1. Internet Business Models and the Competitive Dynamics of the Backbone Market Michael Kende 9 April 2001

2. Introduction Analysys is Europe’s leading independent telecom strategy consulting and research company, with 240 staff in 10 offices around Europe, Asia, and the United States. Clients include operators, policy-makers and regulators. Authors have a wide range of experience in analyzing the Internet backbone market in Europe and the United States Analysys was invited to discuss the competitive dynamics of the Internet backbone market

3. Agenda Overview of the Internet Peering Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

4. Agenda Overview of the Internet Peering Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

5. The Internet can be broken into four types of players Internet backbone providers Internet service providers (ISPs) Content providers (e.g. web sites) End-users Overview of the Internet

6. Internet service providers (ISPs) enable end-users to access the Internet ISPs have two types of customers w Dial-up customers using their personal computers with modems w Businesses and other large organizations using direct leased line connections ISPs combine two inputs w Access facilities (e.g. modems) w Backbone services Overview of the Internet

7. Internet backbone providers connect end-users with each other and content Overview of the Internet Web site ISP Web site Transport Router

8. Internet backbone market has an impact on ISPs’ costs Internet backbones charge ISPs a monthly fee for wholesale access to the Internet Internet backbones require two inputs to provide wholesale access to the Internet w Transport w Connectivity to other backbone providers Overview of the Internet

9. Connectivity makes the Internet the “network of networks” Overview of the Internet Web site C ISP A Backbone 1 A FED BC Web site B Backbone 2 Traffic from ISP A can only reach Web site C. ISP D

10. Agenda Overview of the Internet Peering Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

11. Internet backbone providers have opposing incentives Backbones compete with one another for customers Traffic exchange requires co-operation among backbone providers w Connectivity is not regulated w In place of regulation, a system known as peering has evolved w In the peering system, backbones connect when it is mutually beneficial Peering

12. In a peering relationship, backbones only exchange traffic between their own customers Web site C ISP B ISP A Backbone 1 Backbone 2 Backbone 3 A ZYXW BC Web site D Peering connection Backbone 3 will not pass traffic from backbone 2 to backbone 1 Peering

13. Peering is a mutually beneficial relationship Traffic is exchanged on a settlements-free basis Peering is based on a perception of equality along several measures w A measure of the flow of traffic at a point of connection between networks w A comparison of the geographic size of networks w A comparison of the size and composition of customer bases Peering

14. Any analysis of the Internet backbone market must be dynamic Static focus on peering issues ignores important forces Dynamic nature of Internet constrains action of any one backbone provider w Direct constraints from new entrants w Indirect constraints from input suppliers and customers Peering

15. Agenda Overview of the Internet Peering Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

16. Access to two inputs is required to enter the Internet backbone market Connectivity w peering is not the only option Transport w long distance telecommunications infrastructure (e.g. fiber or satellite) Entry into the backbone marketOverview

17. Peering may not always be mutually beneficial Peering may enable one backbone to “free-ride” off the other w Peering can provide a smaller backbone with free access to a larger backbone w Peering may require one backbone to utilize more capacity than another One backbone may refuse to peer with another to prevent free-riding Entry into the backbone marketConnectivity

18. Example of free-riding between networks of different size Web site C ISP A Backbone 1 Backbone 3 A ZY BC Web site D Traffic from ISP A to Web site B will pass between points A and B in both directions Entry into the backbone marketConnectivity

19. Transit is a comprehensive alternative to peering In a transit relationship, one backbone agrees to route another backbone’s traffic to all points on the Internet The transit provider is paid for these services Transit customer can provide backbone services and grow to qualify for peering Entry into the backbone marketConnectivity

20. Example of a transit relationship Web site C ISP B ISP A Backbone 1 Backbone 2 Backbone 3 A ZYXW BC Web site D Peering Connection Backbone 3 will take traffic from backbone 2 to backbone 1 Transit Connection Entry into the backbone marketConnectivity

21. Backbone providers have incentives to compete on transit prices Transit customers provide revenues for backbones Transit customers improve the bargaining position of backbones in peering negotiations Entry into the backbone marketConnectivity

22. Long distance infrastructure is the core of a national Internet backbone provider Long distance infrastructure markets can support multiple competitors Fiber optic technologies enable economical overbuilds of existing networks Regulations often enable entrants to lease capacity from incumbents to complete national build-out at affordable rates Entry into the backbone marketInfrastructure

23. The competitive dynamics of the Internet provide for numerous means of entry Entrants can connect to existing backbones through different means w Peering w Transit Infrastructure is increasingly available w Leasing of existing infrastructure is regulated w Technology enables new entrants to build their own infrastructure Entry into the backbone marketConclusion

