Streetwise Professor

The IHT and NYT ran a very sensible article on the “bourse merger stampede” by Jenny Anderson (with contributions from Heather Timmons). Anderson, and the people she quotes, express considerable skepticism over the economics of exchange mergers, especially cross-border mergers. Anderson says: “[w]hile the Big Board and Nasdaq are excited about global consolidation, neither has made an effective case for how to accomplish such a merger and what it offers, beyond diversification.” Here, here!

Anderson states that Nasdaq’s CEO, Robert Greifeld, believes that a merger with the LSE would allow creation of a single system with lower costs. Where are these savings to come from? LSE and Nasdaq already have trading platforms up and running. Is one going to replace the other? If so, there will be some significant costs to be incurred upfront by the exchange whose system is replaced, and perhaps more importantly, by its customers. There will be savings in development costs down the line, but it is by no means clear how big these savings will be. Moreover, there will be other costs. Furthermore, and perhaps most important, cultural and regulatory differences may make a Nasdaq-LSE tie up very expensive and cumbersome.

As for a combination of NYSE and a European exchange (with Euronext being the likeliest candidate at this round of speed dating), the most commonly cited benefit is “diversification.” Run, don’t walk, away as quickly as possible when managers justify a merger through its diversification benefits. That’s what equity markets are for–to allow investors to diversify so that firms don’t have to do it through acquisition. Moreover, it is arguable whether a purchase of a European stock and derivatives exchange really generates much diversification. The correlation between trading volumes across equity markets is pretty high. And there are downsides to geographic and product line diversification, most notably the cultural and regulatory factors alluded to earlier.

Several hedge funds, most notably Winchfield Holdings are hot for Euronext to merge with DB. This suggests that they see some cost savings, and indeed this may be the case for an intra-European combination. Next week’s non-binding Euronext shareholder vote on this merger will provide some indication of whether this is a commonly held view.

Articles about the energy futures and grain and oilseed futures markets make it abundantly clear that the ultimate dominance of electronic trading is drawing nigh. The commodity markets have been the last bastions of open outcry, but soon the largest of them–at NYMEX and the CBT–will begin side-by-side electronic and floor trading. If the experience in other markets is any guide, volume will move inexonerably to the electronic platform.

Although one can sympathize with the NYMEX floor traders quoted in one of the articles, realistically speaking they are whistling past the graveyard. Those leasing seats have no ownership in the exchange, and will thus have no vote and effectively no voice in the exchange’s future direction. They have no legal claim to any proceeds from the IPO. They are no different than renters of real estate with no control over the sale or conversion of their apartments.

And one piece of free advice–don’t strike, as the article suggests that some NYMEX traders are threatening. Learn from the French–as shocking as that sounds coming from me. The floor traders at MATIF (the French futures exchange that is now part of Euronext) tried that when that exchange introduced side-by-side trading in 1998. All this did was accelerate the movement towards electronic trading and led to the closure of the floor in weeks, rather than months. The striking traders exchanged a shrinking fraction of something for 100 percent of nothing. Not a good idea. The floor will continue for awhile even after the screens go live during regular trading hours. For most of the seat renters, it’s better to hang around and get some business than strike and get nothing. Moreover, seat lease prices will decline as the electronic system gains market share. Those that stick around will make a fair return on their capital. Those that strike won’t.

Although electronic trading currently has an aura of inevitability–and indeed obviousness–that wasn’t always the case. I’ve been around since the conventional wisdom in the futures markets–and the securities markets too–was that open outcry is inherently more efficient and liquid than electronic trading. Indeed, I played a role in challenging and changing that conventional wisdom. In so doing, I was subjected to scorn from some important people in the business, but as the the expression alluded to in the title says–he who laughs last laughs best.

I have followed developments in electronic trading since Globex’s development was first announced in 1986 (I was working at an FCM in Chicago at the time). Although Globex has become the orb-straddling collosus that its name connotes, it wasn’t always that way. I followed the system’s checkered early years, which were beset by disputes between the (then) partners in the endeavor, CME, CBT, and Reuters, and the opposition of many members of CME and CBT who viewed electronic trading as a threat. I remember when MATIF did the most business on Globex.

I wrote my first working paper on electronic trading in 1991 or 1992. The paper analyzed the potential efficiencies of electronic trading, emphasizing the ability of computerized markets to reduce the costs of access (thereby likely leading to higher volume) and to reduce error costs. The early paper also compared liquidity supply on electronic and open outcry exchanges. I didn’t reach any definitive conclusions on liquidity because there appeared to be potentially offsetting impacts. This was essentially an empirical issue.

