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April 10, 2005

The Forces Shaping Mobile Media (2 of 3)

Three Kings Bearing Gifts of a Closed System

To distribute digital media without encumbering consumers with DRM, you simply need a closed system. This is easy to accomplish. There are basically Three Kings on the value chain that must collaborate in an attempt to secure digital media: The Device, The Application Provider and The Network. All three are at odds with each other, so collaboration appears to be impossible. (And so see the Second Law.) My explanation…

The Device Manufacturer
The Device manufacturer wants to add value to their devices in the form of features and functionality. The more devices they sell, the more money they make, so the more features and functionality they want to cram into each device, and the more competitive it will be in the marketplace, which is their goal. You want to play MP3 files on your device? No problem. After all, it is not the responsibility of the device manufacturer to secure the digital intellectual property rights for the Media industry. RIAA vs. Diamond Multimedia decided that.

Why did the RIAA have to sue Diamond? Because the Diamond Rio can enable people to make unsecured copies of unlicensed content and distribute it without any degradation of quality. This is essentially the same argument that the MPAA used against Sony back in the day to try to stop the introduction of the VCR. It is funny now to think that the MPAA didn’t want the VCR to happen. This is the same VCR that is now responsible for more revenue than box office receipts. Of course, hindsight is 20/20. Sony wanted to sell VCRs (but Betamax ones, oops) enough to take on the movie industry and by winning, they created an entire industry that benefited consumers, device manufacturers and the movie industry in addition to creating a multibillion dollar movie rental cottage industry that never existed before. The net result is that we cannot rely upon the Device Manufacturer to accept responsibility for digital media security because they have no economic interest in selling media. Funny that I can only articulate this bluntly, but if you sell devices, all you care about is selling devices. If I made mobile phones with razor-thin margins among cutthroat competitors and an SDMI-like organization was trying to force me to put their DRM solution in every handset I sell and on top of it they were trying to make me pay for it, I would rigorously defend my position that it is not my problem.

Nonetheless, creating a superior consumer device that in any way opens a closed system, no matter how much consumers value your innovation, apparently will eventually get you sued.

The Application Provider
The application provider’s business model is simple: I sell you the media, you pay me the money. Simple enough, except when you are selling a commodity that people can buy or get for free elsewhere. Let’s say Apple is selling a million songs per month on their popular iTunes site. According to Big Champagne’s Eric Garland, the RIAA claims 2.6 billion unauthorized downloads per month. “…so the whole of the legitimate marketplace accounts for less than 1% of total downloads.”

Ok, so there is and always has been illegal activity. It seems fairly out of control, but the lawyers of the people who own the very valuable intellectual property rights are doing their best to get it under control, so that’s good. And even with this rampant illegal activity, there appears to be a market for paid digital media, so that's good, too.

But put that aside for a moment and look at a classic content distribution model: Radio. When enough people have receivers, they become a market for whoever is providing content, in this case the broadcasters. And there are a lot of broadcasters. The iPod is sort of an evolution of radio in that it can receive content. If the only way to get digital media into your iPod is to buy it from the iTunes digital media site, then the collective iPod users become a market, but only for one content provider. They become a closed market and the mechanism to deliver the content is a closed system, like a radio that only tunes in one station. I say that if you can sell that kind of radio, more power to you. The content is secure enough to satisfy the music industry, consumers are happy with the apparently fairly priced media, and Apple is happy with their gross profit of $.06 per download or whatever it is because even if they aren’t making a ton of money on digital downloads, they sure seem to be selling a lot of iPods. Everyone’s happy, right? Well, everyone except other companies that make money selling digital media and all of a sudden find themselves shut out of the huge market that is the iPod consumer collective. Real Networks is a good example of a company shut out of the market. So what did they do? They hacked the iPod so that iPod users could download digital media from their competing service. The iPod/iTunes construct was a good example of The Device Manufacturer collaborating with The Application Provider to create a closed system. The problem is that the system doesn’t work when you try to include other application providers. Unlike Apple, Real doesn’t sell iPods and so doesn’t care about the careful plans Apple has laid for media distribution domination. If all you do is sell media, all you care about is selling media. So creating a market of your own, however logical it sounds, puts you at odds with other Application Providers and apparently you will eventually get hacked, possibly sued or at least elicit some strong words from a congressman or two.

