continued..
The market is understood as a discovery and learning process which rewards the best informed
participant with the greatest knowledge arbitrage profits. Market process theory is therefore the antipode to neoclassical theory,
which does not endogenize information but neglects the information problems of markets (Holleis, 1985, p. 26).
The design of market transparency is the most important issue of market process theory. Following the ideal of the perfect
market, this would be a maximization problem: the more transparent a market is, the more efficient is the market mechanism.
This design goal follows neoclassical theory,which studies the market under the assumptions of costless information and
atomistic market structures. But reality has proven that designing market transparency is not a question of maximization because
of the strategic reactions of market participants when full transparency is provided (Rudolph, 1994, p. 426).
This problem is very important for institutional trading. If blocktraders had to report a trade immediately, they could not achieve
the same price compared to discrete trading due to the strategic actions of other market participants. This problem parallels the
purchase of a car, when the dealer tells his potential customer of his unusually large stock. With this knowledge the customer's
bargaining power is strengthened, resulting in a price reduction.[23]
The upstairs traders' refusal to report their trades immediately is understandable. The market makers on the London Stock
Exchange have therefore been granted a time span of 90 minutes to report their trades (Rottenbacher, 1991, p. 37).[24] This
results in a loss of market transparency due to heterogeneously informed traders. The fine tuning of pre- and post-trade
reporting proves to be a delicate process and the outcome significantly influences the efficiency of a market.
It is important to stress that institutional trading covers an ever-increasing volume of exchanges' transactions.[25] Therefore the
market providers have to pay close attention to the trading demands of institutional traders and to decide where to position their
own trading system in the trade-off between wholesale and retail trading.[26]
The question of anonymity arises in the light of market process theory as well. Floor trading is conducted face-to-face and
therefore not in an anonymous manner. Screen trading systems normally allow for anonymous trading. Experienced floor traders
find fault with the lack of information, as the orders in an anonymous trading system have no discernible background and
interpretation of the market reactions is hardly possible. Institutional traders therefore prefer anonymous trading because they
are afraid of the strategic behavior of the other market participants who observe their actions very carefully.[27]
Looking at the problem of designing optimal market transparency leads to the assumption that the paradigm of neoclassical
theory was at work. One of the most prominent claims of computer exchange supporters is the approximation of the capital
markets to the ideal of perfect markets with the help of information technology. Only after a trial-and-error process was it
apparent that the strategic behavior of the market participants has to be recognized when designing electronic trading systems.
The design of a computer exchange is therefore shaped by the trade-off between market transparency and market efficiency.
Figure 11: Market Transparency and Market Efficiency
The vision of computer exchanges can be compared with the discussion of the introduction of management information systems
in the late 1960s and early 1970s. There was great enthusiasm about the capabilities of those systems for management support.
Only after the understanding of the information, communication and decision processes changed from a decision logic point of
view to a more realistic one, was it realized that a complete collection of information through electronic systems is not possible
(Ciborra, 1987, p. 18). If a parallel exists between the introduction of intra- and interorganizational information systems, then a
coexistence of transaction systems, accommodating different transaction demands, will exist in the foreseeable future. This will
mean a further automation for retail trading, whereas wholesale trading will still be based on human interaction.
Microstructure Theory
As shown above, it is of great importance to have a profound knowledge of the markets in order to automate them. A major
obstacle to the creation of an electronic market is the lack of detailed market knowledge from both a practical as well as
theoretical point of view.
The branch of capital market research which works on the organization of securities markets is called microstructure theory
(Cohen et al., 1986; Franke, 1993, p. 396). This theory attempts to understand the trading processes of organized markets by
modeling the participants' decisions (Berkman, 1992; Copeland and Galei, 1983; Demsetz, 1968; Mildenstein, 1982; and
Neuburger, 1992), from which researchers attempt to develop design alternatives (Cohen et al., 1986, p. 195).
The models are extremely intricate and very seldom represent an adequate approximation to reality (e.g. Hakansson et al.,
1985). It seems that the processes are so complex that they are hardly reproducible (Cohen et al., 1987, p. 190). One of the
reasons is that the participants' interactions are deeply affected by their tacit knowledge. The difficulties of reproducing tacit
knowledge are known from the software engineering of artificial intelligence (see, for example, Winograd and Flores, 1987). At
this time it is only possible to program well-structured, describable decisions. As soon as decisions become unstructured and
characterized by tacit knowledge, the replacement of human decision makers is not realistic (Franck, 1991, p. 214).
