Second Quarter 1998

BY LAURENCE J. FROMM

Readers of this magazine are well aware of the strategic value of IP telephony. This strategic value includes the deployment and administration savings of converging all our communication needs on to a single network; the engineering economic advantages of packet networking gear versus circuit-switched network gear; and the enhanced communication applications that are enabled by multimedia, open communications infrastructure. Most readers will also recognize that much of the early interest and investment in IP telephony systems and services is spurred by once-in-a-generation opportunities to arbitrage international settlement rates.  The global telecommunications system is undergoing deregulation.

Competition is replacing monopoly regimes, for the benefit of consumers (and entrepreneurs) worldwide. But the process is not complete, and many of the old rules still apply. (For a fascinating look at life on the edge of deregulation, look at the cat and mouse games that international call-back operators have played with national telecom operators around the world.) The rules that policymakers apply will affect the shape and growth of the IP telephony industry; particularly this first stage of life as IP telephony builds critical mass and credible products and services. And, unfortunately, the rules of engagement are moving to the front burner.

BACKGROUND
The United States has long been one of the most vocal advocates and visible proponents of deregulation and competition, particularly in the arena of telecommunication services. Much of the world follows the lead of the United States Federal Communication Commission and Congress in determining their own policies. Ironically, among the economic powers, it is in the United States that the IP telephony industry faces the most significant risk of regulation.

The U.S. has long had a public policy to promote universal services for basic telephony service. (This public policy has both an economic and political motivation behind it. The economic motivation, ironically, is the same one that contributes to the explosive acceleration of Internet use — Metcalfe’s law — that is, the value of a network increases with the square of the number of people connected to the network. In other words, telephone service in the U.S. and other developed countries is so valuable because virtually everyone is connected to it.) In essence, users of long-distance telephone service subsidize basic service so that basic service may be provided more cheaply. In the old days of AT&T, the basic service subsidy was transparent since the same regulated company provided both long-distance and basic service. With the AT&T breakup and deregulation of long-distance service, a new set of rules was developed. The FCC is now examining what rules should apply to IP Telephony Service Providers (ITSPs) and, more broadly, ISPs.

The rules for long-distance carriers today consist of a direct tax to fund universal services — long-distance service providers pay 4 percent of their gross revenue to the Universal Services Fund (USF). On the surface, this 4 percent tax does not seem onerous or threatening to the infant life of our industry. But the means to assess the 4 percent USF tax is to classify ITSPs as long-distance carriers. This classification carries a great deal of additional baggage with it. For starters, long-distance carriers pay access charges to the local exchange carriers. Access charges vary by area, but are in the range of $.03-.05 per call, per minute. When long-distance carriers offer long-distance for $.10 per minute or less, access charges constitute a major portion of the cost. More ominously, the cost of international long-distance calls is driven largely by international settlement rates that are a vestige of the old monopoly telephone regimes. Subjecting ITSPs to international settlement charges would slow the pace of IP telephony development and deployment, and hence hurt the objective of driving international settlement rates lower in order to offer lower cost international calls to consumers and business. Additionally, ITSPs — if classified as long-distance carriers — would be subject to additional federal requirements for non-discrimination and nationwide rate integration; payment of annual regulatory fees; support for numbering and relay systems for the hearing impaired; certification, tariffing and reporting; and assisting with tracking interstate gambling and establishing wiretaps. State requirements include certification and perhaps bonds and posting of tariffs. In sum, the mechanism to impose a relatively benign Universal Services Fund tax on ITSPs is a burdensome regulatory apparatus that is changing due to deregulation anyway.

There are a number of good reasons why IP telephony is exempt from the regulation that applies to long-distance carriers.

IP TELEPHONY IS AN ENHANCED SERVICE
The FCC created an enhanced services category in the 1980s exempt from access charges and not subject to regulation at a federal or state level. The FCC created this category because enhanced service providers did not exhibit market powers and because of practical considerations in trying to regulate enhanced service providers — both arguments that apply to IP telephony today. The technical definition of an enhanced service is one "offered over common carrier transmission facilities used in interstate communications, which employ computer processing applications that act on the format, content, protocol, or similar aspects of the subscriber’s transmitted information; provide the subscriber additional, different, or restructured information; or involve subscriber interaction with stored information." 

When one calls from a phone to a PC running Microsoft NetMeeting or any of a number of other PC phone clients using an IP telephony service provider, the service is acting on the format, con tent, and protocol of the transmitted information. At a minimum, voice compression and protocol conversion to H.323 is occurring. When one makes a phone to phone call using IP telephony and a pair of gateways, two format, content, and protocol conversions are occurring, one at each gateway. By definition, IP telephony is an enhanced service.

IP TELEPHONY FURTHERS THE GOAL OF UNIVERSAL SERVICES
IP telephony increases competition for communication services. Dozens of ITSPs are in business, and more enter every day. Competition increases the choices and lowers the cost of communication services. This is a good thing. The ISP market provides a good example of what competition — unfettered by regulation and non-cost based surcharges and with low barriers to entry — can offer. 4,500 ISPs big and small, global and local, compete on different aspects in the United States alone.Some focus on service, some on reliability, others on quality, many focus on price. Consumers have their choice, and prices have dropped precipitously. The same dynamic is already playing out among ITSPs. Increasing competition and lowering the cost of communication services serves the objective of universal services.