I had the opportunity to begin an empirical examination of liquidity on electronic and open outcry exchanges in 1994. I was retained by Deutsche Terminborse to determine whether it was advisable for the exchange to create a new class of members analogous to locals on open outcry exchanges. DTB had heard ad nauseum that the open outcry LIFFE was inherently more liquid because of its individual market makers–locals. To determine whether DTB really needed electronic locals to allow it to compete more effectively with its London rival, I decided on a novel approach–to look at the data. The data showed that if anything, DTB was more liquid and deep than LIFFE.

Although DTB had originally intended to keep the report private and use it for internal decision making purposes only, upon seeing the results (subsequently published in a peer reviewed journal) the exchange released them publicly. The reaction was swift, and decidedly negative from some quarters–notably LIFFE. LIFFE’s CEO, Daniel Hodson, insinuated that a pointy headed academic shouldn’t be taken seriously–everybody KNOWS that open outcry is more liquid. (I’m looking through my clip files to get the exact quote from an old FT article–will update when I find it.) Other industry people were equally critical.

It therefore took some restraint on my part to avoid gloating when less than 4 years later DTB routed LIFFE in the Bund market, and Hodson was forced out as CEO. DTB used my study as part of its marketing blitz in 1997-1998. It’s fair to say, however, that LIFFE’s near death experience was more attributable to its own complacency than any academic study. When making its concerted attack on LIFFE, DTB cut prices aggressively and the British exchange did not respond until it was too late. In less than a year the Bund futures market–the largest in Europe and one of the largest in the world–had tipped from an open outcry exchange to an electronic one. No one would ever sneer at computerized markets again, and from early 1998 it was abundantly clear that the future was electronic and that open outcry markets were fighting a rear guard action.

Another working paper of mine presents a theoretical framework that helps illuminate why electronic trading has prevailed in the end. Open outcry advocates focused on two things that were right before their eyes–the pool of liquidity provided by locals on the floor, and the evident information advantage of those on the floor. Although these are features of open outcry (though the information advantage of floor traders may be exaggerated), in emphasizing these aspects, the floor partisans overlooked another important fact–the huge latent liquidity pool upstairs. The time and space advantages of those on the floor make it difficult for upstairs traders to supply liquidity in competition with the locals, especially in very volatile markets. The time it takes to send and revise orders from upstairs makes those trying to trade via limit order from off the floor vulnerable to being picked off. This taxes upstairs liquidity supply.

Electronic markets annihilate the floor’s time and space advantage–they eliminate the tax on supplying liquidity from upstairs. The dramatic reduction in the cost of accessing electronic markets has unleashed a flow of liquidity supply from what might term the “globals”–as opposed to the locals. The liquidity on the floor was visible–one could see the locals. In the floor era, the potential liquidity supply from off the floor was effectively invisible–since it was largely untapped, it was hard to understand how big it could become if the costs upstairs traders incurred to access the market were to fall dramatically. My 1994 DTB report hinted at the potential for alternative liquidity supplies, but in all honesty I too am surprised at the torrent of liquidity that computerized trading has loosed. In some respects, therefore, the skepticism about electronic trading that was so common in the 1990s was due to a failure of imagination–a failure to imagine how technological change would alter fundamentally the economics of liquidity supply.

In the old days, those on the floor were able to profit from their time, space and information advantage. Seat prices capitalized value of these advantages to the marginal exchange member–inframarginal members (the better traders, the more risk tolerant, and better capitalized ones) earned even more. The rents accruing to floor traders have disappeared as computerized markets take over, but the skyrocketing valuations of exchanges with publicly traded stock indicates that the pool of potential rents is even bigger in an electronic environment. Computerized trading, with its lower access costs, has driven substantial increases in volume. Seemingly small (but supercompetitive) fees on each trade generate large revenues for exchanges. Again, this was unimaginable only a few years ago, but now seems almost self-evident. It obviously wasn’t though. Even though I was an early supporter of electronic trading, I didn’t buy CME at the IPO or shortly thereafter. If I had only put my money where my mouth was;-)

My head spins trying to keep up with all of the rumors of this exchange talking to that exchange about a merger. Everybody seems to be talking to everybody else in very rapid succession–hence the analogy to speed dating, events where busy and available singles serially interview potential partners.

Ms. LSE seems particularly popular, but somewhat coy. Mr. CME has money falling out of his pockets, but really wants to find Miss Right. Herr Deutsche Borse got badly burned in his courtship of Ms. LSE, and is making overtures to the girl next door–Mlle. Euronext.Liffe, who wants things definitely on her terms or not at all, and seems to have major reservations about Herr DB. Ms. CBOE needs to get completely moved out of her dad’s (Mr. CBOT) house before she can commit. The mature bachelor freshly on the market–Mr. NYSE–appears a little unsure on what to do, but seems to be looking for someone who is very different.

