Bet Exchange News - March 2004

1. Introduction

The betting exchanges are currently the fall guys of the racing industry, seemingly taking the blame for all of its woes. Apart from the integrity issue which has exploded so spectacularly this month, there is the ongoing issue of the funding crisis. The racing industry with the help of their friends in the media have been very successful in getting across their message that betting exchanges are responsible for the shortfall that the racing industry is facing at present. Indeed, my father who has relatively little interest in the subject was carefully explaining to me how the racing industry was losing out because betting exchanges pay so much less to the racing industry than the bookmakers do. The arguments of the racing industry to all but the well informed observer make perfect sense and they are currently winning the PR war on this point.

As you would expect Betfair have come out fighting. The Funding Report is an extremely well argued document which supports all of its conclusions with facts and figures, many from the bookmakers themselves. Not only does the report detail many reasons why the betting exchanges are not responsible for the funding deficit, they have actually gone further and demonstrated that betting exchanges have the potential to deliver greater funding to the racing than the mainstream bookmakers. The problem that Betfair have got is that the racing industry's views are delivered in easily understood sound bites which the media happily pass on to their audience. It is not possible for Betfair to reply in such a simplistic manner. The subject is not easy for the casual observer to understand and Betfair's arguments, whilst powerful and thorough, are also by definition complicated and technical. This it could be argued, is the problem with Betfair's report, which with 86 challenging pages would be few people's idea of bedtime reading. I hope that the following analysis will give anyone who has not had the time or inclination to the read the whole document a good feel for the main points it contains. I also hope that having read this many readers will then take the time to read what is a highly revealing and interesting report.

2. The calculations on which the OCP report was based are flawed

In September 2001 turnover tax which was payable at a rate of 9% by punters on all bets was abolished. It was replaced by a Gross Profits Tax (GPT) of 15%. This tax is paid by the bookmaker, resulting in much improved value for the punter. GPT is calculated on the bookmaker's gross profit, the definition of gross profit being total stakes - total winnings. The turnover tax contained provision whereby 1.25% - 1.4% of punters' stakes went to the racing industry. GPT contained no such provision, leaving the British Horseracing Board (BHB) to make separate arrangements with the bookmaking industry.

In 2002 the BHB and the bookmaking community signed a five year deal whereby Racing would receive 10% of bookmakers' gross profits from betting activity on UK horse racing. This funding model was based on a study by the Organisation Consulting Partnership (OCP). Betfair in the Funding Question argue that the assumptions and calculations on which this model was based are fundamentally flawed.

The OCP Report calculated that a Levy of 10% on bookmaker's gross profits, would deliver the same return to racing as the previous scheme as long as the betting turnover on racing increased by 45% following the tax change. This calculation was dependent upon the assumption that the gross margin (ie the % profit made from racing turnover) would not fall. The possibility was voiced at the time that a change in punter behaviour might cause the margin to fall, but this was not factored in to the calculations. In the event racing turnover did, as predicted rise by 45%, however, margin dropped considerably. The Tote's profits on horse racing are quoted as falling from 16.9% in 2001 to 11.2% in the year to March 2003. Given this drop in margin, Betfair calculate that racing would have needed an increase in racing turnover of 95% rather than 45% to maintain the Levy at expected levels. The two most significant shifts in punter behaviour are as follows:

2.1. Punters moving to less profitable horse racing bets

The change in tax affected some types of bets more than others. The problem with a turnover tax is that it is particularly burdensome for punters who like to place single bets or bets on short priced favourites, whereas the impact is relatively low on accumulators or long priced outsiders. The report shows that the removal of turnover tax has more than halved the losses that a long term backer of favourites could expect . In contrast, backers of horses priced at 10-1 or more will only have seen their long term losses reduce by 10%.

