The Net Neutrality Monster Has A Close Relative

Feb.12.14 | About: Netflix, Inc. (NFLX)

Executive summary:

  • The death of net neutrality is not Netflix's only problem.
  • Data indicates large ISPs are seeing lower streaming speeds for Netflix.
  • At the source of this increasingly-visible consequence are peering agreements.
  • Peering agreements mean Netflix will pay more, with or without net neutrality.

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"Net neutrality" means handling all traffic the same way, not discriminating between traffic sources. If ISPs could discriminate - not be neutral, naturally they'd prioritize traffic sources which paid the most.

When net neutrality died in the courts one month ago, Netflix (NASDAQ:NFLX) was said to be the biggest victim. The reasoning was simple: Without net neutrality ISPs would be free to charge web firms fees for better service, and Netflix was the biggest traffic generator of them all, thus both the biggest target and the most incented to pay for better service.

Netflix had a couple of rough days back when the news of net neutrality's death came out. But things being as they are now, the stock has since recovered and is now up around $100 from those dark days. After all, there's still the chance that FCC will backtrack on letting net neutrality die.

In a way, the net is already not neutral

But things are complicated. As Dan Rayburn writes when there are quality of service problems, the problem is not always the ISP's even if it behaves neutrally. But on the other hand, and this is not well-known, the internet has not really been neutral for a long time. The internet is a network of networks, and to make traffic go around those, someone has to invest in capacity. Whoever invests in capacity needs to have a return.

So people accessing networks pay for access. And companies injecting data into the networks also pay for bandwidth. But moreover, when data crosses from network to network two things can happen:

  • The networks have a settlement-free peering agreement, where no network needs to pay the other. Obviously these agreements are in place only when traffic is rather balanced both ways;
  • Or the networks have to pay each other, with the network driving more traffic paying the other.

What this means is that there's a long-standing practice of charging for traffic when the traffic is not balanced. And naturally, serving up streaming video generates nearly no inbound traffic, so the networks injecting such traffic will end up having to pay those delivering it. In this sense, Netflix having to pay more seems inevitable.

Things might be coming to a head

Against this backdrop there might already be some factual reason for concern. In between the court acting and FCC clearing things up, some ISPs might already be preparing the ground for battle. And there might already be evidence of such preparation. That evidence shows up provided by Netflix itself.

Netflix calculates an "ISP Speed Index". This serves as a means to pressure ISPs to invest in more capacity so that quality of service does not visibly degrade. After all, NFLX's customers can see, month after month, what ISPs would probably provide them the best service for watching Netflix. It is in this Speed Index that a worrisome trend is emerging:

Click to enlarge

The trend pictured above shows that several large ISPs, Verizon (NYSE:VZ) chief among them, are seeing a quick drop in throughput speeds. While some might interpret it as a reaction to the net neutrality ruling, it should be noticed that the trend started a couple of months before the ruling - though it now accelerated.

This trend might thus have a meaning that's related, though not entirely dictated, by net neutrality. It might mean that the interconnection/peering problem is rearing its head, a problem made even worse by the death of net neutrality. And in this problem, Netflix is again the most obvious victim, because for Netflix it's about the same paying the ISP to positively discriminate it, or paying it to receive excess traffic from the networks it uses!

Favoring this interpretation, is the fact that by Summer 2013 there were already problems emerging with the peering agreements, for instance between Verizon and Cogent (NASDAQ:CCOI) (where Netflix is a large customer). It seems likely that such problems have only deteriorated since, and will keep on deteriorating until money exchanges hands.

Conclusion

The ability of ISPs to discriminate internet traffic and charge for better service to some sources is not the only problem facing large traffic sources. A close relative of that problem is the fact that when traffic between networks is not balanced, it is already standard practice to charge for traffic - and obviously networks injecting streaming video will not show balanced traffic.

There is already evidence of this problem taking place, with Netflix ISP Speed Index showing several large ISPs with dropping speeds. This is not happening because of discrimination of traffic, but because of the interconnection with networks injecting Netflix traffic. The death of net neutrality makes it easier to try and charge for that problem, but even with net neutrality restored this problem wouldn't go away.

In the medium to long term, the only likely solution for this problem will be Netflix paying more. Not really because the ISPs are discriminating against it or shaking it down, but because whatever network Netflix chooses to use to deliver its traffic will end up being unbalanced with the last-mile ISPs, granting these the right to get paid and not carry settlement-free peering agreements with such network.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.