Sure Clint.. here goes (don't think the chart's will post here?). ascusc.org
" The Automation of Capital Markets
Arnold Picot, Christine Bortenlaenger and Heiner Roehrl
Institute of Organization
Ludwig-Maximilians-Universitaet Muenchen
Ludwigstr. 28
D-80539 Munich, Germany
Phone: +89-2180 2252
Fax: +89-2180 3685
picot@bwl.uni-muenchen.de
bortenlaen@bwl.uni-muenchen.de
roehrl@bwl.uni-muenchen.de
Table of Contents
Abstract
About the Research Project EMIWA
Research Object: The Capital Market
The Classic Transaction Arena: Trading Floor
The Vision: Computer Exchange
The Reality: Survey of Installations
Reasons for the Vision - Reality Discrepancy
Transfer to Other Markets
References
Footnotes
List of Figures
Figure 1: Exchange as a Market Organizer
Figure 2: Price Discovery Processes
Figure 3: Transaction Procedure on the New York Stock Exchange's Trading Floor
Figure 4: Threefold Intermediation of an Exchange Transaction
Figure 5: Diffusion Path of Electronic Support
Figure 6: Computer Exchange
Figure 7: Computer Exchange in a Broad Sense
Figure 8: Computer Exchange in a True Sense
Figure 9: Automation of a Security Transaction
Figure 10: Automation of the Price Discovery Process
Figure 11: Market Transparency and Market Efficiency
Abstract
The aim of the research project EMIWA (elektronische Markte und institutioneller Wandel) is to achieve a better understanding
of technology-induced changes of markets. For this purpose, the capital market and its exchanges are studied as one of the
most prominent installations of electronic markets. A noticeable gap between the postulated rationalization potential of computer
exchanges on the one hand and the existing technological support on the other can be observed. Reasons for this installation gap
are supplied and conclusions are drawn for a more differentiated discussion of the impact of information technology on the
market as a coordination mechanism.
About the Research Project EMIWA
Since March of 1994, the German Science Foundation has been sponsoring the research project "EMIWA: Electronic markets
and institutional change". In this project, research is conducted on changes in the capital market and its exchanges due to their
increasing automation. The project will continue until March of 1996. During this period, the most important financial centers in
the western hemisphere have been visited and formal interviews with market organizers and market participants have been held.
Research Object: The Capital Market
Before focusing on the automation process of the capital market, an explanation will be given as to why this market was chosen
for research purposes. Principally, other markets such as the market for transportation services (e.g. Anner, 1993; Berlage and
Buellinger, 1994) or waste (e.g. Meyer, Schober, and Siefert, 1994) also would have been suitable. But the following attributes
predetermine the capital market as the appropriate research object:
The capital market is regarded as the best approach to the neoclassical ideal of a perfect market and holds an inherent
fascination for economists. (Hintner, 1961, p. 12)
The substitution of market objects through securities makes the physical exchange of goods obsolete. Only abstract
property rights are dealt with (Hubman, 1989, p. 30).
At least on exchanges, the transaction procedure is widely standardized.
The need for highly efficient execution of securities transactions grows with the professionalization of the capital market
(see Keim and Madhavan, 1994)[1].
The intense competition between different market organizations (central exchange, regional exchange, proprietary trading
systems and internalization of order flow [2]) is mainly created through information technology (Lucas and Schwartz,
1989)
The universal application of information technology by all important capital market participants facilitates the introduction
of innovative trading systems.[3]
The requirements for worldwide information and trading possibilities are leading the industry towards a 24-hour,
around-the-globe-by-fingertip system (see Freund, 1991, for a discussion of international securities trading).
So-called computer exchanges and airline reservation systems are considered as the most prominent installations of
electronic markets (Copeland and McKenney, 1988).
Stock, currency, and derivative markets in Germany, Switzerland, Great Britain, Canada and the United States were chosen as
research units. The selection of these countries was primarily based on the trailblazing role that Anglo-Saxon capital markets
play in the development of innovative transaction systems. The selection of market objects covers the broad continuum from
quoted ones (shares) to non-quoted ones (swaps) (see Brady, 1990 for a distinction between exchange-executed vs.
over-the-counter transactions). Market organizations (exchanges, proprietary trading systems and over-the-counter markets)
serve as survey units. For survey method purposes, interviews with experts support the exploration of the automation process of
the capital market.
