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How the ‘Net works: an introduction to peering and transit


Transit economics

Providing transit has its own rationales and economic mechanisms. Transit providers charge transit fees in order to recoup their investment in the lines and switches that make up their networks. The price of transit will be a combination of the costs of running the network, plus the amount of transit the transit provider has bought, minus (maybe) the traffic that is destined directly for peers and customers of the transit provider.

Being a pure transit provider with only Autonomous Systems as customers puts a network in a weird spot. Such a network's business case is built on being the intermediary in the flow of traffic, so it tries to charge all of the other autonomous systems for their traffic. The problem for a pure transit provider is that its customers are always looking at ways to lower their transit fees, and lower transit fees can be had by switching to a competitor or by not using the transit provider at all. So disintermediating the transit provider is standard behavior for the transit provider's customers.

How can the transit provider prevent its customers from going to competitors or from cutting it out of the loop? The first way is to keep prices down. If a transit provider is the only provider of a link between Geneva and Amsterdam, it will have to be very aware that its price stays low. If it's too high, the customers may opt to cancel their transit contracts and either build their own links or compel a competitor to step into the market and start competing.

The other trick is to actively work to keep competitors from entering the market. How do you persuade people not to enter the market? By keeping margins low, even as growth rises. Fiber is a fixed-cost investment, because traffic can be supported for little or no extra cost. Though it's tempting to let profits rise with the growth of traffic, the network will actually have to lower its traffic price every month in order for margins to remain the same, thereby keeping intact the barrier to entry for a competing network.

A couple of cooperating ISPs can also be dangerous to the business plan of a pure transit player. These networks could cooperate in creating a backbone between their networks in order to carry traffic to and from eachother's systems. For instance, Dutch, Belgian, French, and Swiss ISPs could work together and bypass a Trans-European transit provider. So a pure transit play is under constant threat even from existing customers who resell traffic.

An interesting tactic that I once heard about was from a content-heavy hosting provider who was trying to buy transit from residential ISPs. ISPs have a high inflow of traffic; hosting providers have high outbound traffic. Because incoming and outgoing traffic are bundled into the same price, the hosting provider rightly had determined that there would be ISPs willing to resell upstream capacity they didn't use. For the pure transit player this might be seen as a loss of income.

In the end, pure transit is debatable as a real business model. An average end-user is bound to its ISP by numerous switching costs (change of e-mail address, lack of knowledge, time, hassle, etc.), but this customer lock-in just does not apply to transit. The Border Gateway Protocol propagates a change in transit provider within seconds, globally. Autonomous Systems can switch within seconds and there is little a transit provider can do to differentiate itself from rivals. Add to this the effect of competitors and mutually assured destruction, and one can understand that there is not much money to be had in this business.

Tough at the top: word about Tier 1 networks

Tier 1 networks are those networks that don't pay any other network for transit yet still can reach all networks connected to the internet. There are about seven such networks in the world. Being a Tier 1 is considered very "cool," but it is an unenviable position. A Tier 1 is constantly faced with customers trying to bypass it, and this is a threat to its business. On top of the threat from customers, a Tier 1 also faces the danger of being de-peered by other Tier 1s. This de-peering happens when one Tier 1 network thinks that the other Tier 1 is not sufficiently important to be considered an equal. The bigger Tier 1 will then try to get a transit deal or paid peering deal with the smaller Tier 1, and if the smaller one accepts, then it is acknowledging that it is not really a Tier 1. But if the smaller Tier 1 calls the bigger Tier 1's bluff and actually does get de-peered, some of the customers of either network can't reach each other.

If a network has end-users (consumers or businesses), it's probably in a better business position than a Tier 1 or a pure-play transit provider, since having end-users provides stability to a business. Autonomous Systems can switch within seconds, but end-users are stickier customers. Churn is less of a problem and revenues are therefore more stable and easier to base decisions on, since prices don't have to drop on a monthly basis. So an end-user business, combined with a bit of transit is, therefore, ideal for a network provider.

Can peering and transit lead to a steady state?

Economists often ask if peering and transit can lead to a steady state, i.e., a situation that can sustain itself by generating enough money for investments while also providing a dynamic and competitive environment.

I personally think the answer is yes. Experiences in recent years have shown a big boom and bust in long haul networks. However, I do believe these are the result of over-investment and not problems with the model of peering and transit. Five overprovisioned networks on the same route are too much for any business case. So yes, if investment is done prudently, and if the owners of transit networks understand that they will have to lower prices continuously or face mutually assured destruction, then it is possible to have a stable state.

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