great opportunity for us to build some of the foundation technology that made that delivery possible, and then to start to build some of the consumer services that would be enabled by that.

How I got to specialize in that has to do with the field that I was in, professionally, and the work I did for about 10 years before starting RealNetworks, as well as personal interest. I mean, I started a radio station in high school. At Yale, I was editor of a newspaper. So I was always interested in media, as well as having an interest in economics and also having a technical interest in computer science. So it was something that combined a set of things that I was interested in, and that I was trained for. And then it turned out that the timing in which that digital dial tone became a technical and then a commercial reality happened to be consistent with when I was setting out to start what became RealNetworks.

Luck, particularly as pertains to timing, played a tremendous role. The difference between being too early and too late to enter into a new area as a start-up can be measured in a small number of years. A part of the vision was seeing that there was an opportunity that looked to me like it was just over one or two hills, as opposed to five thousand miles away.

Podolny: Richard, can I ask you to elaborate a bit on the institution building that you say needs to be done to make the vision a reality? On a day-to-day basis, how much of your time is spent on that activity?

Sandor: Sure. In the execution of this idea, the Chicago Climate Exchange, the first work we did was at the Rio Summit in '92. And the first really active notion of a pilot market began in '95, with a joint activity with the UN. So it started with the notion — which we accept as academics, but it really was not widely accepted — that you could get around problems of externalities through trading a new secondary good, and that is the right to emit. That required an enormous amount of education, for policy makers, for industry, as well as accountants and lawyers. It also required doing some pilot trades, doing structured finance. We represented the Salish and Kootenai Tribes and we developed a structured financial product where we gave them cash for the 80-year accumulated carbon that would be sequestered in a reforestation project they were undertaking, and then we sold the note to some investors. We securitized a rainforest in Costa Rica. We had to get the Costa Rican government to understand what it was. We had to educate the investors.

Then, after all of that, you get policy makers on board. You get industrial concerns on board. You need to also get academics on board, so that they understand what it means to have the right to emit. You know, sometimes I laugh. I think I'm like a lounge act. I've probably given a thousand talks. In the case of interest rate futures, I was on the rubber-chicken dinner circuit with savings and loans and industry groups across the country.

In my case, it is a 10-year institution-building process. The creation of the idea is only the first step. We probably spend 90% of our time, or 95%, on the execution. I take a Schumpeterian view of this, in that we can divide the process into three components: invention, that is coming up with the novel idea; innovation, the commercialization of it; and then the diffusion or replication process. The invention component is 5 to 10%. The innovation, the commercialization of the idea, which requires a lot of details, is probably 70%. The replication or the diffusion or the imitative aspect of it takes the balance.

We have more ideas than we have the capability to implement. Ideas are not as scarce a resource, both financially and from the human-capital perspective, as the ability to execute. If you take a look at futures contracts and things like that, 90% of them fail. It's not that they're bad ideas. They're poorly executed. I've designed some real failures. In some of the cases, it was because the timing was wrong. In some cases, like a futures contract I developed in the 1990s to help insure insurers against catastrophic losses from severe weather and other natural events, I think there were execution problems. I couldn't get the exchanges to focus on a new product. In this case, it was the Board of Trade. I just couldn't shake them into looking at devoting the resources necessary to launch a new product. Here's an example of a critical institutional framework: The exchange didn't have the resources to go around to the state insurance commissioners and convince them to treat risk-transfer mechanisms on the exchange in a similar way to reinsurance. The result was that for insurance companies to use these contracts, either hurricane options or earthquake options, they had to go in the 5% basket on the assets side. That limited its use. It was inferior to a reinsurance product, although it served the exact same purpose. As opposed to reinsurance being treated as capital, this was treated as a speculative asset. That alone was enough to kill it.

Those are the kinds of details we focus on, because if you don't get that right, no matter how good the idea is, it won't succeed.

Podolny: Bob, as you think about your experience with the Case-Shiller Home Price Indices, do Richard's comments on institution building resonate with you?

Shiller: Richard's story was interesting. It goes back in time just about as far as mine does. He said 1992, is that what you said, Richard?

Sandor: Yes, that was the carbon.

Shiller: I first started with an SOM student, Allan Weiss, and Karl Case from Wellesley College in 1990. We were traveling around to the futures exchanges, trying to get a home-price futures market started.

