Industrial organization of financial markets

Control of market institutions

Not all financial markets operate within formally constituted exchanges, but those that do can be divided into two categories.

  1. Mutually owned cooperatives. In this case the exchange is organized as a club, or cooperative, controlled and managed by its members. The cooperative controls the market’s facilities (e.g. computer networks or dedicated telephone links), writes the market’s rule book and administers the rules. The membership typically comprises ‘member firms’ (dealers) but, in principle, could include brokers and public investors.
  2. Shareholder-owned companies. In this case a company, legally distinct from the market participants, owns and operates the exchange. The company’s shares could be privately owned (perhaps by another company); they might be owned partly or wholly by the state. If constituted as a public company, its shares would be openly traded. The exchange’s member firms may wholly or partly own its shares.

Regulation of financial markets

Practically all financial markets are regulated in some way or another. The regulation is typically highly complex – too complex to warrant discussion here. Very often exchanges themselves form part of the regulatory mechanism, together with the involvement of external organizations. Thus, for example, the Securities and Exchange Commission (SEC) oversees financial markets in the United States, while the Financial Services Authority (FSA) has broadly similar responsibilities in the United Kingdom. The declared purpose of regulation is normally to protect investors from practices and conduct deemed to be unfair or improper. Most directly, the protection is intended to guard against fraud. More indirectly, regulation ostensibly seeks to foster competition, with resulting benefits for the consumers of financial services. Investors themselves would possibly favour protection against all losses sustained on their investments, including losses incurred when asset prices fall. Such comprehensive protection stretches beyond the bounds of regulation that has been, or is likely to be, adopted. However, when losses occur as a consequence of what is perceived to be bad advice, investors may feel justified in seeking compensation – either from those who gave the advice or from the regulators responsible for overseeing the advisers. In these circumstances, resorting to litigation will test how far the law requires investors to bear the consequences of their own decisions. Much of the regulation in financial markets is self-regulation. Whatever the merits of such regulation (such as the expertise of the regulators in their own lines of business), the justification of its proponents should not necessarily be taken at face value. For regulation can have its drawbacks. These include: (a) regulatory capture, in which regulation is designed to protect the regulated institutions rather than their customers; and (b) lax regulation, such that the activities of institutions may not be properly supervised.

Competition within and among financial markets

As already mentioned, many financial markets approximate the competitive ideal in that market participants typically take prices as given, beyond their individual control. However, although the underlying ‘commodities’ (the assets) are homogeneous, the services offered by brokers and dealers may well be differentiated, offering the scope for non-price competition. Moreover, the organization of exchanges and their regulation can have the effect of restricting competition among market participants. Competition among members of the market can be restricted in several ways.

  1. It is commonly necessary for members of exchanges to be able to provide capital as a guarantee against default or fraud. The capital requirement can be interpreted as a cost of doing business, but may be used as a device to limit competition by restricting the number of members.
  2. The exchange may designate individual market specialists as monopolists in specified securities, in the sense that only the specialists can trade on their own account; all other members can act only on behalf of public investors. This monopoly power is usually regarded as compensation for the obligation imposed on specialists to quote firm prices guaranteed for trade with other market participants.
  3. Members of an exchange may be restricted in their trading activities outside the exchange. For example, rule 390 on the NYSE requires its members to trade listed securities on the exchange rather than the over-the-counter market. The rationale for this type of rule is, presumably, that it restricts the extent to which investors can free-ride on the price discovery function of the exchange.

Trading and asset prices in a call market

Among the market mechanisms described a call market is one of the simplest and provides a starting point for modelling flows of trading in asset markets. In the model outlined here, market participants are divided into three groups: (a) informed investors; (b) uninformed investors (or noise traders); and (c) market makers.7 The informed and uninformed investors are interpreted as public investors, while market makers exist to ensure that a price that balances the purchases and sales of public investors is realized. Members of all three groups are assumed to be risk-neutral. Exchanges of assets among investors could take place for a multitude of reasons, here divided into two: (a) an information motive; and (b) a liquidity motive. The information motive applies to those investors who trade because they seek to make gains (or avoid losses) on the basis of their beliefs about future payoffs from assets. The liquidity motive is a catch-all, encompassing the other reasons why investors trade. It includes circumstances in which investors sell assets to raise funds for consumption or to meet some unforeseen contingency, or when savings flows are invested in traded assets. The caprice and whims that motivate noise traders are also absorbed into the liquidity motive.

Bid–ask spreads: inventory-based models

Explanations of the bid–ask spread fall into two groups: inventory-based theories, and information-based theories. In each case market participants are classified into market makers and public investors. Market makers are assumed to be dealers who quote bid and ask prices at which they guarantee to buy and sell the asset (if the size of each order falls within a pre-announced range). Public investors are subdivided into informed and uninformed investors as in the previous section, though this distinction is relevant only for the information-based models. The framework studied here abstracts from reality in a number of ways. Dealers who are not market makers are ignored. Brokerage services are not treated separately from the services of market makers. Hence, the bid–ask spread should be interpreted as including all transaction costs (such as commission fees and taxes). Also, phenomena such as deals made within quoted spreads and special arrangements for large block orders are neglected.

In both inventory-based and information-based theories, public investors are assumed to arrive at the market in a random flow and to issue orders to buy or sell one unit of the asset. The market makers execute buy orders at the ask price and sell orders at the bid price. Price quotations are then changed according to some rule, studied below, according to the market makers’ observations of orders to buy or sell the asset. Inventory-based models view the price quotations as determined by the need for market makers to hold inventories of the asset to satisfy the flow of demands and supplies from public investors. The main influences on the bid–ask spread are assumed to be these.

  1. Costs of holding inventories. There is an opportunity cost of holding inventories, in the sense that the funds could be invested elsewhere. For physical assets (e.g. soya beans or precious metals) the cost of storage may be important, though storage costs are probably negligible for most financial assets.
  2. Market power. To the extent that competition among market makers is restricted, the exploitation of their market power implies that bid prices are lower, and ask prices higher, than otherwise. Also, the costs associated with the privileges of being a market maker (e.g. the obligation to quote firm prices or the need to fulfil minimum capital requirements) would be covered by the bid–ask spread.
  3. Risk aversion. Market makers, because of their obligations to the market authorities, or concern for their reputations, or for other reasons, may seek to avoid the prospect of zero inventory.

Bid–ask spreads: information-based models

The information-based models studied in this section take it for granted that inventories are always adequate and that the costs of holding them can be ignored. Instead, the analysis highlights (a) the asymmetry of information between informed and uninformed investors, and (b) the assumption that market makers cannot observe whether the orders they receive come from informed or uninformed investors.

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