In removing the turnover tax, an artificial barrier to betting on favourites was removed and as a result betting on favourites post GPT has become far more attractive to punters, a number of whom it is argued have moved their business accordingly. On the face of it you may not think this would be such a problem, however, the UK horse racing betting markets have two marked biases relating to favourites which have to be understood in this context.

The first bias is that the bookmakers' margin is considerably lower on favourites than their margin on outsiders. The second bias is that the UK betting public place a disproportionate value of their bets on favourites. This means that if a favourite wins, the bookmakers generally lose, which explains why the 2003 Cheltenham Festival was such a disaster for them. The disproportionate impact of the value of bets placed on favourites explains why a migration from non favourites to favourites reduces the bookmaker's margin and therefore becomes a major contributory factor in the funding shortfall.

The same applies for the comparison between betting on singles and accumulators. Turnover tax was more burdensome on single bets than accumulators, and the removal of this tax has seen a reduction in the popularity of accumulators accompanied by a growth in the number of single bets placed. Accumulator bets are more profitable for bookmakers than single bets therefore this shift has also had the impact of reducing margins.

Betfair argue that the OCP report was fundamentally flawed as it failed to allow for this effect.

2.2. Punters moving away from horse racing to other types of bets

The impact of the new tax was to create better value for punters and reduce the cost of gambling. Assuming that punters continued to bet to lose the same amount, the increased value meant that the punters' money would last longer before it ran out. The OCP's projections expected 100% of winnings to be recycled through horse racing. However, the new tax has allowed for the emergence of a number of products which are successfully competing with horse racing and preventing this target of 100% being achieved. A key example is soccer betting which due to a combination of increased television coverage and the introduction of singles betting has enjoyed a boom. However, the biggest success story and the one which has had the most significant impact on horse racing is the emergence of random number games such as Fixed Odds Betting Terminals. FOBTs offer a number of games, the most popular of which is electronic roulette. These are high turnover low margin games which would have been impossible before the tax change in 2001.

In a market place which has seen such innovation from other betting products, the horse racing product has remained largely unchanged. A revealing table on page 52 of the report shows that the contribution by horse racing to William Hills' gross win has reduced from 59% in 1999 to 41% in the first half of 2003, with corresponding increases in football and numbers games.

The fact that numbers games are devoid of all skill and allow punters to bet more frequently means that they are likely to attract the less sophisticated customer. This exasperates the problem for the horse racing industry because these are the people who lose most on the horses due to their lack of skill in picking winners, plus their propensity to bet on high margin products such as accumulators and outsiders.

When the National Lottery was introduced, its poor value and zero skill content attracted the business of the less sophisticated punter with a marked effect on betting shops who suffered a drop in turnover, but a larger drop in profitability due to the loss of these key punters. The report suggests that racing is facing the same difficulties at present.

Whilst it would be harsh to criticise the OCP for failing to predict the emergence of FOBTs, and its impact on recycling, there seems to be no denying that this has fatally undermined the assumptions on which the calculations are based. However, according to the report there seems a reluctance in the racing establishment to accept that this may be the case. In the conclusion the report says:

"Now that margins have fallen further than expected, recycling is rarely mentioned. It has been easier, instead to lay the blame for funding difficulties at the feet of the exchanges."

3. Reasons why betting exchanges are not to blame for the funding shortfall

The racing industry argues that betting exchanges are the cause of the funding shortfall because of two key factors:

Firstly, it is alleged that the betting exchanges have impacted on the on course market and therefore adversely impacted on the Overround Per Runner (OPR), which the industry are suggesting is their key measure of profitability. Betfair produce evidence that betting exchanges have not impacted on the on course prices, except perhaps indirectly on the price of outsiders. They also argue that the OPR is a meaningless measure in this context and that attention should instead be focussed on the margins on the favourites as these have the greatest impact on the profitability or otherwise of the bookmakers.