Micropolicy
The micropolicy perspective tries to see the decision processes within enterprises from the point of view of each individual's
rationality and power position (Bosetzky and Heinrich, 1980, p. 180). This strategic organizational analysis has been
predominantly employed for the automation of intraorganizational coordination instruments (Ortman et al., 1990) but seems to
be adequate for the analysis of the interorganizational reorganization processes as well.[28]
At this point light must be shed on the governance structure of exchanges. A membership organization allows the participation of
each member in the politics of the exchange. But this participation is a tedious decision process requiring many compromises
(Stoll, 1992, p. 88). When members anticipate significant changes, they fear a loss of their traditional position. Influential
members in the automation of securities dealing can be split up into three groups: locals, brokerage houses and investment
banks, and market intermediaries.
The locals display aversion to further automation. They fear an increasing institutionalization of securities trading and are afraid of
losing trading volume due to their lack of capital.[29] In addition they try to prevent direct access by institutional investors who
could, at least theoretically, gain direct access to an electronic trading system. Their specific human capital is bound to floor
trading and because of the impending devaluation of their specific abilities, they fear screen trading Hubman, 1989, p. 289).[30]
Furthermore, the costs of automation are allocated amongst the members, meaning the locals would be financing their own
disadvantages. The degree to which they can successfully defend traditional trading depends upon their power position on the
exchange.[31]
The market intermediaries (specialists and market makers) also generally try to prevent a complete automation of securities
trading. They are afraid of losing their trading privileges which are a result of their monopoly (Blume et al., 1993, p. 181). [32]
Additionally they fear the shrinkage of their brokerage commission which would result from an improved market transparency.
Their fees could no longer be justified due to the changes in the intermediation service. [33]
The brokerage houses and investment banks would like to separate securities trading as much as possible into retail and
wholesale trading. In their opinion, the standard transactions should be automated as much as possible to curtail handling costs.
Institutional trading should remain non-transparent (non-electronic), preventing a disintermediation of upstairs trading, because
they would like to retain their discrete scope of action. They would also like to internalize trading as much as possible. In so
doing they can keep a larger portion of the commission charged to their customers. Only those orders not matched in-house
would be sent to an exchange. Whether they can impose their strategies does not depend on their formal voting power but on
the volume they attract to an exchange.
It is not in the interest of any party mentioned above to open access to the exchange to non-members. They will not choose to
bring about their own disintermediation but simply rationalize the communication link with their customers. [34]
This survey of the important members' positions illustrates the intricate decision making process with respect to the automation
of the transaction arena. Proprietary trading systems, on the contrary, have differing governance structures and do not encounter
such complicated decisions. Their objective is to earn income through providing a transaction arena, compared to an exchange
whose objective is to organize a transaction arena allowing the members to experience financial gain. Proprietary trading
systems prove to be innovators for transaction systems that take advantage of information technology capabilities. Therefore
they accommodate an increasing securities transaction volume and have become a relevant source of competition to the
established exchanges in offering custom-made transaction services.[35]
Institutional Framework
The change in the technological framework of the transaction arena can result in a modification of other framework factors. The
most important is surely the redefinition of the regulatory frame of the capital market including the exchanges, as well as other
forms of securities trading arenas. This has become necessary because the old regulatory regime focused on floortrading on
established exchanges and not on the capabilities of electronic trading (Becker et al., 1992; Domowitz, 1992, p. 320; Saunders
and White, 1986). Important problems to be solved are:
regulation of exchange competition
allocation of regulation costs
regulation of cross-border trading
regulation of property rights on exchange products
guarantee of technical integrity of the trading systems
The quest for an appropriate regulatory regime can be characterized as the conflict between concentration and competition
(Schmidt, 1977; Securities and Exchange Commission,1994, p. III; Stoll, 1992, p. 92).[36] Supporters of exchange
competition see the competition as an innovation and incentive potential for the provision of a minimal transaction cost market
arena. Critics argue that a myriad of transaction systems reduces market liquidity.[37]
The allocation of regulation costs results from the fact that exchanges are in general self-regulating organizations, meaning they
organize and pay for their own regulation. In contrast, proprietary trading systems are not classified as exchanges and therefore
do not have to bear any regulation costs. If exchanges compete against proprietary trading systems the playing field is not equal.