The Network
Make a mobile phone that can download digital media and don’t talk to The Network about it first. See what happens.

Either you didn’t consider the cost of getting all of that data across the network (which would result in enough money to make The Network happy, but would make the price of a song somewhere around $27) and so it is impossible for them to sell your product because nobody would buy it or you knew it would be too expensive so you put together some sort of bluetooth or USB solution to transfer content, which admittedly isn’t the best user experience, but hey – it’s the first of its kind so people will buy it.

So you just cut out The Network. And guess what? They don’t sell your device to their subscribers.

When you own the network, you know it is very, very valuable because you own the customer. Of the three kings of digital media distribution, it is the most valuable because people will pay for access even when the content isn’t valuable enough to pay for.

Which brings us to Conahan’s Third Law of Digital Media Distribution: “The network gets paid whether the content is secure or not.”

We have a secure digital media distribution model in place right now, wherein the three kings, The Device Manufacturer, The Application Provider and The Network all cooperate harmoniously because they are all making money. Ringtones are sold in this country through a simple distribution chain where The Network gets a percentage for distribution, The Application Provider gets a percentage for provisioning the content, and The Device Manufacturer need only disable the ability for a user to forward a ringtone to someone else. It is called “forward lock” and it works well enough to support a multibillion dollar industry. In the case of ringtones, nobody is forcing the handset makers to install expensive DRM, the ringtone companies aren’t wrapping their files in DRM and the network operators aren’t encrypting transmissions. It is a completely closed system and everyone is happy, including consumers.

So if everyone is happy and making money, why wouldn’t they keep it a completely closed system? Here is where the interests of participating parties diverge.

Say you make handsets and to be competitive with other handset manufacturers, you put Bluetooth in your phones because people like it, maybe to enable a wireless headset. That’s good until you realize that you also just disrupted the closed system and people can transfer ringtones from their PCs or other devices for free.

Remember earlier this year when Verizon Wireless crippled the Bluetooth functionality on the V710?
They did this so that a user could connect a wireless headset, but couldn’t transfer media from their computer to their handset for free, requiring instead that the user pay for the media through the closed network. The response was largely negative and someone even initiated a class-action lawsuit against them. Why? Are we saying Verizon Wireless isn’t entitled to make money from the transfer of content in the same way they have been doing for years, namely by monetizing their very expensive investment in their network infrastructure that enables them to make money in this way? That is absolutely ridiculous. Yet, here they are having to spend time and money to defend their closed system that makes money for them and many others, which they probably partially did because of an assumed liability that some intellectual property rights holder could hold them accountable for not securing their media.

I could go on, but the point is that when you are repackaging and reselling someone else’s content that is protected by rigid intellectual property laws, you have a responsibility to distribute it in a relatively secure environment, lest you get sued. The traditional media industry can only survive if those intellectual property rights are vigorously protected, and now that they are finding the wireless space to be a legitimate distribution channel for their Media, they have (quite correctly) dragged the handset manufacturers and network operators into the fray to defend their rights by attempting to make them pay for expensive DRM.

The inevitability of the open network is one of the biggest issues shaping mobile media because the interests of competing links on the same value chain are at odds with each other. This will result in a standoff because each link has a legitimate business model that unfortunately requires at least one other link on the chain to cooperate in order to realize its full potential, and it only takes one small seemingly innocuous hole to pry the whole closed system wide open. The value always flows to the link on the chain that consolidates, rather than feeds, the ultimate value to the consumer. Ask any network operator what they sell the most of and they will tell you, “Whatever is at the top of the deck.” When the Network’s ability to monetize their infrastructure investment by selling content to their consumers is delayed by the inability of other companies to agree on the method to secure that content, the Network will find something else to sell.

Posted by Shawn Conahan at April 10, 2005 10:32 AM