The Classic Transaction Arena: Trading Floor
The first exchanges came about in the middle ages on those days when goods were traded in central locations and the
settlement of payments followed at the end of the fair (see Pohl, 1992 for the history of German exchanges). Settlement days
became more independent, eventually forming a sovereign market place. Today's market organizations have been submitted to
an ongoing institutionalization process. This began with the erection of trading buildings and the growing regulation of trading.[4]
Meanwhile, exchanges have accumulated a vast store of knowledge concerning the organization of their specific markets. Within
this evolution, it seems to be important to not merely distinguish planned structures and processes.[5] In the course of their
evolution, in order to increase efficiency, the exchanges have standardized not only their market objects but also the transactions
themselves (Schmidt, 1988, p. 7).
Figure 1: Exchange as a Market Organizer
The exchanges formed different trading processes, whose merits are still debated (Rottenbacher, 1991, p. 33). Two
fundamental types of exchange organizations can be distinguished: the market maker system (practiced e.g. on the London
Stock Exchange) and the auction system (Chicago Mercantile Exchange) (Cohen et al., 1986, p. 15; Stoll, 1992). The major
difference lies in that two orders may directly meet in the auction-system, whereas in the market maker system, direct order
matching is impossible. Here the market maker always intermediates and is bound to quote bids and asks. His revenues result
from the spread between bid and ask. Between these two trading forms there is a continuum of hybrid forms such as the
specialist at the New York Stock Exchange (Schmidt, 1971) or the Kursmakler in Germany (Bruns, 1965, p. 60). There the
intermediary temporarily functions as market maker if the market condition requires a stabilizing intervention or if a slight
intervention by the intermediary can cause a significantly higher matching quote.[6] Even a voluntary market making by the
crowd in an auction exchange allows for balancing a market disequilibrium.
Figure 2: Price Discovery Processes
When examining exchanges it is especially striking that despite the heterogeneity of trading processes there exists a homogenous
governance structure. Exchanges, often understood as the embodiment of capitalism, distinguish themselves from an
organization- theoretical point of view by the fact that they are non-profit membership organizations.[7] Their task is the
organization and the operation of a trading arena in which their members can achieve profits.
A security transaction on a traditional trading floor is well illustrated by the trading procedure of the New York Stock Exchange
(see Hasbrouck et al., 1993 for a full description).
Figure 3: Transaction Procedure on the New York Stock Exchange's Trading Floor
A wealthy investor calls his or her broker and orders the sale of 25,000 IBM shares per limit actual course plus 2%. [8] The
broker notes the order and calls his or her colleague at the New York Stock Exchange who is sitting in a booth just off the
trading floor. He or she notes the order and pages the relevant trader. As soon as the floor trader receives the page, he or she
walks to a phone, picks it up and calls a booth colleague who supplies the order to be executed. The floor trader goes to the pit
where IBM shares are traded and delivers the order to the specialist for execution or offers it by shouting to the crowd. When a
counterparty is found, the execution has taken place. Both parties note the transaction in their trading book and the buyer
reports the transaction to the trade reporting system. The trader again makes a call to the booth with the information about the
sale. The booth informs the broker, who in turn informs the client about the execution. This procedure typically lasts about 5-15
minutes.
Only through the agreement of two corresponding orders can the settlement of the transaction be covered. The transfer of
securities is managed by clearing and settlement, in which the alignment of the tickets of both trading parties takes place. [9] The
automation of the clearing and settlement procedure started in the 1970s, leading to a reduction in paperwork. Today, a
physical transfer of securities has largely become obsolete. [10]
The transaction procedure described above is marked by a threefold intermediation together with several media disruptions
within the internal and external interfaces. Because the investor is not entitled to deal directly at the exchange, he or she has to
hire an agent, the broker, to get access to a security market arena. The second step of intermediation is the exchange itself,
which organizes and controls the transaction arena. The third step of intermediation takes place through the price discovery
process, which adjusts the orders of the investors through the interaction of trading participants.
Figure 4: Threefold Intermediation of an Exchange Transaction
Through the application of information technology, the rationalization of floor trading can be achieved by:
reducing interfaces
avoiding media disruptions
disintermediation
The Vision: Computer Exchange
Before specifying the automation process of the capital market with respect to its exchanges, a theoretical excursion will add
some taxonomy. Simultaneously, the foundation for the understanding of the automation process of capital markets will be set
(see Bakos, 1992 for a discussion of the economic reasons for institutional change following the introduction of information
technology).