At the end of the night, who will end up with whom? Beats me, but here are a few thoughts.

First, don’t be surprised to see a few mistakes made, as is wont to happen when there are strong expectations that one should really be married by now. Some exchanges are swimming in free cash flow, and it is well known that this sometimes leads to ill-advised purchases. Marry in haste, repent in leisure.

Second, look for economies of scope and scale. As noted in the just-previous post, NYMEX-CME makes sense. CME-Euronext.Liffe also has some attractions given their complementary derivatives products–both are strong in short term interest rate (STIR) products. But both have good technology platforms, so it’s hard to see what they gain from the pairing on that front. And inter-cultural marriages are always a challenge. The scope economies between derivatives (especially futures) and equities don’t strike me as compelling, but I could be wrong. There is a superficially plausible case for combining an exchange that offers individual equity options with an equity exchange, but again I don’t find it compelling. There are potential advantages to trading equities that are currently traded on different exchanges on a single platform, so an equity exchange + equity exchange merger (e.g., NASDAQ+LSE, NYSE+Euronext) may make sense, although they may face some daunting issues regarding integration of their trading platforms. In futures, the big savings come from the clearing side, and potentially the technology side. CME and CBOT have already combined clearing, so a merger between them doesn’t bring a lot of savings on the clearing end. Moreover, there may be some nettlesome legal issues involved in integrating clearing for a US and a European exchange.

In brief, nothing jumps out at me as a no-brainer. Hence, as I’ve often said in the past, don’t believe stories of exchange marriages until you see the rice fly.

After earlier negotiations went nowhere, the Chicago Mercantile Exchange and the New York Mercantile Exchange entered into an agreement whereby NYMEX contracts will be listed on CME’s Globex system and traded side-by-side with the NYMEX open outcry markets. This followed a brief interval in which NYMEX tried to convince an apparently skeptical (and probably justifiably so) marketplace that its legacy electronic systems (Access and ClearPort) were up to the task of staving off ICE’s challenge.

As I noted in my February post “Whither NYMEX,” the NY exchange was vulnerable due to its technological weaknesses, and viewed in that light the deal makes perfect sense. I surmise that NYMEX played hardball in the initial negotiations, and the CME walked. CME then played its cards perfectly, announcing that it intended to offer energy futures of its own on Globex. Already having its hands full with ICE, NYMEX was in no position to tangle with the biggest kid on the block, so it did the prudent thing and combined with the CME.

NYMEX did what it had to do, but the deal is a coup for CME. It gets a nice revenue stream (with very little additional cost) from an established franchise, whereas competing with NYMEX would have been expensive (with marketing expenses, likely fee waivers, etc.) and of uncertain outcome.

Is this the end of the story, or just the beginning? Methinks the latter. There is a potential double-sided opportunism problem here. CME has the technology. NYMEX has the contracts. They have entered into a contractual relationship whereby they share these assets. If Globex trading of energy contracts takes off, as is reasonably likely, each party is in a position to hold up the other. It is very possible that we will see haggling over fees, threats to walk from the agreement, and so on.

How can these problems be forestalled? Merger. A combination would economize on the transactions costs inherent in the double-sided holdup problem. It could also result in some cost savings, especially on the clearing side.

Whether or not this will occur will depend on how electronic trading fares. If my conjecture that electronic trading of NYMEX energy contracts will take off is correct, the deal is almost imperative. Moreover, such a development will undermine the strength of the floor community who might otherwise oppose the deal. The deal will also be easier to consummate after NYMEX has an IPO.

If things play out this way, then the question will become: Whither ICE? That’s a post for another day.

All the coverage of Alan Greenspan’s recent retirement as Chairman of the Federal Reserve Board reminded me of a story related to me by Leo Melamed, the Chairman Emeritis of the Chicago Mercantile Exchange and one of the giants of the world’s financial markets in the last half of the 20th century.

The story took place early in the morning of October 20, 1987–the day after the ’87 Crash. Along with the leaders of the other major exchanges (including the NYSE and the CBT), Melamed was a party to a phone conversation with Reagan administration officials including Secretary of the Treasury James Baker, Chairman of the President’s Council of Economic Advisors Beryl Sprinkel, and newly appointed Fed Chairman Greenspan. Baker wanted to shut the markets on the 20th in order to prevent a further meltdown. (Perhaps this isn’t surprising–Baker was never a strong free market advocate and comes off as something of a control freak.) Sprinkel would have none of it. When Baker asked for Sprinkel’s opinion, Beryl said: “We’ll close the markets when monkeys fly out of my ass!” Baker, somewhat taken aback, turned to Greenspan for support: “Well, what do you think, Alan.” To which Greenspan replied: “I go with the monkeys.”

