Edition 31: Exchanges and The Wide Moat They Face

How far can the merits of exchanges stretch and lead to mass adoption?

Jan 31, 2022

Welcome to the 31st edition! This week’s edition takes a deep dive into the moats exchanges are facing as they attempt to build and achieve critical mass of adoption.

The Handle newsletter is presented by American Affiliate’s Wagers.com, a hub for all things U.S. sports betting.

Let’s dive in.

The Exchange Landscape

Exchanges have drawn a ton of buzz and excitement. They have received strong VC and celebrity investment from entities across the board. This comes as no surprise given the overall influx of capital and publicity to the industry as a whole. Today, we’re going to run through some of the major actors and then finish up with a look at why we are not as bullish on exchanges.

To start, let’s look at Wagr, a betting exchange app with social chat features. They recently completed a $12M Series A round of funding. The hybrid between gambling and socializing drew funding from both the Kraft Group (operated by Patriots Owner Robert Kraft) and HSBE Ventures (the venture arm for owners of the Devils and 76ers owners). On the celebrity front, Wagr has also received funding from Reddit co-founder Alexis Ohanian. In July 2021 he led a $4M seed funding round which also featured Greycroft, Pear Ventures, Saks Inc. former chairman and chief executive officer Brad Martin and Tinder co-founder Justin Mateen. Wagr was founded by two HBS students and has the backing that makes it seem like it could take off. It is currently active in Tennessee and just offers spread bets. Wagr also incorporates a social function that allows users to communicate about their bets. They are trying to position themselves as the middlemen for casual bettors looking to cross each other.

Moving on, we’ll now turn to Prophet Exchange which is currently based in New Jersey. Prophet Exchange launched pre-registration in October 2021, and is one of the first pure peer-to-peer U.S. sports betting exchanges. The company is co-founded by CEO Dean Sisun and COO Jake Benzaquan (who weirdly enough I have crossed in peer to peer wagers before). As it’s first big move, Prophet Exchange announced Victor Cruz as a Strategic Partner and Advisor. The former Super Bowl Champ and salsa king explained his rationale to join Prophet Exchange as, “I’d been approached by many different sports betting companies, but Prophet Exchange is the first team I’ve ever wanted to join because of how much emphasis they put on delivering value to their customers.” While all services tout an enhanced customer experience, Cruz believes this one is a standout and the partnership seems to be a win win for both sides. We’ve yet to see Prophet Exchange launch, but they are hoping to be in New Jersey soon.

The last case we’ll examine is Sporttrade inc, the Philadelphia-based fintech sports betting company. In June of 2021, they raised $36M in funding from some large name firms such as Jump Capital and Impression Ventures and big name individuals such as Jim Murren (former CEO of MGM Resorts International) and Tom Wittman (former CEO of the Nasdaq Stock Exchange). In addition, they issued convertible debt to Nasdaq Ventures alongside the funding. These big names not only provide the capital for, “customer acquisition, expansion into additional states, and continued investment in a diverse, talented team” but also give the companies validation and the invaluable social capital. For example, having famed bettor Rufus Peabody as an investor in Sporttrade gives the company organic publicity. Currently, Sporttrade is targeting a 2022 launch in New Jersey. In our humble opinion, Sporttrade seems to have the best handle on what it will take to make an exchange successful in the U.S. They have the domain knowledge that will be a prerequisite to success, even if they are going to have to fight for customers in a crowded market.

Not surprisingly, VC money in these cases is hoping to replicate previous successes from other countries. Looking over to the United Kingdom, we can get a sense of how exchanges can function in a large ecosystem, albeit with different sports as the main focus. The name most familiar to Americans is probably Betfair, which runs a large exchange and significant advertising campaigns. In addition to Betfair, Smarkets and Matchbook both offer functional exchanges in the United Kingdom where average bettors (or “punters” in the UK) can find lower vig. These exchanges function mainly through strong market makers offering tighter spreads than sportsbooks are willing to. Smarkets is known to take bets themselves and act as the market maker, whereas Betfair allows various syndicates to provide liquidity on its markets. This seems to be good news for Americans, exchanges are sustainable in other markets. But it’s not a guarantee of success. Let’s dive into why we think exchanges will struggle in the United States.