International trading has to be regulated as well as national securities trading. Through the growing use of proprietary trading
systems, a larger share of securities trading is being dealt cross-border.[38] Important regulatory questions include access,
listing of securities, and responsibility for market surveillance (International Organization of Securities Commissions, 1994;
White, 1993).
A further problem with the emergence of computer exchanges is the definition of property rights on the price discovery of an
exchange (Alchian and Demsetz, 1973). If exchanges and proprietary trading systems free-ride on the price discovery process
of the dominant market, they can offer a transaction service with similar quality but do not have to bear the costs of operating
the transaction arena. Considering that the price discovery is one of the major products of an exchange, it is necessary to
concentrate the property rights on the price discovery process.[39]
The market objects require a concentration of property rights as well. Only when derivatives are exclusively traded on an
exchange are sufficient incentives provided for the invention and marketing of new derivatives (Mulherin et al., 1992). [40]
Another important regulation question is the safeguarding of the technical integrity of the trading systems (Mechler and
Niedereichholz, 1991). This point has not yet been sufficiently emphasized due to the focus on regulation of the trading floor.
Transfer to Other Markets
The capital market and its exchanges still have a long way to go for complete automation. Though a trend towards further
automation is apparent, the price discovery process will not be fully automated in the foreseeable future.
All important exchanges are planning to install more information technology for the rationalization of their trading arenas (United
States General Accounting Office, 1991, p. 4.). The New York Stock Exchange and the Futures Exchanges of Chicago, for
example, are introducing hand-held devices which allow direct order routing to the floor traders and the substitution of their
trading books. At this time an abolition of the trading floor is out of question for the dominant marketplaces. As an example in
support of this, the Chicago Board of Trade plans to add on a new trading floor for $170 million because the existing floors can
no longer accommodate the exploding trading volume. In comparison the $1 million investment for Project A (an electronic
after-hours trading system) is trivial. An imaginable scenario for the capital market is characterized by the coexistence and
interaction of a variety of transaction systems. [41] An integrated global computer exchange in the narrow sense with 24-hour
trading is not in sight.
The automation of capital markets can be characterized as an evolutionary process. This process is predominantly marked by a
growing understanding of the securities market process. The parallels to the evolution of management systems are evident: only
when the understanding of the participants' interactions of the coordination mechanism is improved can a modeling of an
electronic coordination mechanism be successful (Gerke and Bienert, 1991).
Application of these observations to other markets is difficult to conduct due to the specific features of the capital market. The
most striking observation is the discrepancy between the mechanistic market concept of the proponents of electronic commerce
and the real-life market process which is deeply characterized by the strategic behavior of the actors. To understand how
markets behave, the proponents of electronic commerce should take a closer look at market microstructure. In so doing, it will
most likely be observed that market processes are difficult to explain, and therefore the organization of markets is an intricate
task, whether with the support of electronic devices or not. To extend the first findings of our research project to other markets
the following cautious observations can be made.
The automation of the price discovery process is the most difficult task in designing and running electronic markets. This is
especially true for highly standardized products because the only remaining variable for the actors gaming in order to maximize
profit from the market transactions is the price at which a transaction takes place. For this game the actors guard their
information jealously in conducting order exposure management in order to outplay the other traders. In markets for less
standardized goods such as for clothing and furniture, etc., the actors have more gaming variables in conducting a market
transaction for the maximization of their profits. Therefore, the revelation of price information may not be so crucial in these
types of markets.
The automation of highly organized markets is difficult due to vested interests. Organized markets are designed to
accommodate the economic demands of the actors and as soon as reorganization jeopardizes the interests of the actors,
technological rationalization potential is difficult to realize.
The competition between different market organizations is mainly influenced by traders' inertia. Liquidity attracts further
liquidity, which means that traders always want to trade where others are already trading. This is a network effect, which makes
it difficult for competing start ups to attract enough orders to reach the critical mass of orders in order to produce a liquid
market. This liquidity inertia is a major barrier for innovative market organizations that are attempting to compete against
established ones.
Complete replacement of human intermediaries will not take place. But it is likely that there will be an unbundling of the
activities of intermediaries so that consultative and pure order handling activities are separated. Standard transactions will
become more and more automated, even their price discovery, as long as the orders are atomistic and one order has no
significant impact on the price. Intricate transactions will still need human intermediaries but may be conducted with electronic
support. |