The upshot was that the markets opened on the 20th. After a scary morning, there was a major rally in the afternoon. Some ascribe the rally to a mysterious Fed intervention. Regardless of the cause, the rally would never have occurred if Greenspan hadn’t gone with the monkeys–and if Beryl Sprinkel hadn’t had the good sense to smack down James Baker.

Zelig-like, I had some involvement in these events. At the time, I worked for a futures commission merchant, GNP Commodities. On the Friday before the Crash, I had told the company’s founder, the late Brian Monieson, that I was leaving the company because of a dispute with my direct boss. (Now you know the REAL reason for the Crash;-)} ). Brian had tried to talk me out of leaving over the weekend, but those discussions were obviously put on hold in the turmoil of Black Monday. I went into the office early Tuesday the 20th. Upon arriving at the Merc, I went directly to Brian’s office. When I saw him, he looked drawn and haggard. I said, “Brian, you look like hell. Did you get any sleep?” Brian said that he had not, and related the harrowing events of the night before.

A large firm owed the CME clearinghouse a huge sum, which if not received would have resulted in the failure of the clearinghouse. Beryl Sprinkel’s monkeys notwithstanding, such an event would have resulted in the closure of the Merc and undoubtedly the NYSE too–with consequences for the world financial system that are too frightening to contemplate.

Brian and other members of the CME braintrust spent the night trying to make sure that the payment would be made. They were assured by the firm that owed the money (Kidder Peabody, if I recall correctly) that they would make the payment. But they worried whether there would be sufficient funds to make the payment. There was little doubt that the firm was solvent, but there was concern whether they had adequate cash. As Brian put it–“They said the check was in the mail, but we wondered how high it would bounce.” That’s where Greenspan came in. He assured the Merc that the Fed would supply sufficient liquidity to ensure that the firm would have access to enough ready funds to make the payment. That was Greenspan’s first–and arguably greatest–major contribution as Fed Chairman.

Update. My memory failed me–Kidder Peabody wasn’t the firm that owed the big payment. According to Bob Tamarkin’s The Merc Kidder was actually owed money. Tamarkin doesn’t name the firm that owed the clearinghouse.

The New York Mercantile Exchange–NYMEX–is in the midst of very challenging times. In some ways, these are the best of times for NYMEX. Energy trading is booming. This has generated substantial volume increases at the exchange, while the rebound in over-the-counter trading has led to record setting business on ClearPort, the exchange’s OTC clearing system. The boom in business led to a steep rise in the NYMEX seat price to $3.775 billion–though this price has fallen substantially, as I will discuss in more detail below.

But not all is sunshine and roses. The exchange has also experienced some difficulties. A die-hard advocte of open outcry trading, NYMEX was originally planning to assist in the creation of a floor-based exchange in Dubai. It later bowed to reality and Dubai will be an electronic marketplace. More importantly, NYMEX spent a pretty sum to set up a trading floor (first in Dublin, then in London) to compete head to head with the International Petroleum Exchange (now ICE Futures) in the trading of Brent crude. The effort failed miserably, and NYMEX is now going electronic in its battle for Brent.

NYMEX has also seen steady erosion in gold trading volume. The Chicago Board of Trade’s electronically traded gold futures contract now has about 20 percent of a market that was once virtually 100 percent COMEX/NYMEX.

And the biggest threats are just beginning. ICE has launched trading in a West Texas Intermediate (WTI) futures contract in direct competition with NYMEX’s flagship WTI (light crude) contract; indeed, the ICE contract is cash settled against penultimate NYMEX WTI/CL futures. In its early days, the electronic ICE WTI has attracted a market share of better than 10 percent. (Registration required.) And now the Chicago Mercantile Exchange is considering entering the energy derivatives market. ICE is clearly a strong competitor, but the CME, with its Globex trading system, sterling reputation, and excellent marketing channels could be in another league altogether.

These developments have put a dent in NYMEX’s seat price. A seat last sold for $3.05 million, a very respectable number, but almost 20 percent of its recent (and all-time) high.

NYMEX is responding. The exchange has announced a rapid move to side-by-side trading (i.e., electronic trading while the floor is open). It has also indicated that it will invest $15 million in new technogy, and there have been reports that NYMEX is looking to partner with Euronext or Eurex to get access to more advanced trading technology. (Eurex is also shopping for a US partner–could NYMEX fit the bill? Reports I have read suggest that Eurex is looking more to a securities exchange with an options license.)