Sandor: I think that this is a critical point. I don't mean to interrupt, Bob, but I think that Bob and I experienced the same sort of thing. This is a long process. It just is not, "Boom! It happens." I'd be curious to hear everybody's viewpoint on a timeline on invention.

Glaser: My timeline is, we first created the prototype for what became RealAudio in the summer of 1994. One of the big differences between, let's say, non-commercial entrepreneurship versus commercial entrepreneurship is, typically, if you have commercial entrepreneurship, you assemble venture capital or whatever kind of risk capital for a particular purpose that's looking for a return over, let's say, a three- or five-year period. So for a given enterprise, the fuse for how long it is between the time that you start investing serious money in the idea and the time that the idea has to demonstrate significant signs of working so you can raise additional capital, if more is needed, or gain profitability, if you've gotten to that point, is about a three- to five-year fuse per enterprise. You can have an idea that's in the backwater for a long time, and there'll be a trail of carnage of companies that have started too soon, or that didn't start with the right mix of bootstrap approaches.

That's an important factor in looking at these things. The role of the bootstrap strategy, I think, is extremely important, because you need something that shows enough of a spark that you can get other people interested in participating — be it the other people that are necessary to fund the venture to the next scale or be it the customers that are necessary to create the economics associated with the development of the new market.

In my view, the combination of how long it takes to build these things and the role of bootstrap strategy is quite a tight feedback loop. If you are in the wilderness, trying to get people excited about an idea, you can have a relatively long period of time when you're doing that. But in the commercial world, most ventures are either on a path to success or on the scrap heap within a three- to five-year period from launch.

Sandor: Bob, how long did it take you? I'd love to hear about the inventive process.

Shiller: Well, we started in 1990. I wrote a book in 1993 called Macro Markets. We started out producing real-estate price indices at a company called Case Shiller Weiss. Our initial thought was to create futures markets, but what happened is we did a kind of switching, which I think is actually common in entrepreneurship. You start with a grand idea, and it creates a fertility of imagination that produces a smaller idea that works and keeps paying the bills.

So what we produced was price indices and automated valuation models, which we were doing in the 1990s. That kind of distracted us from our mission, because we now had a business that was going. It took some courage, but Allan Weiss, my partner, called me up, it was around the late 1990s, and he said, "I think we have to sell this business, because it's just becoming day-to-day, and it's distracting us from our bigger mission." So we ended up doing that and getting back into it. But over that whole period, I was involved in academic research. I wrote another book in 2003, called New Financial Order. And all this was a long process for me of thinking and understanding and talking to people.

Rob was talking about how most companies make it or don't in three to five years. I think maybe that's true, but this goes beyond a company. This is a personal, lifetime mission. We've discovered in our business that we tend to attract people who have a sense of mission in their careers. And we have attracted as employees — tell me if this is true for you as well — people who are really not just in it for the money, people who are excited by new ideas.

Sandor: I want to throw in a couple of things which ratify your experience. Maybe we're coming to a common thread. Certainly on that last point. We've got a bunch of zealots, here. I mean, they are 24/7, total focus, believe that markets can solve social and environmental problems. They're people who either after 9/11 became disenchanted with the world that they were living in and sought to do something differently, or coming out of a PhD program, they're interested in problems of water and endangered species, and things like that.

The second thing, which I find really fun, was the notion of a big idea and a little idea, and I think there's ratification if we study markets. The first interest-rate derivative that was started was Ginnie Mae futures contracts. But, in fact, the big idea was the long-term bond. So you had this vision. You implemented something you could, but ultimately, the pot of gold at the end of the rainbow was the Treasury complex. The first short-term interest-rate futures contract was on the Treasury bill, but the real pot at the end of the rainbow was eurodollars.

So in almost all of the invention and innovation that has occurred, at least in the derivatives market, the first product launched was never the mother of the complex. The mother of the complex came secondarily. People launched things that could work, and they preceded the dream.

Glaser: I think both of those points connect up with my commercial experiences. The first is the role of that messianic zeal of the group of true believers who are absolutely convinced that they are on to something that is important and that the world doesn't yet understand. They have a mission, both to bring that to life as a positive societal development, and then also, because they are converted, they want to convert the rest of the world. That sense of mission is an incredibly important element.