The Big Moat: No SGPs, No Betting Across State Lines, Limited Liquidity

Now this may be a bit technical, but bear with us. For an exchange to work, there needs to be an active participant in the market who is taking the other side of any bet, which means that there needs to be a lot of liquidity. That liquidity, especially for recreational bettors, needs to be there the moment they want to place their bet. No recreational bettor wants to leave an order open only to check back later and see what they thought was a winning wager never got filled. That would be a quick way to lose any customer who might have been lured by a large sign-up bonus. Smarter recreational bettors also will never want to leave an order open on the off chance that some breaking news comes out against the team they are hoping to wager on and do not have time to take their order down before it is filled. No one wants to be stuck with a -EV bet because she isn’t a professional gambler and wasn’t at the computer when something like Lebron taking a rest day is announced.

So now it’s clear we need instantaneous liquidity for adoption by recreational bettors. But why is there a liquidity shortfall? First, wagering across state lines is explicitly prohibited right now. That means that liquidity pools can only exist within any one given state at a time. Inherently, it will be challenging to find enough actors all on the exchange at the same time placing opposite bets in just one state (especially if that state is small @Wagr in Tennessee). Second, there won’t be much interest in random bets that people place on smaller markets. Is there really going to be someone out there taking the other side of my first half bet of one of 20 college basketball games every night? Maybe, but it can’t be guaranteed.

Now, the obvious solution here is to just let in market makers who will offer tighter spreads than traditional bookmakers who will take every bet, as done in the UK. A few exchanges don’t want to do this because they want the experience to feel social and like betting against peers rather than the house (love the spirit, but these are dead in the water). The idea of betting against peers rather than the house is antithetical to allowing market makers to provide liquidity because the market makers are functioning as the house.For the exchanges that aren’t so blinded by idealism, getting market makers on exchanges isn’t as simple as it sounds. For market makers to participate in an exchange, there needs to be significant money to make it worthwhile. We see operators with low hold percentages and significant variance in current legalized states that do have a critical mass of gamblers. Any new entrant into an established market will be fighting hard to sign up any customers they may have. There simply isn’t a big enough profit motive to offer full market making capabilities for a small number of bettors. In order for a market maker to jump in, the exchange would need to have a critical mass of bettors already. It’s like the chicken and the egg problem! A lot of bettors and market makers are needed to make an exchange successful. But bettors won’t adopt exchanges unless they have guaranteed liquidity and market makers won’t jump in if there aren’t enough bettors to make them money.

An even bigger issue is operators have radically increased the surface area over which they take bets. In layman's terms, bettors have far more options to bet on than they used to. Sure, even I could book first touchdown props and make money at the current market lines, but the issue is deeper than this. Every operator offers a myriad of “customizable bets”. Customizable bets are any bet where a user combines two wagers, ranging from a simple two team teaser to the most ridiculous same game parlay ever placed. Customizable bets are pretty much impossible on an exchange where there are infinitely many combinations that users can create. Operators have allowed bettors to get ever more creative with what they can combine into a wager and consumers have gotten used to these options. Exchanges don’t have someone ready to take the other side of the same game parlay bettors create and even worse, bettors would have to try to price their own same game parlays in order to create the bet on an exchange. We’ve all seen how incredibly popular same game parlays are. Do we really believe that bettors will rush to a new platform to save a few cents on juice when that platform will struggle to allow them to bet even the most basic parlays, let alone SGPs? Of course, market makers could create their own pricing mechanisms for SGPs (and there does seem to be room to bring hold %s down), but at that point it’s just like betting with a traditional operator.

The increased surface area that operators have created to attract consumers have the added benefit of potential exchange competitors a steep hill to climb. We’re happy to be put on old takes exposed for this one if we get it wrong, but as sports betting exists currently in the United States, exchanges don’t seem viable unless the exchange itself is willing to serve as a market maker. Which leads us to the conundrum to conclude this piece: if traditional operators are having trouble making significant profits at their current hold percentages, what makes starting as a new exchange where it serves as its own market maker a more palatable plan?