Secondly it is suggested that betting exchanges are diverting substantial amounts of horseracing business away from bookmakers. The BHB believe that this money would generate substantially more Levy revenue if it were channelled through traditional bookmakers. Betfair in turn present a detailed case demonstrating their contention that most of their turnover is incremental and that the existence of betting exchanges is a positive not a negative thing for racing's funding.

3.1. Betting exchanges and the on course market

The use of Overround Per Runner (OPR) as a measure of profitability

The report goes into some detail examining the use of the OPR as a measure of profitability. The OPR has been falling in recent years and is blamed by the corporate bookmakers as being a key reason for the shortfall in racing's finances. To calculate the overround the odds on each horse have to be converted to a percentage figure. This is achieved by this simple formula: 1/decimal odds. Add all these up and you will get the overround. This figure will normally be in excess of 100%. To get the OPR you divide the figure in excess of 100% by the number of runners in the race. Therefore in a twelve horse race with an overround of 124% the OPR would be 2%. The OPR has been falling in recent years. In August 2003 Ladbroke's Chief Executive Chris Bell was quoted in the Racing Post as saying:

.......against the average margin of two percent per runner in the days before betting exchanges took hold, the figures this year had generally fluctuated between 1.7 and 1.8 per cent, and fell to an all time low of 1.67 per cent over one week in July.

The OPR is used as a measure of profitability by the racing industry. However, Betfair argue that it is an unsatisfactory measure as it gives equal weighting to all horses regardless of the profit or loss that the bookmaker stands to make on each. An analysis of the starting price for every winning horse over the past 8 years shows the bookmaker's margin for winning favourites has not changed since the advent of betting exchanges. The lack of movement in the margins on winning favourites is highly significant because as we have seen, it is the favourites which have the greatest influence on the bookmaker's profits.

To find the explanation for the decrease in OPR we have to look at the outsiders where the 8 year study shows odds have lengthened considerably. Whilst this will have a considerable impact on OPR it will have a negligible impact on bookmakers' gross margin because their turnover on these bets is so low. Therefore, Betfair say that the bookmaking and horse race industry are wrong to use OPR as the key indicator for industry profit and they are certainly wrong to use it as an explanation for racing's revenue deficit.

Interestingly the report does suggest that the reduction in margin on outsiders could be a result of the influence of betting exchanges. In the past it is suggested, the bookmakers would charge a risk premium for pricing up long shots to guard against their fear of potential gambles. The betting exchanges have reduced this risk because the markets have traded for several hours and settled down by the time the on course bookmaker offers any prices. This, it is suggested, could be giving the bookmaker the confidence to price up the outsiders more generously than he may have done previously. Not only does this benefit the customer but it could also benefit the betting industry by shifting some of the turnover back from the favourites to the outsiders.

The impact of exchange money on the starting price

The BHB have suggested that the Starting Price has been forced up due to on course bookmakers arbing with the exchanges. They argue that this makes the on course bookmakers increase their odds, in order to get bets accepted which they can then trade into the exchange for a guaranteed profit. The report firstly points out the practical difficulty of executing such an arb, due to the constantly moving prices, which means that the arb on the exchange may have disappeared by the time the bookmaker has accepted punters' bets. They also present a compelling economic argument demonstrating that a bookmaker who accepts the arb on the betting exchange will actually make less money in the long run than the bookmaker who sticks to offering the lowest prices on course that the market will stand.

As further evidence that such arbs do not happen, the report discusses the well known effect whereby a number of winning favourites in a meeting results in lower prices for favourites in subsequent races. The reason for this is thought to be two fold, firstly because the punters on course are seeking to maintain their lucky run, and secondly because the off course bookies are building up potential liabilities from emerging accumulators. In either case the weight of additional money will suppress the odds. According to the report this effect however does not impact upon on the exchanges in the same way. Knowledgeable exchange gamblers are aware of this anomaly and therefore offer more generous odds than the on course bookmakers. The fact that these superior odds do not impact onto the on course market is presented as evidence that the on course market and the betting exchange markets are not as interlinked as some perhaps think.

