In a power-broker e-mail exchange a few weeks ago, Profit Rank President Mike Gunn asked search guru and Did-it.com Executive Chairman Kevin Lee how affiliates cheat.

His answer was a word from the world of finance: arbitrage. Here's his answer in full:

The most common methods of affiliate arbitrage cheating are they buy brand names in certain geos (cities, states of DMAs) and at certain times of the day. Affiliates are less likely to get caught if they don't buy business hours in the HQ city of the merchant. 

In some cases they research the most likely phrase that will result in a brand being used but isn't the brand itself, and buy as a phrase or broad.  A fictitious example might be to want to bid on Kentucky fried chicken and instead bid phrase match on Kentucky fried.

Also popular is breaking the rule between display domain and landing page domain.  They display one domain and then do a direct link.

The question was prompted by our observation that a very prolific affiliate of one of our clients had acquired the remarkable capacity to drive lots of traffic to our client's website without employing a website of his own, e-mail, or any other method that we could detect. 

What's left? Sponsored Search: we presumed that the client was buying Pay-Per-Click (PPC) ads and sending the traffic to our client's site, generally a violation of the Sponsored Search provider's terms of use.

Arbitrage Explained

So, where does arbitrage come in? Recall that an affiliate program generally works on a Pay-Per-Action (PPA) basis, rather than PPC. In other words, the affiliate receives a commission when the customer makes a purchase. Since not everybody who clicks through actually opens his wallet, the average PPA commission has to be higher than the PPC bid for the same traffic. In fact, in a perfect world, a merchant with a 10% on-site conversion rate would be paying a PPA commission exactly 10 times higher than his per-click charges.

The world isn't perfect, though. In reality, there is always some misalignment between the two models: affiliates are either making slightly more or slightly less on the average click-through than the average PPC bidder is paying. If the numbers work out in the right direction, this represents an arbitrage opportunity for the affiliate: he can buy traffic from the Sponsored Search provider in the form of clicks, sell it to the merchant in the form of conversions, and pocket the difference.

Now, with the exception of a successful affiliate, nobody but the merchant is normally in a position to do this. Why not? Because the arbitrage calculation depends critically on the merchant's conversion rate for incoming traffic, and this is information that merchants won't normally share. The one exception to this rule, of course, is the successful affiliate, who sees conversion data as a matter of course in reports from his affiliate network, and enough conversion data—due to his success—to know this conversion rate with some degree of precision.

Effectively, it's an inside job. And our client was quite naturally concerned that this practice might be siphoning traffic away from their own PPC effort.

Naughty or Nice?

The three major Sponsored Search providers are split on the subject of affiliate arbitrage: Google explicitly allows it, whereas MSN and Yahoo do not. Since, in either case, the reasoning behind the decision must to some degree involve the interests of the client, it's interesting that we find disagreement here.

Let's look at the objections to affiliate arbitrage, from the merchant's perspective:

I don't want to lose control of my brand!

A reasonable objection, and precisely what would happen if affiliates were allowed to bid on branded keywords (Coca-Cola, for example). As a matter of fact, though, all Sponsored Search providers—including Google—restrict affiliates from bidding on these.

If you're concerned that affiliates are bidding on your branded keywords, a few searches conducted at odd hours and by Aunt Thelma in Akron should ferret out most offenders. If you're really concerned, congratulations: you are obviously a very successful company that can afford the platoon of lawyers it's going to take to reduce the problem to a mere annoyance.

I already have a Sponsored Search program. If affiliates bid against me to send traffic to my own site, they'll bid up cost of my clicks and I'll still have to pay their commissions!

Now, this is a meaty objection. It rests on two assumptions:

1. That competition from affiliates can have a measurable effect on the price you pay for a click; and
2. That the extra cost to your business—possible PPC fee inflation plus commission—will not be offset by additional traffic contributed by the affiliates.

The first objection is the simplest, so let's deal with that one first. Who nets more dollars on a sale, excluding PPC fees: you or your affiliate? This number represents the absolute maximum that either of you can afford to pay in click fees for a sale before taking a loss. Here's the formula for your absolute maximum bid:

Max Bid = Net $ per Sale x Conversion Rate

Pay more than that for the average click, and you'll start hemorraging money.

So: who makes more on the sale? If you do, relax... the only way your affiliate can outbid you is by throwing money away. He won't do that. On the other hand, if you run a narrow-margin business and your affiliates make more than you do, you might have a problem.

Maybe.

What about the extra cost? Well, consider that, one way or the other, you're paying something in excess of your PPC fees to sell your product via PPC. If you're large enough, you pay somebody's salary, or several. If you aren't, you pay the cost of dividing a key person's attention... maybe yours! So here's the question: are these hidden costs more or less than the dollar value of that commission? If more, congratulations...

You've just identified an arbitrage opportunity.

Putting Market Forces to Work For You

In the real world, market forces dominate: put enough people to work on a problem and pay them according to their degree of success, and your problem is more or less guaranteed to be solved, and solved well.

Within the context of affiliate arbitrage, your market is that army of affiliates, and their economic incentive is that commission. Their stock in trade? The click.

The fact is that many successful affiliate marketers are PPC geniuses. Imagine, for a moment, if you could hire a thousand PPC specialists—who would provide their own office space and equipment—and only pay the successful ones. This is precisely the opportunity afforded by handing your Sponsored Search operations over to affiliates! Think of that affiliate commission as inescapable overhead: you're going to pay it anyway—either as rent and salaries or as a commission—so you may as well pay it to the folks bringing home the bacon.

Of course, you have to organize for success. Recall that—of the three major Sponsored Search providers—only Google explicitly allows affiliate marketing. You can enable it in the other networks, though, by the simple expedient of:

1. Inviting your affiliates to link directly into your site;
2. Soliciting their feedback, paying attention to it, and implementing their best ideas; and
3. Getting out of their way.

Now, you may have gathered the impression that I am urging you to fire half your marketing department. In short:

Yes, I am.

Unless, of course, the folks on the chopping block can find creative ways to make themselves as effective and as useful as your newly-enabled affiliates...

For ideas, interested marketing employees might see #2 above.