Competition between Exchanges: A Research Agenda

The financial exchange industry has undergone profound changes in the past 20 years. On the technological front, advances in telecommunications and computer power have changed the economics of the business entirely by offering new ways to make markets, greater speed of dissemination of financial information, greater access to exchanges from anywhere in the world, new interfaces allowing traders to route their orders where most profitable and algorithmic trading. On the governance front, most exchanges have moved from a memberowned structure, where users of the exchange were also its shareholders, to a for-profit structure. Many have eventually sought to issue shares publicly. Finally, the industry has experienced an unprecedented wave of entry of new platforms and, at the same time, an unprecedented wave of mergers. As the industry is in flux and it is unclear whether the current organization is permanent or transitional, policy-makers must take a stance on merger applications and new regulations to improve the performance of financial markets. For many of these decisions, they combine institutional and industry knowledge with the “standard industrial organization toolkit” of industry analysis. In this paper, we argue that this toolkit is not sufficient to answer questions such as, for example, the likely or even optimal market structure for the financial exchange industry. There are important gaps in our understanding. Financial exchanges are special because their microstructure is part of their business models. Financial markets are special because of the heterogeneity of trading motives and because of the way in which these markets create value. No “off-the-shelf” IO model integrates these aspects in a way that is useful for policy. The finance literature is of no greater help because it tends to narrowly focus on the trading decision, at the cost of abstracting from the economic implications of the other events