May 2000

As traditional circuit-switched telephony services become applications using global IP (Internet protocol) data networks, the need for authorizing and billing inter-IP domain traffic will grow. This commercial function, known as clearing and settlement in circuit-switched telephone networks, presents a major new revenue opportunity for IP carriers.

Clearing and settlement lets IP carriers duplicate the functionality of a wholesale circuit-switched network, but at substantially lower costs: it is the economic process of compensating interconnected networks for shared traffic.

To enable revenue sharing among network providers involved in the origination and termination of VoIP/FoIP (Voice over IP/Fax over IP) traffic, there must be an efficient mechanism to securely authorize, route, and rate individual calls; and to allocate or transfer revenue to the network providers who terminate traffic at their gateways. Clearing and settlement is the critical commercial enabler of IP telephony. Without this tracking mechanism, there would be little revenue incentive to originate or terminate IP telephony traffic.

INTERCONNECTION MODELS
The following sections illustrate interconnection models for existing circuit-switched telephone networks, the World Wide Web, and IP telephony.

Circuit-Switched Interconnection
The interconnection model for the traditional circuit-switched telephone network is shown below:

This model starts with the calling party, who pays for the call to be completed to the called party. The originating network operator relies on other networks to complete the call to the called party. The circuit-switched telephony model works well because each network operator is compensated for carrying its segment of the call.

Network operators compensate each other for the traffic they exchange through bilateral interconnection agreements. These agreements specify how two networks are physically interconnected at the network level. These agreements also specify how the networks are paid on a business level.

The two interconnected carriers periodically determine how much traffic they have sent to and received from one another. The traffic exchanges between the two networks are netted out to yield a net traffic flow. The net traffic flow is multiplied by the interconnection fee. The result is a net settlement payment from the net originating network (the calling party's network) to the net terminating network (the called party's network).

In the circuit-switched interconnection model, network and business interconnection occurs between adjacent networks. Network security related to the exchange of traffic is simple since the networks have a direct connection between tandem switches. There is no risk of fraudulent interconnection since each operator has complete control over trunk group installation and Call Detail Records (CDRs) generated by their switch.

Web Interconnection
The Web interconnection model is different from the interconnection model for circuit-switched telephony in two important ways:

First, in the circuit-switched interconnection model, wholesale network resources are paid for on a usage basis. In the Web interconnection model, customers and operators pay for access to network resources. With simple access pricing, interconnection pricing is based on the size of the pipe used to physically interconnect networks, not the volume or type of traffic exchanged between networks. For example, a T1 connection may cost a fixed $1,500 per month regardless of the volume of voice or data traffic exchanged between the networks.

Second, in the circuit-switched model, all service revenues are paid by the calling party. In the Web interconnection model, revenue is derived from both the originating and terminating networks. As shown below, the browsing party (analogous to the calling party) pays its ISP to get access to the Internet. The browsed party (analogous to the called party) pays its ISP to make its Web site accessible to all browsers on the Internet. In turn, both ISPs pay a wholesale IP network operator for access to the Internet.

IP Telephony Interconnection
The IP telephony interconnection model is a combination of both the circuit-switched and Web interconnection models. At the IP network level, interconnection between the IP networks is the same as the Web interconnection model. Smaller IP networks pay for access to an IP backbone network.

As shown above, layered on top of the IP infrastructure are VoIP (voice over IP) gateways located at the edge of the IP network. These gateways convert telephone calls into IP packets for transmission across the IP network. In a typical scenario, a telephone call will be received by an originating VoIP gateway. The originating gateway will convert the telephone call into a stream of IP packets that are transmitted across the IP network to a terminating gateway. The terminating gateway receives the IP packets and completes the telephone call to the called number. The entire voice over IP segment of the telephone call is transparent to the calling and called parties.

Like the traditional circuit-switched interconnection model, all Internet telephony service revenues are generated by the calling party. Also, like the circuit-switched interconnection model, network operators will not complete calls on behalf of other firms unless they are compensated for the use of their network. The Web interconnection model ensures that the IP backbone operator is compensated for the IP traffic it exchanges with the originating network operator. However, the Web interconnection model offers no means for the terminating VoIP operator to be paid for accepting the VoIP packets and completing the telephone call.