NYMEX definitely has some vulnerabilities. As at some other open outcry exchanges (but not all), its electronic system was something of a stepchild. This is not the only time that floor traders thought that stinting on the development of an electronic system would extend the life of the floor. Such thinking makes sense if you live in a bubble and need not fear competition from other exchanges, but is potentially lethal in the real world where competitors can offer a potentially superior technology. Ironically, the NYMEX floor community might have been better served by investing in an advanced and robust electronic system years ago as such a system could have helped deter entry; competitors would have been less likely to enter knowing that NYMEX was in a position to move its order flow advantage to a viable electronic platform at the flick of a switch.

It’s too late for that, however: NYMEX is in the position of playing technological catch up. Its order flow advantage is clearly important, but as the Eurex-LIFFE episode proved it is not insurmountable if the incumbent (NYMEX in this instance) does not respond quickly to the competitive threat. NYMEX is not behind the 8 ball to the same degree LIFFE was in 1998, but it needs to act quickly to protect its franchise. Technology has not been the exchange’s strong suit (take a look at its web page if you want a quick demonstration of that), and even adopting somebody else’s trading technology (e.g., LiffeConnect) doesn’t happen overnight.

Moreover, to an outsider NYMEX’s internal politics seem byzantine even by comparison to other member owned exchanges–which is saying something. There is considerable opposition to the proposed sale of a 10 percent stake in NYMEX to General Atlantic. As always, it is difficult to gauge how deep the opposition runs, but the opposition is vocal and includes many well known NYMEX members. Fifty-five people (!) are running for the 10 open board seats in the next board election. That further suggests considerable discontent and division of opinion at the exchange. That’s not conducive to a nimble response to one–and perhaps two–looming competitive threats.

How will things play out? Prediction is risky, especially about the future (as Mark Twain said), and that is particularly true in the present instance. One should never underestimate the importance of network effects and the order flow advantage of an incumbent exchange–but one shouldn’t overestimate it either. It is not a talisman that makes the incumbent invulnerable. NYMEX has an achilles heel–its technology. The open question is whether the order flow advantage will buy NYMEX enough time to address this vulnerability. If I was a betting man, I’d say that it will, but that the odds are only a little better than 1:1.

A recent Wall Street Journal article (subscription required) discusses growing unease among brokerage firms over rising trading fees at NASDAQ and NYSE. European traders have expressed similar disquiet at rising fees on European bourses. The heady valuations of publicly traded exchanges, such as the CME and CBT, are predicated in part on the belief that they have pricing power that they will be able to raise fees in the future.

Is it plausible that exchanges have market power, and therefore can charge supercompetitive prices? In a nutshell: hell yes. There is little doubt that exchanges have considerable market power. Over the years I’ve written several articles on the subject setting out the arguments and evidence, but the essence of the story is rather straightforward. (This article sets out the argument in a non-mathematical way.) When some traders have better information than others, the relatively uninformed are better off when they concentrate their trading in a single marketplace. This creates a network effect. Traders like to trade where others trade. There are therefore natural monopoly elements to trading. (In the future I plan to blog about things that weaken the network effect and therefore facilitate competition between trading venues.) Moreover, it is hard to contest an incumbent monopolist’s position. (Cf., Eurex’s not-so-excellent US adventure, ditto EuroNextLIFFE.) Attracting liquidity to a new platform requires the simultaneous defection of numerous traders from the incumbent. This is a daunting coordination problem.

Hence, DTB/Eurex’s victory over LIFFE in Bund futures in 1998 is the exception rather than the rule. As I’ve shown in a working paper , moreover, that was something of a fluke for two reasons. First, DTB/Eurex had a less severe coordination problem because the German banks that were the source of large order flows also owned the exchange, so it was easier to build a base order flow to challenge LIFFE. Second, when DTB/Eurex had attracted enough volume to reduce the price impact disparity with LIFFE, it cut fees aggressively and LIFFE did not respond. If LIFFE had responded in kind rather than dilly-dallying for 3 crucial months, it might have hung on to a big chunk of the Bund business.

The CBT and CME learned from LIFFE’s errors and cut prices aggressively when faced with the prospect of entry; it’s always much more satisfying to learn from others’ screw ups than one’s own. Moreover, neither challenger could tap a block of affiliated order flow to build liquidity in contracts offered by the incumbent exchanges. As a result, the entrants weren’t able to repeat the Eurex coup on this side of the big pond.