Then the notion that the first product isn't always the one that is the full embodiment. Our experience with that was when we started with streaming audio in 1995. We knew that, over time, video would be more important, but that the characteristics of the internet at the time, and the ways that people connected to the internet, particularly in terms of bandwidth, were not going to be good enough to make video good. Rather than doing a lousy job with video and audio, we decided, "Let's do a good job with, first, voice audio and then music audio, and then let's get to video," which we started two years later. That turned out to be early to video, which has only exploded on the internet in the last two or three years.

I think of a phrase that a guy I knew used to describe the original Macintosh computer. He called it "good enough to criticize." By that he meant, and I mean, that it was good enough that you could see the vision inside it, and you could understand why it was so valuable, and why it was so important, but it wasn't necessarily good enough to be the thing that would drive the masses and create the mainstream phenomenon. So I think one of the essential elements in creating new markets is to create that first product that is at least good enough to criticize.

Sandor: That's exactly the case in organized derivatives markets, whether it's the CBOE or the Board of Trade or the CME. It's got to get some gravitas so that the interest is maintained and people get the vision.

Shiller: When you put products out there that are not perfect, of course, you invite competition. That's a good thing, overall, but it creates anxiety. So you may have a core idea which is very good, and since you can't quite get the details right, you could become something for someone else to target and then improve some of the details. Then they could sweep you away. But that's the challenge of business life. The companies come and go, but people survive.

Glaser: You want to make sure that you haven't just played the catalyst role and set somebody else up to drive the commercial opportunity. When you look at the food chain between small, start-up companies and some of the larger companies that are not, typically, first movers, but that are poised to pounce in because they have structural assets that are relevant, that plays out all the time, and creates one of the dilemmas that entrepreneurs often face as a market is exploding. Do they want to sell out at that stage in the market, and take whatever gains are available to them, or do they want to ride independently?

It's interesting. In a given market, there's always a lot of speculation. In our industry, famously, YouTube sold out to Google for a very, very large amount of money, which I think was the right call for them, given the litigation risks that they faced in that business and the large amount of money that Google was willing to throw at them, because Google has such a rich — whether it's frothy or not, we'll see in the fullness of time — but a very rich valuation. And so Google was willing to pay what amounted to $1.7 billion, and rode up to about $2 billion, for a company that probably had about $10 or $15 million of paid-in capital at the time.

Sandor: If we take a look at industrial R&D, it follows the pattern of Google. Most big firms don't come up with the big inventions. There's lots of case studies in industrial organization which suggest that they buy rather than invent internally. In the case of financial know-how and R&D, as is the case with Bob, it's being outsourced. As a matter of fact, since 1982 or so, there have been no new products in the Chicago exchanges. No basic inventions, only improvement inventions. There is a role for inventors outside of the system for either their products to be licensed or, ultimately, to be bought up by larger institutions. The inventive activity isn't residing within the large institutions.

Glaser: Although I think that is true in general terms, the classic saying that big companies can't invent and only the small companies can sort of ignores the fact that small companies are subject to a kind of Darwinian efficiency. Around the time that YouTube was started, there were tens of companies that were doing what YouTube did, and 99% of them people never heard of. So Google was allowed to use the sifting of the market to pick the winner. When big companies have their own intrapreneurial activity, even if you just assume that the intrapreneurial activity has no better or worse a batting average than the average entrepreneur — which may be a good assumption, maybe not — it would still only be, in any given market opportunity, a one-in-a-hundred chance that the intrapreneurial one would work. The bias toward innovation coming from small companies has to do with the fact that the creative spark to try to figure out how to make the idea bootstrap is not something where the massive scale of the large companies necessarily helps.

Podolny: One of the topics we touched on, early on, was the issue of the time that's required. Rob, the phrase you used was "time in the wilderness," and you pointed out that once you're out of the wilderness, there's a relatively short time-horizon that one has to make something happen. For these products or creations that are bringing about markets, and aren't just products that fit incrementally into another set of offerings, within a market — if one issue is time, another issue seems to me to be timing. How sensitive are you to the set of developments that are going on, simultaneously, that allow for a particular manifestation of the market? If I think about, for example, the way RealNetworks's vision is developing now, and this phrase I've heard from you, "celestial jukebox in the sky," you are very much trying to integrate what's going on with wireless devices and phones. And Bob, when I think about where the housing market is now, versus where it was 15 or 20 years ago, what does that imply for what you're trying to create? I mean, how much is timing a central issue that you have to be sensitive to in how you move from the vision to the details?