PRACTICALITY
PC-to-PC
IP telephony enables many applications and comes in many forms. The earliest and still most popular form is PC-to-PC. Even if it was desirable, it is not practical to separately tariff or regulate PC-to-PC IP telephony — bits are bits are bits. It is difficult and counter-productive to try to distinguish audio bits from e-mail bits or Web page bits. It is even more difficult and even more counterproductive to try to distinguish real-time, full-duplex audio bits from store-and-forward audio bits. Unless the FCC is prepared to tariff and regulate the Internet industry as a whole — a monumentally bad idea that is the epitome of throwing the baby out with the bath water — it is not practical to regulate PC-to-PC IP telephony.

PC-to-Phone
Another form of IP telephony is PC-to- phone. A gateway is used to bridge traffic from the Internet to the public switched telephone network. PC-to-phone enhances IP telephony calls in many ways:

• Directory services: A standard telephone number is used to direct a call.
• Quality of service: If your ISP is also offering the PC-to-phone service, all calls stay "on-net."
• Addressable endpoints: Every phone in the world is now addressable.
• Inexpensive terminals: The receiving terminal is a standard telephone.

The task of regulating a PC-to-phone call is a quagmire. Clearly, there is no access charge for the origination of the call — to the service providers involved, the origination looks like a PC-to-PC call. Hence, even in a regulated environment, a PC-to-phone call avoids two-thirds of the access charges (which are typically higher for origination than for termination).

Even if PC-to-phone service providers were characterized as long-distance carriers (an odd designation since they may carry the "phone call" several inches from the line they lease from their ISP to the line they lease from their local phone company, providing appropriate conversion in between), not all calls they terminate are subject to access charges. The service provider may provide termination services to both local (not subject to access charges since the service provider already pays metered charges for local calls) and long-distance callers. So how is a service provider to know where the call originated? The service provider just wants to terminate calls in his local area for a low per minute charge.

In summary, the effect of regulating phone-to-phone or even PC-to-phone IP telephony service is to artificially spur demand for PC-to-phone services.This means the consumers that will most enjoy the increased competition and low prices that IP telephony provides will be precisely those consumers that least need low cost communication services — those that can afford PCs and ISP connections to originate calls.

THERE IS NO MONEY HERE (YET)
Despite optimism for a bright and promising future, sensible observers are forecasting measured growth. Probe Research, for example, projects that IP telephony will take less than 4 percent of traffic from the public switched phone network in 2000. Piper Jaffray estimates that total IP telephony equipment sales in 1997 were just $20M.

FOSTERING COMPETITION IS PUBLIC POLICY
The IP telephony arbitrage opportunity spurs much of the early interest and investment in IP telephony, but the strategic drivers of IP telephony are the engineering economics of collapsing to a single network for all our communication needs, and the enhanced services that multimedia, open communication infrastructures can bring. Already, vendors are delivering systems for Internet call waiting, call center integration, conferencing, virtual ACDs, virtual PBX, and telecommuting servers that all utilize IP telephony technology to offer value-added benefits to users.

Nevertheless, the early interest and investment from IP telephony is important. From the perspective of the U.S. Congress, it seems relevant that many of the leaders in Internet and Internet telephony products and services are based in the United States, and are creating the jobs and industry dynamics that other countries envy. Companies like Dialogic, VocalTec, ITXC, and scores of others in the emerging IP telephony industry are hiring the skilled employees that AT&T and the RBOCs are letting go. Regulatory decisions that limit IP telephony service provider opportunities in the U.S. will diminish opportunities for IP telephony equipment vendors, too. So, who is to gain? Possibly, the Europeans.

The European Commission has recently ruled that IP telephony services cannot yet be considered "voice telephony" and are not subject to formal licensing requirements at this time, though the EC may amend its position based on market and technology developments.

SUMMARY
IP telephony is increasing competition, increasing choice, and lowering the cost of communication services. It is the forefront of the technology and services that lead to a dramatic re-architecture of our communication infrastructure over a span of years or even decades. It does not fit neatly into the regulatory framework for telephone calls that was constructed during monopoly regimes and is being torn down. The answer is not to apply old, regulated, non-cost-based mechanisms to this dynamic industry. Rather than regulating IP telephony and throttling innovation, competition, and job creation, the FCC should concentrate on deregulation and increasing competition in the traditional telephony service industry. The FCC should forbear regulation of IP telephony.

Laurence J. Fromm is vice president, new business development for Dialogic Corporation. Dialogic is a leading manufacturer of high-performance, standards-based computer telephony components. Dialogic products are used in voice, fax, data, voice recognition, speech synthesis, and call center management CT applications. The company is headquartered in Parsippany, New Jersey, with regional headquarters in Tokyo and Brussels, and sales offices worldwide. For more information, visit the Dialogic Web site at www.dialogic.com.