When evaluating the prospect—or reality—of rising exchange fees, its important to remember that exchanges have always had market power, but they just exercised it in different ways. The traditional member-owned, not-for-profit exchanges did not exploit their market power by charging supercompetitive transaction fees. That would have cut into their members’ ability to make money by reducing the derived demand for brokerage and market making services. Instead, traditional exchanges exploited market power by limiting entry. With a few exceptions (primarily resulting from legislation and regulation rather than exchange choice) traditional member-owned exchanges limited the number of members. They also had rules that advantaged floor traders at the expense of others. These measures allowed the members to earn rents. As I’ve shown in a couple of articles, network effects make it possible for an exchange to choose a suboptimally small membership, raise trading costs, and yet face no credible competitive threat. Thus, exchange customers have historically paid supercompetitive prices for floor brokerage and floor market making services rather than supercompetitive exchange transaction fees.

Things are changing now that exchanges are moving away from the mutual non-profit (“MNP”) form. Investor-owned exchanges in particular have a new clientele to serve. Rather than catering to the interests of exchange members (typically floor traders or those who leased floor trading rights), some exchanges now respond to the interests of investors. For profit investor owned (“FPIO”) exchanges have no incentive to do things that inflate liquidity or brokerage costs. Indeed, they have the very opposite incentive. Higher profits to brokers and market makers reduce the derived demand for the services exchanges offer (namely, access to the trading engine.) As a result, they want to minimize barriers to entry by liquidity suppliers and suppliers of brokerage services. Exchanges will exploit the market power conferred by network effects by charging supercompetitive transaction fees.

High exchange fees are a more transparent way of exploiting market power. Market power wasn’t a secret to savvy folks in the old regime; I’ve talked to many upstairs traders, including some very successful ones, who routinely complained of being “robbed by the floor.” However, I imagine a lot of folks were unaware how limitations on entry and trading rules inflated trading costs. In-your-face increases in trading fees attract more attention, but the bottom line is that it’s just a different way of taking advantage of network effect-induced market power.

As an aside, I’ve been surprised for years at how little academic commentary and regulatory scrutiny has been directed at exchange membership limits. Economists since Friedman (in his dissertation on the medical profession) and Stigler (and probably before—I just learned it from Stigler and Sam Peltzman) have noted that entry restrictions are the most straightforward way for regulators or professional organizations (e.g,. the AMA) to cartelize an industry and create rents for producers. To most economists, the use of entry restrictions is prima facie evidence of the inefficiency of a regulatory policy. Yet although I’ve read pretty much all I can get my hands on about exchanges, I can’t recall seeing anyone level similar criticisms against exchanges despite the fact that they have almost universally imposed such limits. Indeed, it’s not uncommon to hear exchanges lauded as the exemplars of perfect competition. ‘Tis a puzzlement. (Hat tip to anybody who can provide a cite contradicting my assertion regarding the absence of academic criticism of entry limits at exchanges.)

Is there any way of comparing the relative efficiencies of the old and new monopolies? Looking at output—trading volume—may provide some evidence. IPE experienced an appreciable volume jump when it closed the floor, which would suggest that the new model is more efficient than the old. Other comparisons of this type could be illuminating.

The moral of the story is that exchange market power inheres in the fundamental nature of trading, but that the means by which an exchange reaps the rents of market power depend on its organizational and ownership form.

It may be the case that the transparency of exchange fees has regulatory and anti-trust consequences. As exchanges become more like traditional firms, they may draw more anti-trust scrutiny. That will be, as Arte Johnson used to say, verrry interesting.

Update. I followed up on the “note to self” on Internet pricing (see below). There were indeed several papers on Internet pricing schemes that were intended to address the congestion issue. Salient examples include Jeffrey MacKie-Mason & Hal Varian, “Some Economics of the Internet” and the same authors’ “Pricing the Internet.” Alan Wiseman’s “The Internet Economy” (2000) summarizes several pricing proposals. Perhaps not surprisingly, several Internet pricing proposals parallel the trading system capacity market schemes that I outline in this post. The tâtonnement process is similar to the MacKie-Mason & Varian auction approach. The capacity right system is analogous to David Clark’s (1997) expected capacity pricing mechanism. End Update.

After a series of embarrassing technology-related stumbles in 2005, the Tokyo Stock Exchange outdid itself with its early closing on Wednesday, 18 January 2006. The TSE’s electronic trading system has a built-in constraint that prevents it from handling more than 4 million transactions (regardless of their size) in a day. A flood of sell orders washed over the exchange when it was announced that Japanese authorities had raided the offices of internet highflier Livedoor during an investigation of securities fraud.

