For most of 2014, Netflix (NASDAQ:NFLX) streaming speeds on Verizon's (NYSE:VZ) FiOS fiber-optic broadband service have been falling like a rock. By this summer, average Netflix speeds for FiOS users had slowed to a crawl at less than 1.6 Mbps. That's barely above the 1.5 Mbps connection speed recommended by Netflix for basic streaming.
Some users experienced even worse performance, with long buffering times that Netflix blamed on Verizon. However, in the last few months, average Netflix streaming speeds on FiOS have doubled to 3.17 Mbps. FiOS customers are reaping the benefit of a new "paid peering" arrangement between Netflix and Verizon.
Netflix straining the Internet
In the past few years, Netflix has put increasing strain on the U.S. Internet infrastructure as it has grown its subscriber base, encouraged subscribers to spend more time using the service, and introduced higher-quality streaming options. Netflix now accounts for more than 34% of downstream Internet traffic in North America.
Rising Netflix usage has swamped the capacity of Internet service providers at key choke points during peak hours. Given Netflix's ever-increasing demands on their infrastructure, many ISPs were not inclined to increase their capacity without getting some level of compensation from Netflix for the amount of traffic it was sending over their networks at peak times.
This caused Netflix streaming quality to fall across a wide range of ISPs throughout late 2013 and early 2014. For example, FiOS customers achieved average speeds -- the technical term is actually "throughput" -- of 2.2 Mbps while streaming Netflix videos last fall. That's comfortably above the 1.5 Mbps level Netflix recommends for decent streaming quality.
Streaming speeds fell for most of the next few months, though, bottoming out at less than 1.6 Mbps. Similar slowdowns occurred for Verizon's DSL customers, as well as customers at other major ISPs like Comcast and AT&T.
Holding the Internet hostage?
The slowdowns experienced by millions of Netflix users in the U.S at one point or another in the past year has led to many theories about what is going on and who is to blame. Some users have blamed the Internet providers for deliberately slowing down ("throttling") Netflix speeds.
Meanwhile, Level 3 Communications -- one of the firms that delivers Netflix content over the Internet -- argued that U.S. ISPs were refusing to make basic upgrades to their networks in order to extort big payments from Level 3, Netflix, and other firms carrying large amounts of traffic.
Netflix wasn't quite so crass. Earlier this year, it told investors that it didn't think ISPs were actively throttling Netflix traffic. However, in March, Netflix CEO Reed Hastings began to push for a concept he calls "strong net neutrality." In essence, this would require ISPs to provide sufficient capacity at key interconnection points to all sources of Internet traffic at no charge.
Paid peering, for now
Since this strong net neutrality doesn't exist today, Netflix has been striking "paid peering" deals with various ISPs this year in order to ensure better service for its customers. This involves Netflix paying a fee to the ISP for a direct connection to its network. In essence, Netflix is covering some of the cost to the ISP of upgrading its infrastructure to handle the additional traffic.
Netflix reached this type of deal with Verizon in late April. At first, this didn't seem to fix the problem -- Netflix speeds on Verizon FiOS and DSL connections bottomed out this summer. However, in the last few months, Verizon FiOS has become much faster.
In August, FiOS moved up 2 spots in Netflix's speed rankings among major U.S. ISPs. Then, in September, it jumped all the way from the No. 10 spot to No. 1, edging out a variety of cable companies. Verizon's regular DSL service continues to be near the bottom of the Netflix ISP Speed index, though.
Even the average FiOS speed of 3.17 Mbps still isn't as fast as the average speeds at many Canadian and European ISPs. Still, that could be partially attributable to the fact that Internet video adoption is unusually high in the U.S. While the Netflix-Verizon paid peering deal isn't perfect, it has vastly improved the Netflix streaming experience for FiOS customers.
Paid peering may be here to stay
Obviously, Netflix would love to get the speed improvements it has recently achieved across multiple ISPs (including Verizon) without paying for them. However, Netflix's domestic streaming contribution margin has grown nicely this year despite the payments, indicating that the costs are very affordable for Netflix.
The "strong net neutrality" provisions favored by Reed Hastings are unlikely to become law. Since the days of dial-up, ISPs have advertised based on the maximum bandwidth available -- actual performance has always varied. (Indeed, when dial-up was the norm, at peak times it could be impossible to get on the Internet at all!)
Reed Hastings' suggestion that ISPs should be required to deliver the advertised throughput 24/7 no matter what would force ISPs like Verizon to spend huge sums of money to expand network capacity or reduce their advertised speeds. Neither scenario would help consumers very much.
The status-quo seems to be working well right now. Netflix customers across numerous ISPs are getting better Netflix streaming quality than ever before, with Verizon FiOS leading the way. In the end, that's all that most Netflix users care about.
Adam Levine-Weinberg is short shares of Netflix. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.