There are two fundamental coordination mechanisms for the organization of economic transaction: market and hierarchy
(Coase, 1937; Williamson, 1975, 1985). Between these poles there is a continuum of hybrid forms, such as network
organizations. Depending upon the characteristics of an economic transaction, one coordination mechanism will prove more
efficient than the others. While hierarchical coordination is for the most part efficient for highly specific and strategically
important transactions, market coordination is mainly applied to standardized transactions. The most widely used application of
transaction cost theory is the make-or-buy decision (Picot, 1991).
In hierarchies, markets and hybrid forms of communication take place between the participants. Because this communication is
not frictionless and the participants act strategically, the use of the coordination mechanisms incurs costs, known as transaction
costs (Picot and Dietl, 1990). An exchange as a market organizer attempts to optimize these transaction costs by providing an
appropriate transaction environment (Schmidt, 1988, p. 3). The provision of this service causes costs for the market provider,
who covers these costs by demanding fees from the market participants. These fees, which are in turn carried by the investors,
are also called transaction costs.[11]
An important and increasing cost block for a market provider is the information technology support of the securities trading.
From the transaction cost theory point of view, those investments alter the framework of the transaction arena. Properly used,
the investments in information technology allow for a more efficient communication (Ernst, 1990) and a potentially greater
coordination of the market participants (Himberger, 1994). As a result transaction costs are reduced.
Before 1980, information technology was predominantly used for the reduction of hierarchical, intraorganizational transaction
costs. In the last decade, the focus shifted to the electronic support of interorganizational division of labor (Cash and Konsynski,
1985; Kubicek, 1991). First the electronic integration of hybrid coordination mechanisms (subcontractors and network
organizations) was managed. In the meantime, a further shift in academic and economic interest towards the electronic market
can be observed. The interest in Internet is a prime example of this phenomenon.
Figure 5: Diffusion Path of Electronic Support
Malone, Yates, and Benjamin (1987), inspired by the development of airline reservation systems, realized this trend and
developed a scenario for the steps in implementation of information technology. The impact of information technology on the
coordination mechanisms are outlined as follows (Malone et al., 1987; Picot, 1986, p. 9):
electronic communication effect
electronic integration effect
electronic brokerage effect
The electronic communication effect allows for a faster, wider and less costly application of information. The electronic
integration effect combines different, previously separated functions into a single one by avoiding media disruptions. The
electronic brokerage effect leads to a disintermediation of middlemen. Positions like wholesaler, travel agencies or even agents
on an exchange (specialists and market makers) are supplanted by information technology. There is a growing tendency
towards a direct connection between original transaction partners (Picot, 1986, p. 9).
The three effects accumulate to a relative advantage of the market mechanism in comparison to hierarchy. Using a Darwinian
"ecology of coordination mechanisms," the hypothesized superiority and ease of market mechanisms has encouraged the "move
to the market" thesis" supported by Malone and others. [12]
After explaining coordination mechanisms and their electronic support, we turn to a discussion of process organization. This
allows for the realization of the processual character of a security transaction chain. Process organization as well as transaction
cost theory considers information technology as an enabler in determining the framework for the process management (Picot
and Franck, 1995). A fundamental design recommendation is the creation of transaction chains which surpass company
boundaries. This has to be realized with as little media disruption as possible.
Combining these two perspectives results in a distinct call for action: the fundamental reorganization of the transaction chain
should take place without media disruption and without human intermediation. This process vision goes far beyond the mere
support of the common transactions by adequate communication technology, for example the substitution of a runner by a
handy. It requires more than the mere one-to-one translation of existing structures. A complete new definition of the transaction
chain becomes necessary (Kaplan and Murdock, 1991, p. 35; Picot, Neuburger, and Niggl, 1993, p 243; see also Neuburger,
1994, p.37, for an application to EDI). Following this vision, a computer exchange is a market which electronically coordinates
investors.
Figure 6: Computer Exchange
It is necessary to emphasize that a computer exchange with such features no longer requires human interaction in the price
discovery process. The transformation function of the price discovery interaction of the market intermediaries (matching, risk,
time, place, and information transformation) is instead supplied by a computer. [13] This computer would independently quote
the spread in a market maker system, balance out order disequilibria in a hybrid system and assure, within the auction system, a
deliberate market making for the provision of liquidity.
A computer exchange as characterized above incarnates a process vision. Searching for such computer exchanges in the
practical world, one is first confronted with a terminological problem: The expression "computer exchange" is used in a very
undifferentiated manner (Gerke, 1993, p. 726). In order to define computer exchanges, a two-step approach is used (Schmid,
1993, p. 468):
A computer exchange in a broad sense is a market for securities, realized through the support of information technology,
automating parts of the market transaction.