As a result, IP clearing and settlement are even more fundamental commercial requirements for voice over IP networks than they are for circuit-switched networks.

VALUE PROPOSITION FOR IP CARRIERS
There are several reasons IP clearing and settlement is an attractive proposition for IP carriers (IP backbone operators):

1. The IP infrastructure of these firms is well suited for handling IP voice and fax with an acceptable quality of service.
2. IP carriers are seeking ways to stimulate demand for their core service -- wholesale IP bandwidth. Clearing and settlement is a critical commercial enabler for IP telephony applications, and these applications will increase demand for wholesale IP bandwidth.
3. Clearing and settlement services enable IP carriers to provide their service provider customers (ISPs, ITSPs, and CLECs) new value-added services. Furthermore, by clearing and settling inter-network IP voice/fax traffic, IP carriers can effectively charge higher rates for voice/fax traffic than for commodity IP data traffic.
4. An IP carrier's installed base of ISPs and CLECs represents an existing community of users who, with a small capital investment, can immediately benefit from inter-network clearing and settlement by offering new value-added voice/fax services to their customers. (Clearinghouses can provide CDRs to ISPs, ITSPs, and CLECs for billing retail customers.)

The IP telephony business model represents a significant value opportunity for an Internet Telephony Service Provider (ITSP) in the U.S. market.

TAPPING EXCESS NETWORK CAPACITY
In the IP telephony model, 1.5 cents per minute* is the average of all economic costs, fixed (gateways) and variable (bandwidth and LEC termination). Economic costs are defined as accounting costs plus profit margin. This point is important because the mesh architecture of an IP network does not require direct interconnection between ITSPs to exchange IP telephony traffic. Since ITSPs are fully interconnected, the market opportunity for them to buy or sell excess capacity at marginal economic costs (cost + profit margin) can be very efficient and profitable for all participants.

The economic appeal of VoIP termination is driven by two factors. First, the peak traffic load for the average ISP offering dial-up services occurs in the evening. The peak for telephone traffic occurs during the day when ISPs have excess capacity available. ISPs are a natural market for offering VoIP termination services since their traffic loads are asymmetric with telephony traffic. Second, ISPs generate approximately 1.5 cents per minute in gross revenue for dial-up services. This 1.5 cents per minute in gross revenue must cover all network, marketing, and customer service expenses. ISPs would not incur marketing or customer service expenses for IP telephony termination services. Therefore, ISPs can profit from offering IP telephony termination service at a price well below 1.5 cents per minute. This assumption is even more compelling if the ISP offers VoIP termination services when it has excess capacity available.

Tapping the value of excess network capacity is not a new concept for circuit-switched telephony operators. Traditional telephone companies have been profitably buying and selling excess capacity at marginal economic costs for decades. We believe, however, that an IP architecture enables the trading of network capacity between carriers at dramatically lower transaction costs.

* The author arrives at this figure using list prices from Level 3 (an IP carrier) and pricing from an interconnection agreement between BellSouth and ICG Telecom Group. For a full explanation of this cost analysis, see TransNexus' whitepaper "The Value Of IP Clearing And Settlement," from which this article is adapted.

Jim Dalton is CEO of TransNexus, a leading provider of IP network clearinghouse solutions and products. TransNexus offers a range of standards-based clearing and settlement solutions and products for real-time authorization, routing, clearing, and settlement of inter-domain voice/fax communications among VoIP carriers. TransNexus' clearinghouse solutions and products are ideal for wholesale IP carriers and IP backbone providers wishing to become a V/FoIP clearinghouse and offer their ISP/ITSP/CLEC customers inter-carrier clearing and settlement of VoIP traffic as a value-added service. With the TransNexus range of clearinghouse solutions, IP carriers can leverage their existing IP network into a wholesale telephony network, increase bandwidth demand derived from wholesale telephony services, and offer a more differentiated service.