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2 I Quaderni di Finanza hanno lo scopo di promuovere la diffusione dell informazione e della riflessione economica sui emi relaivi ai mercai mobiliari ed alla loro regolamenazione. Nella collana «Sudi e Ricerche» vengono pubblicai i lavori di ricerca prodoi o promossi dalla Consob; nella collana «Documeni» rovano spazio gli inerveni isiuzionali e gli ai di convegni. Comiao di Redazione: Marcello Bianchi, Carmine Di Noia, Alfredo Macchiai, Aldo Magnoni, Giovanni Siciliano. La cura edioriale di queso numero è di Eugenia Della Libera.

3 THE STOCK-EXCHANGE INDUSTRY: NETWORK EFFECTS, IMPLICIT MERGERS, AND CORPORATE GOVERNANCE (*) Carmine Di Noia (**) ABSTRACT The evoluion and inegraion of financial markes in recen decades have creaed increasing compeiion among sock exchanges, which are behaving more and more like sandard firms. Sock exchanges are peculiar firms ha produce lising, rading, and clearing services and sell price informaion. They have differen ypes of cusomers: firms ha wan o be lised, financial inermediaries who wan o rade securiies, and insiuional and privae invesors. Some of hem, in paricular financial inermediaries, are ofen he owners of he sock exchanges, which radiionally have been organized as cooperaives or public eniies. This paper focuses on he sock-exchange indusry, analyzing he compeiion among exchanges and, more heoreically, he corporae-governance problem of cusomer-conrolled firms, of which sock exchanges are a clear example. Policy implicaions are provided in boh cases. Afer he inroducory chaper, he second chaper, Compeiion and Inegraion among Sock Exchanges in Europe: Nework Effecs, Implici Mergers, and Remoe Access, analyzes he role of nework exernaliies in he sock-exchange indusry hrough a model in which wo exchanges compee. I is shown, using he European regulaory background, ha compeiion may end up in inefficien equilibria while an implici merger may be Pareo opimal and give greaer profis o boh exchanges. In he end, exchanges may specialize in lising and rading services, or unilaerally sar o rade socks lised on oher markes (as did Seaq-Inernaional some years ago or many auomaed rading sysems in recen years). (*) This paper is a slighly revised version of he Ph.D. disseraion of he auhor a he Deparmen of Economics of he Universiy of Pennsylvania. The auhor would like o hank he members of his Commiee - Richard Kihlsrom, Franklin Allen and Anhony Sanomero - and Raphael Rob, Ian Domowiz, Paul Arlman, Albero Cybo Oone, Alfredo Macchiai, Andrea Moro, Marco Onado and Adel Varghese for many valuable conversaions and helpful commens. The view expressed in his paper are solely hose of he auhor and do no necessarily reflec he views of Consob. (**) Divisione Mercai, Consob. 3

4 The hird chaper, Cusomer-Conrolled Firms: he Case of Sock Exchanges, shows ha monopolis cusomer-conrolled firms, like cooperaive banks, or life insurance companies, and sock exchanges, never price heir goods a he monopoly price, so ha minoriy shareholders always receive less profis. When he firm is compleely cusomer-owned, he monopolis achieves he firs bes, and pricing policies are irrelevan if hey face a uni demand, while price equals marginal cos if he firm faces a downward demand. 4


6 I. INTRODUCTION Compeiion among sock exchanges, boh naional and inernaional, is a recen phenomenon, especially in Europe. Unil some decades ago, i was difficul o hink of exchanges as firms ha produce and sell goods o cusomers and compee among hemselves. Tradiionally, exchanges were seen eiher as public eniies (like he coninenal European exchanges), or as formally privae bodies, regulaed, more or less, by public rules (he Anglo- Saxon exchanges). In boh cases, hey were ofen legal monopolis, given he special naure of heir aciviy ha very much resembled ha of a public good. The increase in compeiion, due mainly o he echnological innovaion and ransformaion of he securiies markes in Europe, has produced new rading sysems, echnological agreemens among exising exchanges, price wars, mergers, akeovers, and he creaion of new exchanges, even wihin he same counry, as well as he failure of previous aggreemens and alliances. Furhermore, many quasi-exchanges (auomaed rading sysems) have developed. From an economic poin of view, an auomaed rading sysem can be seen as a special kind of exchange, which specializes in producing rading services wihou producing lising services, given ha i generally rades securiies already lised in regulaed exchanges. Many exchanges, formerly cooperaives of inermediaries who were boh members and owners, have changed heir ownership srucure o become sandard corporaions while ohers, formerly public, have been privaized. Some of hem are, in a sense, cusomer owned or conrolled. Only a few of hem, unil now, have belonged o shareholders oher han financial inermediaries. Since many exchanges are self-regulaed, conflics of ineres may arise. For example, a manager of he exchange may no enforce a rule agains one of is owners. Thus he governance srucure may maer in he process of compeiion. The process of moneary union and he full implemenaion of he Invesmen Service Direcive (ISD) will furher inegrae financial markes in Europe. The single currency will eliminae one of he reasons for fragmenaion of firm lising among differen naional exchanges (and a reason behind heir naural monopoly). The ISD, in fac, allows each recognized exchange o offer remoe access o inermediaries in oher counries. There will be muual recogniion and home-counry conrol for all securiies firms and banks performing invesmen services. Finally, banks are already, or will be, allowed o rade direcly on exchanges wihou he need of subsidiaries. Of grea uncerainy sill is he evoluion of he exchange indusry in Europe. Will he exchanges merge? Is here enough space for some of hem o survive? Wha abou inegraion wih off-european exchanges? Is i beer for he exchanges o have an agreemen among hemselves or o decide unilaerally o rade shares lised in oher exchanges and/or o offer remoe access? Will he price-war game in lising and rading fees come o an end? In Chaper, he economic heory of nework exernaliies and a simple-game heoreical framework are used o explore he issue of compeiion among sock exchanges and he 7