A computer exchange in the true sense is a market for securities, realized through the support of information technology,
automating the entire market transaction.
Figure 7: Computer Exchange in a Broad Sense
This figure represents an incomplete automation of the transaction phases. The price discovery process is not shaded due to the
fact that this phase has proven to be the one most difficult to automate.
Figure 8: Computer Exchange in a True Sense
In the next section, the automation process of capital markets will be evaluated based on the process vision.
The Reality: Survey of Installations
The capital market is a complex social-economic configuration with a very high information sensitivity. Due to its influence on the
interaction of the market participants, automation is a difficult task. If this alteration of the transaction arena intervenes too much
in the information processing, unexpected market reactions can result. A prime example for the intricate information process of
the capital market is seen in the problem of insider trading regulation. In this case, it was recognized that a healthy balance
between information production and legitimate use of gathered information is essential (Picot and Dietl, 1994).
With the installation of the telegraph, information technology made its first heavy impact on the capital market. Garbade and
Silber (1978) examined the intermarket price differences between several US exchanges before and after the installation of the
telegraph between major eastern cities in the US in 1840 . They also examined changes after the laying of the transatlantic cable
between London and New York in 1866, which reduced the time lag of a transatlantic transaction from six weeks to one day.
They found that intermarket price differences equaled the costs of transportation plus a risk surcharge in case of an alteration in
prices during transportation. The introduction of information technology reduced the intermarket price differences according to
the new transmitting time of information (see also Jassawalla, 1989, p. 87, for the immediate use of new information technology
in the financial industry).
With the reduction of communication costs the tendency towards a centralization of exchanges began. At the turn of the century,
about 100 exchanges existed in the US. By 1935, this number was cut down to 35; in 1965, 15 exchanges were counted.
Today only 5 regional exchanges and the New York Stock Exchange and the American Stock Exchange remain (Blume and
Goldstein, 1995, p. 4).
A classification of the automation of exchanges can be based on the conversion level of the classical transaction chain over to a
computerized one. In conformance with the phases of a capital market transaction (information, order routing, execution,
clearing and settlement phases) the systems can be classified as follows (United States General Accounting Office, 1991, p. 4):
information systems
order routing systems
execution systems
clearing and settlement systems
Figure 9: Automation of a Security Transaction
First, information systems were supported by information technology. A prime example is NASDAQ (National Association of
Securities Dealers Automated Quotation) (Pieseler, 1990).[14] The impulse for the development of an electronic information
system came from the Securities and Exchange Commission (SEC). They demanded in 1970 that NASD replace the quotation
by "pink sheets" with an electronic information system (Pieseler, 1990, p. 196). The pink sheets were inefficient because the
papers had to be printed and distributed after every trading day. Timely price information was impossible. When NASDAQ
was introduced in 1971, the quotation from the different market makers could be observed in real time on the screen. Therefore
transparency, reaction time, and efficiency of the market greatly increased (Hamilton, 1978).[15]
In addition to pre-trade information systems, post-trade systems exist which publish details about executed transactions, such as
prices and volumes.[16] These systems are well known from TV where a ticker tape runs at the bottom of the screen.
Order routing systems are responsible for the electronic transmission of an order to the relevant receiver. First, the order
transmission was rationalized through the substitution of a runner by a pager or by hand signals from a handy. [17] In a further
rationalization step, order routing systems were connected to an execution system which allows for the automatic or partly
automatic execution of small orders. A well-known order routing system is SuperDot (Super Designated Order Turnaround) at
the New York Stock Exchange which substantially increased the volume of institutional trading.[18]
Clearing and settlement systems are prime applications for information technology since these procedures are very time
consuming and error-prone. Therefore all the major exchanges have invested large sums in the automation of their clearing and
settlement systems. The shorter the clearing and settlement process is, the less interest has to be paid by the investors until their
transactions are fully completed.
A further classification of execution systems can be made in reference to the automation of the price discovery process. This
criterion emphasizes the most important function of the market as a coordination system, the price discovery. The price
discovery process adjusts the transaction plans of the investors. Only those electronic securities markets which reproduce this
essential function can be called computer exchanges in the true sense (Gerke and Aignesberger, 1986, p. 16). The different
stages of the electronic support of the price discovery process can be systematized as shown in Figure 10 (from Domowitz,
1992). The price discovery process contains the priority rules of execution and the matching algorithm.