This TSE constraint is a new one on me. I was well aware of what one might term flow constraints—the number of messages (bids, offers, cancellations, transactions, confirmations) that a system can handle per second or per minute, but I was heretofore unaware of the possibility of an “integral constraint”—specifically, that the sum of trades over a day not exceed some preset limit. I’m not a hardware expert, but I would imagine that this constraint arises due to a limitation on system storage. Each trade requires storage of a record that details all relevant characteristics of each transaction—price, quantity, date, time, broker, buy/sell, party, counterparty, etc.—regardless of trade size. Thus, whereas flow constraints are attributable to limits on bandwidth or processing capacity, the TSE constraint is likely due to a limitation on the ability to store all of the transaction records.

Any electronic trading system is subject to capacity limits. Eurex had some capacity issues in the late-90s. NYMEX is considering an upgrade to its electronic trading systems and a possibility of using GLOBEX due to the capacity constraints inherent in its legacy ACCESS system (which experienced problems when volume surged after the London terror attacks in July, 2005).

Every open outcry system is also subject to capacity limits: recall the bottleneck created by slow printers at NYSE specialists’ posts during the October ’87 crash, or the “back office crisis” of the 1960s. Open outcry exchanges are constrained by their capacity to direct orders to the floor, and the capacities of floor brokers and market makers to process, execute, and financially carry trades. (OTC markets have capacity constraints too—cf. the CDO market.)

Capacity is limited because it is costly. It is uneconomic to have capacity to handle all possible contingencies. Therefore, exchanges must decide on how much capacity to install. This raises two issues.

First, how much capacity is optimal? Second, how does one allocate scarce capacity?

These questions are closely related. In particular, if there is a price mechanism that allocates capacity efficiently, and which discovers the shadow value of a unit of capacity, exchanges will be able to make good capacity choices. In the absence of a price-based allocation mechanism, it is much harder for exchanges to choose the right capacity.

The trading industry is not the only one that must answer these questions. These have been key questions in the electricity business since Edison first flipped the switch on the Pearl Street Station in New York in 1882. Since 124 years later the electricity industry is still experimenting with different institutional approaches to capacity allocation and planning, we shouldn’t be too sanguine about the prospects for a quickie solution in financial trading.

Interestingly, there are some similarities between the trading and power capacity conundrums. In particular, at least historically in the electricity business the ultimate consumers of electricity have not paid prices that fluctuate in real time to reflect fluctuations in the scarcity of generating and transmission capacity arising from demand changes, generation outages, etc. Steven Stoft calls this the “First Demand Side Flaw” in electricity markets. Although there are numerous proposals to improve metering and measurement technologies to permit this, widespread adoption of such measures is not likely any time soon.

Similarly, at present, securities and derivative trading systems do not have system usage fees that fluctuate with system usage. Indeed, most systems charge fees on the basis of completed transactions and charge zero prices for other actions that utilize system resources, such as the submission of bids and offers, changes in standing bids and offers, and cancellations. In essence, users pay a zero price at the margin for their consumption of system resources.

This is an issue that has been analyzed in the property rights economics literature that builds on Coase’s insight that it is costly to operate a price system. In the electricity context, real time pricing involves investment in metering equipment. This is a non-trivial cost. In the exchange context, it is costly to monitor, record, store, and bill every system user action. Indeed, creating such a capability would require additional investment in system capacity. Moreover, such a system imposes costs on users, such as, inter alia, the cost of monitoring the accuracy of billing. The question arises, then, as to whether the costs of implementing a capacity pricing system are smaller or larger than the benefit. The benefit arises from the fact that when a scarce resource is unpriced it is overutilized. (Cf. Barzel’s analysis of excessive search.)

Given that the marginal cost curve of using a system is likely close to zero when demands on it are below its capacity, a zero price is right most of the time. When demand bumps against the capacity constraint, however, the zero price is very costly. The exchange must find some non-price means to allocate capacity—such as a shutdown or a system slowdown. The hue and cry over the TSE’s action suggests that a shutdown is very costly (especially as it is likely to occur when information is flowing rapidly and therefore people desire to trade a lot.) Even a slowdown is costly, as traders who due to a slowdown have submitted orders only to find that they cannot cancel or revise them, or who do not know whether their orders have executed, will attest. Traders are typically control freaks who flip out when system problems reduce or eliminate their ability to control their trades and positions.

The problem with non-price rationing is that it impedes the efficient allocation of system resources among different customers with differing reservation prices: those with high willingness to pay may be cut off, but those with a low WTP may be able to trade. Moreover, absence of prices deprives exchanges of information about the value of capacity, which means that they are flying blind when deciding how big to make a trading system.

A price system could conceivably address these problems, and it is interesting to contemplate how such a system would work. It seems challenging—perhaps more challenging than in electricity markets. In electricity, except when generating capacity is completely committed, the value of an additional unit of generation is given by the marginal cost of production, which can be measured with some accuracy in real time (through generators’ bids, for instance). In the exchange context, however, the shadow price of capacity Q is given by the willingness to pay of the marginal consumer. How can this be determined in real time?