3.2. Exchanges - a plus or minus for racing's funding?

Peter Saville, Chairman of the BHB has claimed that racing would be £20 million a year better off if all the money bet through betting exchanges was channelled instead through traditional bookmakers. Firstly Betfair question the figure of £20 million, pointing out that it is virtually impossible to meaningfully convert betting exchange turnover into a figure that would be bet at the bookmakers. Secondly, Mr Saville's statement relies on the premise that betting exchange customers would use traditional bookmakers if betting exchanges were no longer available. Betfair dispute this suggestion and they appear to be supported in this by David Harding Chief Executive of William Hills when he said in 2003

We have consistently said that we are not particularly worried about losing mainstream custom to the exchanges - this is not a product for the average customer

Not only do Betfair dismiss the theory that betting exchanges cost the racing industry significant levy payments, they believe that the converse applies. They argue that for two reasons exchanges bring incremental revenue to racing. Firstly the exchange model results in significantly better value which attracts new price sensitive customers and encourages existing punters to bet more. Secondly, the majority of Betfair's business is turned over on products which the conventional bookmakers cannot, or choose not to offer.

Gambling and price elasticity

The report goes into some detail about the concept of price elasticity and how it applies to gambling.

Economists it seems regard gambling as being price elastic, which means that customers are highly sensitive to its price. By reducing the price of gambling you can expect the additional business you attract to more than make up for your reduced margin, so that your total profits actually increase.

In the report Betfair work through a detailed example based on an actual race held at Salisbury. Despite using a conservative model of elasticity they arrive at the conclusion that in the long run, the lower price of gambling on Betfair would result in punters turning over five times more on Betfair than they would if restricted to traditional bookmakers.

Turnover that the bookmakers cannot generate or do not want

As stated above, there are many new products competing for the punters pound in the betting shops, while the horse racing offering has remained largely unchanged for many years. Betting exchanges are however breathing new life into racing by offering a totally new betting experience and a range of products which the bookmakers are either unable or unwilling to offer. For example 9% of Betfair's racing turnover is derived from their in-running markets. Therefore, the report argues, exchanges are creating incremental revenue for racing. To illustrate this point I can do no better than quote directly from page 28 of the report:

It is clear that betting exchanges have revolutionised certain aspects of the betting experience: a live exchange market offers the opportunity to bet on prices which change in real time to reflect market expectations, as well as on prices which do not include over-rounds which a sophisticated punter recognises stack the odds against him. It also provides the opportunity to bet on an outcome to happen or not to happen, or to "trade" price fluctuations.

When these advantages are combined with the ability to bet in-play - again, in live market with prices changing in real-time - and the opportunity to request better odds, the exchange model enhances the experience of the established punter to a significant degree.

Much of the betting activity on betting exchanges is as a result purely incremental: it simply would not have occurred in the absence of betting exchanges. The interest generated by the above innovations does not simply convert into an equivalent spend with a traditional bookmaker. Betting is fundamentally another form of entertainment and consumers will pay more for new and better entertainment.

It should also be noted that betting exchanges are considerably broadening the punter population contributing to UK horseracing and the Treasury: nearly 25% of all betting turnover on Betfair is now derived from non-UK users. That proportion is increasing constantly over time.

In addition many relatively successful punters who would soon have their accounts closed or limited by traditional bookmakers - or who would otherwise take money from their gross profits (and therefore the racing industry) - are able to participate freely on Betfair. Not only do they generate considerable liquidity and eventually recycle their winnings through the system and into the pockets of revenue-collecting authorities, but they generate funding as well as winning punters.

Betfair argue that the majority of traders and layers bets, which represent some 70% of the total bets matched on Betfair would simply not happen with traditional bookmakers. They further argue that the remaining 30% might be bet with the traditional bookmakers, but because the cost of betting on Betfair is cheaper, the backers' money will be recycled more times to lose the same amount. Crucially, in contrast with the high street bookmaker, the degree of recycling of racing winnings on exchanges between racing and other sports is likely to be reciprocal because the same commission rate applies throughout, and therefore all represent equivalent value.