Glaser: Timing is crucial. I would differentiate between start-ups and scale organizations for a couple of reasons: One, in the case of the start-up companies, as I mentioned earlier in the conversation, you have a short fuse, because you don't have, typically, an existing, sustaining business to fall back on. You have a plan that implies a certain amount of capital needed, and you may be able to go back and get more capital, but typically only if you're demonstrating progress — both technological progress and commercial progress — against that plan. So there's definitely this powerful sense of urgency associated with that model. In a scale commercial entity, you have the disadvantage that you don't necessarily have that same pulsating urgency informing everything you do. You could end up with teams that are good teams but don't necessarily have that intensity (although we try to get as close to that as we can). But then you have the advantage that, if you are a little bit early to a market, you can get in the feedback loop from some early customers and not die on the vine. You can regroup and come back in again.

If I look at what we've done in creating the jukebox in the sky, we have a business that's about a $150 million business. If you look at that business compared to the iPod, which is a closed environment, the iPod is a much simpler proposition. All the consumer has to do is buy the device made by one company, Apple, and plug it into their PC or their Macintosh and start getting songs, either through surreptitious sources or by buying the songs individually. That's a much simpler concept than the notion of jukebox in the sky, which has to introduce consumers not only to a new way of distributing the content, but a new way of thinking about their commercial relationship to the content.

So we knew, going into it, that we were taking a long-term strategy that required putting together a lot of pieces. And it is one that we believe in, but we also knew that one of our competitive advantages was that we would have the staying power that a lot of early-stage start-up companies would not. I think the amount of time things take to develop certainly can be a source of competitive advantage.

Shiller: I think that a common human error is to underappreciate the importance of timing. I tell my students this all the time. History is being made all the time, and it's changing the situation and the world. You have to be timed right for what's happening now. There are some big things that are happening right now in the world. I think of globalization. I think of the triumph of capitalism — that governments all over the world are embracing capitalist institutions. Then there's the information technology revolution. It's really a technological advance. The success of a business depends on exactly how you launch in relation to the stage of these events.

And in our own example, the company that Allan Weiss, Chip Case, and I created was lucky. We started out trying to create a futures market, but then the AVM revolution in mortgage finance appeared — or maybe we helped start it. That's the automated valuation model. What was happening, because of IT, was that mortgage applications were being done increasingly online, and that encourages fast application processing. And it created a demand for fast, online evaluation of the values of homes. So we were able to jump right into that, because we had price indices, and we produced AVM. But that was pure luck for us, that we just happened to launch at a time when the AVM industry was getting started. And regulatory approval happened at that time.

Later we started real-estate futures markets, and this came in right at the time of an enormous real-estate boom, which created tremendous interest in a certain product that has never been dealt with on the risk market. So these are my own personal examples, but things can be timed right and they can be timed not so well. Unfortunately, you only see all of these factors once you get into a business. Of course, the secrets of a rival or a competitor matter enormously, too. But I guess the bottom line is, as I tell my students, that one must always be aware of history and the details that are unfolding right now.

Podolny: Is there anything else you think would be important for the readers to know? Or do you think we've covered the ground well?

Shiller: One thing that emerged is that people who do this kind of thing are people with a sort of mission and a purpose in life and they derive some excitement from it. These people know who they are and whether they can live with the stress of such a life. It has its ups and downs, and I guess 90% of these ideas will fail as an enterprise, but you'll grow from the experience.

Podolny: I think it ends where it begins, which is that all of you have clearly been visionary and missionary in the markets that you've been helping to give birth to. What I hear you saying, Bob, is that part of the opportunity that's created here is the possibility of tying yourself so strongly to a powerful idea. There's personal value and satisfaction in that — understanding, at the same time, the objective reality that a lot of these ventures fail.

Shiller: People really shouldn't be too concerned about failure in a business. It's just one of many episodes in a life. Another thing that people under-estimate is how your human capital matters. The experience of launching something, even if it didn't succeed, is an experience that develops you into a different person. I think purposeful risk-taking, and the adventure it creates, is the best exercise for the intellect and generator of human capital.