One can envision (theoretically) a tâtonnement process. Users submit messages (quotes, cancels, etc.) assuming that the system is unconstrained and the price of system resources is zero. The system evaluates whether these messages exceed system capacity. If so, the price of utilization of system resources is raised slightly, and users resubmit. The price is increased until the capacity constraint is just binding.

The operation of such a tâtonnement process in a continuous market seems impractical. Are there alternatives? One can also imagine the creation of capacity rights and a capacity market. For instance, market users could be required to have capacity rights (which in aggregate equal system capacity) in order to trade. These rights could be traded in a bilateral market—or perhaps the exchange could also provide a mechanism to trade these rights in a continuous market. During most periods the price of the capacity right would be zero. When capacity is constrained, or there is an appreciable probability that capacity will be constrained (one can think of the capacity right as being similar to an option because the value of the right to use capacity is a convex function of capacity utilization, so the capacity price will have some extrinsic value), those who have a high demand to trade can acquire it from those less interested in trading.

Given that settling transactions in anything—including rights to capacity—takes time, I am skeptical that this is a practical way to ensure that those with the highest willingness to pay are not rationed out during a capacity crunch, particularly one that is unexpected (as is likely to be the case in financial markets.) Certainly such a mechanism can ensure the allocation of trading rights to those who anticipate having a high demand to trade during a capacity shortage, so this is better than nothing. That is, those who anticipate having the high WTP can by the capacity option—the right to trade—ex ante. To the extent that ex ante evaluations of WTP track real time WTPs, this mechanism will allocate scarce system resources pretty efficiently and generate information on the value of capacity that exchanges can use to make investment choices.

Implementation of this approach also requires enforcement of the right: how do you know somebody has exceeded their limit, and how do you prevent them from doing so? This seems to me to be a non-trivial problem. Things are likely to be particularly complicated for integral constraints like the one that caused the TSE problems.

To my knowledge, neither the tâtonnement nor the capacity right approach have been even proposed in financial markets, let alone developed. (I do recall reading about pricing of the Internet, which raises similar issues. Note to self: check this out.) This suggests that for the foreseeable future that exchanges and market users will have to live with non-price capacity allocation during periods of market stress.

The absence of a price mechanism that discovers the value of capacity deprives exchanges of information needed to make efficient capacity investment decisions. So how much capacity should exchanges invest in and how do they figure this out? Here again the electricity experience is somewhat informative, and somewhat discouraging. Utility planners traditionally utilized the concept of “value of lost load” (“VOLL”) for system planning purposes. VOLL is an estimate of the cost of “shedding load,” i.e., of turning off customers’ lights in the event that electricity demand exceeds the physical capacity available to produce it. Due to the First Demand Side flaw, there is no equilibrium in prices when the (vertical) demand curve is to the right of system capacity, so it is necessary to shut people off. As Stoft shows, if you assume you can set VOLL correctly (insert economist joke here), market participants will make the efficient capacity choice. After all, VOLL is the opportunity cost of a unit of capacity.

The problem arises, of course, with determining the right VOLL. The VOLL in power markets is typically set arbitrarily. (Australia uses VOLL pricing and has taken a somewhat more systematic approach to estimating it.) Set VOLL too high, and you get too much capacity. Set VOLL to low, and you get too little.

So what is the VOLT—the “Value of Lost Trades”—in a financial market? Beats me, but it is worth some investigation by those who have skin in the game. I’m also curious as to the criteria that exchanges use when choosing system capacity. Do they have some measure of VOLT in mind? Where does this number come from?

In the meantime, it may be worthwhile to cut the TSE some slack. After all, all we know for certain is that an exchange that never hits its capacity limit has inefficiently invested in too much capacity. Without knowing the VOLT, it is much more difficult to evaluate whether the observed frequency of outages is too high or too low. Maybe TSE has the right capacity. Customer complaints about outages aren’t that informative about VOLT, because they don’t directly pay the price for capacity—it’s easy to bitch when somebody cuts off your freebies.

I also wonder how political and regulatory processes will impact exchange capacity planning and investment. The Japanese government has made its disappointment with TSE very clear. Japan’s Economy Minister, Kaoru Yosano has said “[a] Stock exchange that can’t carry on trading simply doesn’t deserve to exist.” There is reason to be concerned that governments will pressure exchanges to overinvest in capacity. Zero tolerance plays well in the press, but ignores the economic reality that trade-offs are part of life. It would be better to step back and apply good economics to evaluate these trade-offs.