Figure 10: Automation of the Price Discovery Process
The simplest form of price discovery is to take it from another market, meaning no independent price discovery exists. Those
systems are mainly appropriate for retail trading and for passive index traders.[19] RAES (Retail Automation Execution
System) at the Chicago Board of Options Exchange, for example, offers an automatic execution function for retail orders
guaranteeing actual pit prices (Domowitz, 1992, p. 308). Some exchanges even compare the prices from other exchanges and
offer the best available price. This function exists mainly for retail trading intermediaries who provide their customers with a best
execution guarantee. The Midwest Stock Exchange offers such a system called Supermax (Domowitz, 1992, p. 309).
A further improvement is the integration of a negotiation function which is very important for blocktraders. They face the
problem of adverse selection as a result of insider information (see Berkowitz et al., 1988 and Lakonishok et al., 1992 for
empirical analyses of the importance of these market reactions). The problem of asymmetric information dissemination can only
be solved by two-sided negotiation (Grossman, 1992; Stoll, 1992, p. 87). Therefore, the SOFFEX (Swiss Options and
Futures Exchange) offers an announcement function, so that the interest of fellow market participants can be scrutinized.
A further technique is the order selection directly from an electronic bulletin board using a mouse as the input device. This is the
principle of Globex, a derivatives trading system, operated by Reuters, the Chicago Mercantile Exchange (CME), and Marchea
Terme International de France (MATIF) (Globex, 1994, p. 100). These systems do not have an automated intermediation
function for balancing order disequilibriums. This must still be done by an intermediary.[20]
The next step is continuous trading with permanent order placement. Transactions occur when two orders match. In this case,
the price discovery is endogenous. Such a system is Project A from the Chicago Board of Trade (Chicago Board of Trade,
1994, p. 5-4 5). There is no automatic intermediation function which ensures the matching of orders that are only slightly
mismatched. Furthermore, it does not enable market orders trading as do conventional trading systems.[21] More computerized
are auction trading systems which collect orders and execute them in intervals according to a turnover maximizing principle. The
Arizona Stock Exchange offers such a system, providing transaction possibilities for institutional investors (see Securities and
Exchange Commission, 1994, p. A-IV-10, for a description). This system does not include an intermediary function for
non-matching orders. Consequently, the level of matching quotes and liquidity are often very low in these systems.
It is very important to recognize that all the above described systems replace only the first two steps of intermediation but not
the third. The price discovery process is not completely automated. None of those systems endogenously calculates the spreads
for the market maker, balances out mismatching orders like a specialist or simulates the liquidity of the crowd. Therefore, a
computer exchange in the true sense has not yet been realized.
With respect to the phase model of a market transaction, it is obvious that only parts of the transaction are electronically
supported. These are mainly the information, order routing, and the clearing and settlement phases which are at least partly
automated at most exchanges. The heart of a market transaction, the execution phase with the price discovery process, is only
minimally automated. In accordance with those findings, the process of automation of the market arena can be described as a
diffusion from the borders to the core of market functions.
Reasons for the Vision - Reality Discrepancy
What factors are responsible for the evolution of such a heterogeneous spectrum of electronic trading systems? The coexistence
of different automation steps is noteworthy, due to the previous identification of the capital market as the ideal object for
automation. This discrepancy is also amplified through the fierce competition between the suppliers of trading systems.[22]
Given this, we should by now have experienced a strong technology-induced shakeout of less efficient market organizers, but
this has not taken place.
Differing perspectives are used to explain the discrepancy between the postulated rationalization potential on the one hand and
the incomplete automation of securities trading on the other (see, for example, Berlage and Buellinger, 1994, p. 2, for research
on logistics markets). The employed perspectives partly overlap, but cover a wide range due to the vast number of influence
factors (Himberger et al., 1991, p. 21; Kraehenmann, 1991).
Market process theory and microstructure theory both focus on the interaction of market participants under the assumption of
transaction costs. These two perspectives lead to a better understanding of the interaction on the exchanges. Micropolicy
scrutinizes the reorganization process from the perspective and power position of the involved participants. A study of the
institutional framework concludes this section.
Market Process Theory
In contrast to neoclassical theory, the core of market process theory is not the efficiency of the market mechanism but the
actions which take place in the market arena (Kirzner, 1978). The information and communication behavior of the participants is
crucial in this analysis. The market is understood as a discovery and lear |