24. Agenda Overview of the Internet Peering models Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

25. Competitive constraints on backbones Competitive constraintsOverview Customer forces Content providers ISPs Technical substitutability Memory/ processing Multi- homing Input suppliers Local Inter- national Backbone provider

26. Input suppliers compete indirectly with backbone providers Local transport w As an increasing amount of Internet usage is local, traffic can bypass national backbone provider’s network w Local telcos can use market power over last mile as leverage against national backbone providers International transport w International traffic can bypass national backbone provider’s network Competitive constraintsInput suppliers

27. Customers are increasing their bargaining power with backbones Local content is increasing w Demand of end users for high-quality local content bestows market power on providers w Local content providers can leverage this market power in negotiations with backbone providers ISPs have powerful brand names w Local telcos have entered the market, and other ISPs have national and international presence w These ISPs can negotiate advantageous terms with backbone providers Competitive constraintsCustomer forces

28. Advanced storage and processing technologies reduce the need for backbone transport Usage of servers near end users w content providers can push content out to mirror sites w users can pull content in to cache sites In both cases, content is only transported on backbone network once Competitive constraintsTechnical substitutability

29. Diagram of the use of mirroring and caching Web site C ISP A Backbone 1 A FED BC Web site B Backbone 2 Content from Web site B is pushed to a mirror site closer to ISP D ISP D Mirror Cache Content from Web site C is pulled by ISP A to a cache closer to its users Competitive constraintsTechnical substitutability

30. End users can multi-home to reduce reliance on backbone networks for connectivity Multi-homing involves an ISP or content provider directly connecting to more than one backbone provider As a result, traffic goes directly to the terminating backbone without passing through a peering connection Companies such as InterNAP sell multi- homed connections to end-users Competitive constraintsTechnical substitutability

31. Diagram of multi-homing Web site C ISP A Backbone 1 A FED BC Backbone 2 By multi-homing to both backbones, ISP A is directly connected to Web site C and ISP D, without any peering ISP D Competitive constraintsTechnical substitutability

32. Agenda Overview of the Internet Peering Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

33. Comparison of Internet and telephony Internet and telephony share the same basic infrastructure w Local w Long distance w International Telephony services are typically regulated while Internet services are not w Input availability w Competitive dynamics of Internet markets Comparison with telephony

34. Input availability for Internet backbones reduces need for regulations Transport w Telephony regulations provide access to existing transport capacity w New technologies lower cost of building new transport capacity Connectivity w Peering is one option w Peering policies increasingly being made public w Transit access makes entry and growth possible until smaller backbones qualify for peering Comparison with telephonyInternet not regulated

35. Dynamism of Internet services reduces need for regulation Basic telephony services are static w Voice call between two users is live w There is no means to reduce reliance on network for end-to-end call Internet services are dynamic w Internet content can be stored w Storage technology (mirrors and caches) increase competitive pressures on Internet backbone providers Comparison with telephonyInternet not regulated

36. Agenda Overview of the Internet Peering models Entry into the backbone market Competitive constraints on backbone market Comparison with telephony Analysis of Brazilian market

37. Analysis of Brazilian Market Market Overview Analysis of Entry Competitive Constraints Analysis of Brazilian market

38. Brazilian Internet market is growing Wave of investment since market restructuring in 1998 Number of lines has risen from 14.8 million in 1996 to 33.2 million in 2000 Number of dial-up Internet users has risen from 471,000 in 1996 to 3.7 million in 2000 Source: Economist Intelligence Unit (2000) Analysis of Brazilian marketMarket overview

39. Necessary infrastructure is available Incumbents must make infrastructure available to Internet companies Entrants building facilities w Local entrants include MetroRed, Diveo, and AT&T w Long distance entrants include Intelig, Global One, and Impsat w International entrants include 360networks and Global Crossing Analysis of Brazilian marketAnalysis of entry

40. Connectivity options are available Embratel sells dedicated access to its backbone to customers and competitors alike Peering is taking place w Embratel and RNP w Regional backbones connecting to increase their coverage Analysis of Brazilian marketAnalysis of entry

41. Existing backbone providers face competitive constraints Input providers w ISPs such as Terra are growing and moving into backbone markets w Local incumbents will be free to provide national backbone services soon While existing national backbone providers grow, utilities are beginning to enter the market with their own facilities ISPs are beginning to multi-home and use content storage technologies to reduce reliance on backbones Analysis of Brazilian marketCompetitive constraints

42. Conclusion There are increasing signs of competition between backbone providers w Investments in infrastructure w Internet usage is growing Competition is likely to increase in the future when local telcos enter the market This competition provides for affordable Internet access services from ISPs Analysis of Brazilian market