In summary Betfair claim that the majority of their turnover is incremental to racing. Any punters who do switch their business from traditional bookmakers are likely, due to the lower cost of betting on exchanges, to increase the volume of bets that the place so that the level of gross profits, and therefore the contribution to the racing Levy will remain the same or increase.

4. Reaction from the industry

I have checked the BHB's website for a response but despite there being press releases on many matters there is no reference to this report. I have also checked the Racing Post where I was only able to find an article dated 25th November which included the following quote from Nigel Smith Commercial Managing Director of the BHB

It is clear that Betfair's analysis is selective and far from objective. The report appears to make some questionable assumptions and its findings are inconsistent with our own. The true picture is not as Betfair has painted it. Our analysis, which is derived from bookmakers' data to which Betfair have not had access, indicates that the primary cause of the shortfall in levy income under the 41st levy scheme was indeed the impact of betting exchanges.

In this statement the BHB, have casually dismissed the whole of Betfair's case without making any attempt to address any of the well argued points from this powerful and intelligent document. If the BHB has evidence which can contradict some or all of these findings surely they should be making it public. Just saying we have access to information which proves that we are right and Betfair is wrong is hardly a satisfactory response. If anything it could lead the observer to the conclusion that they are unable to put together a detailed response to Betfair's argument which would stand up to close inspection.

Obviously in producing this document Betfair are promoting their own agenda and you cannot expect it to be entirely objective. One point that I would question for example, is if there has been a shift of money from outsiders to favourites as a result of punter behaviour, why has the margin remained stable? Surely the additional weight of money on the favourites should force the odds down and the margins on these horses up?

You may expect that there would be other elements of Betfair's arguments which given expert analysis could be challenged. I find the fact that the BHB have seemingly chosen not to get involved intriguing. One possible explanation is that they know they could not win a detailed public debate about the findings of the report. However, if this is the case then it suggests that the BHB privately accept the findings of the report and therefore accept that betting exchanges are in fact good for racing. If that is the case why are the BHB still pursuing an anti exchange line?

Perhaps the BHB are showing some kind of misguided loyalty to the bookmakers who appear to have the most to lose in the long run from the growing success of the betting exchanges. If this is the case the bookmakers in their haste to adopt and develop Fixed Odds Betting Terminals do not show any signs of reciprocating this loyalty. Most of the corporate bookmakers are making record profits, but horse racing is missing out on this bonanza and anyone from the racing world who is looking for reasons to be optimistic is likely to be disappointed. In an ominous speech David Michels, of Ladbroke's parent company Hilton Group said

What you shouldn't forget is that the industry has introduced something which our customers really like, and [which has ] only become possible because of the tax changes. In this high-age FOBTs will not be the last development for a business which some of you said was dead three or four years ago.

Even more explicit was the news from Betdirect who in announcing an operating loss of £3.1m revealed their plans to reduce their reliance on horseracing whilst intending to increase their share of the football betting market.

Rather than rejecting the findings of this report out of hand, everyone who cares about the future of racing should, if they haven't already done so, be examining it very carefully and considering whether the conclusions it contains could be true. If they are and the strategies revealed by the bookmakers above are representative of the whole bookmaking industry, then surely the time has come for the racing industry to embrace the exchanges as the best chance of securing a secure and prosperous future for all those in racing, rather than wasting time and energy in fighting a battle that they cannot win.

The Funding Question is a fascinating and revealing document. I hope that I have given a flavour of it by summarising the main points, but if you want to really understand the issues you need to read it in its entirety. The whole document is available from georgina.hard@Betfair.com In addition, Betfair's own summary of the key points in the report can be viewed in the Betfair Announcements section of the Chatback message board.