7 possibiliy of consolidaion in he European sock-exchange indusry, among he differen exchanges. The main feaures of he second chaper are he following: he reamen of exchanges as firms; he applicaion of nework exernaliies o sudy compeiion among exchanges; he exension of nework exernaliies, hrough implemening cross-nework effecs; and he exisence of equilibria where exchanges may decide, even unilaerally, o achieve full compaibiliy hrough implici mergers and remoe access, specializing only in rading or lising services. One implicaion is ha consolidaion of European exchanges ino one may occur wih a welfare-efficien oucome or wih a lock-in o a Pareo-inferior equilibrium. This is due o he nework exernaliies and he differen saring poins of he various exchanges. Implici mergers among exchanges ogeher wih remoe access are always weakly (in half of he cases, sricly) more efficien han he acual compeiion. This finding also sheds ligh on he exisence and efficacy, especially in he U.S., of auomaed rading sysems, which are exchanges specializing in rading services. Chaper 3 deals wih cusomer-conrolled firms. In many indusries, here are firms whose owners (or some of hem) are also cusomers. They have conrasing ineress: hey ge more uiliy as he firm s profis increase, and he price of he good decreases as heir privae consumer surplus increases. An ineresing example is he sock-exchange indusry, as well as many clearing houses or cenral cusodians. Chaper 3 shows ha a cusomer-owned monopolis always achieves firs-bes social oucome, bu in cusomer-conrolled firms, profis are no necessarily maximized and minoriy shareholders are damaged. When cusomers have equal uni demand, less profis arise if hey hold a share of he firm s capial lower han heir percenage over he oal number of cusomers. When cusomers have equal downward demand, he firm never maximizes profis; furhermore, if he share of capial of cusomer-owners is less han half he weigh of cusomer-owners over oal cusomers, he firm will always price a 0. I follows ha cusomer-owned sock exchanges are welfare efficien if all he cusomers (lised firms, inermediaries, price vendors, ec.) hold all he capial; more imporan, monopoliss price, efficienly, a marginal cos if he share of capial owned by cusomer-owners is equal o heir weigh over he oal number of cusomers. Cusomer-conrolled exchanges do no maximize profis. This finding cass some doub on he policy of lising a sock-exchange company iself on exchanges. 8

8 II. COMPETITION AND INTEGRATION AMONG STOCK EXCHANGES IN EUROPE: NETWORK EFFECTS, IMPLICIT MERGERS, AND REMOTE ACCESS II.1 INTRODUCTION This chaper describes he compeiion among exchanges, applying some of he nework exernaliy lieraure. A problem is ha, in general, exchanges have no been considered as firms. Tha is why, firs, here is a brief analysis of wha an exchange is, wha is producs are, wha is revenues and coss are and who is cusomers are. Exchanges are special kinds of firms ha produce a combinaion of wo goods: lising and rading services. Exchanges have wo main direc cusomers: firms ha wan o be lised and inermediaries ha wan o rade on he exchange. There are many reasons ha hey should wan o be on an exchange and here are many coss hey have o bear. Second, he concep of nework exernaliies is inroduced. This concep has been analyzed in deph in he indusrial organizaion lieraure. As Economides (1993) noes, one can view he various financial exchanges (NYSE, NASDAQ, AMEX, Pacific, London, Tokyo, ec.) as well as he various companies ha provide maching services (Insine, Posi, AZ, ec.) as (a leas parially) incompaible neworks. The exisence of such a variey of organizaions begs he quesion of he poenial for new, innovaive ways of organizaion of ransacions, maching of orders, and price discovery. This chaper concenraes (no on he marke microsrucure bu) on he compeiion among exchanges and on he possibiliy of a sraegic ineracion among hem. Exchanges can be considered as neworks in which he greaer he number of cusomers, he higher he uiliy for everyone (Economides, 1993 and 1995). All else being equal, firms wan o be lised where oher firms are lised (he direc-nework effec) and especially where many inermediaries rade (he cross-nework effec), as more liquidiy is on he marke. Inermediaries wan o be presen a he exchanges where more firms and inermediaries are presen as hey are more aracive o heir final cusomers (invesors) and for hemselves (heir own porfolios and all he risk-managemen services). The model presened here draws upon he nework exernaliy lieraure (especially Kaz and Shapiro, 1986a and 1986b), applying i o he sudy of he compeiion among exchanges. We also adap heir model wih a differen uiliy funcion and inroduce explicily crossnework exernaliies, in order o capure cross-uiliy effecs ha have been developed in he empirical finance lieraure. We compare a model of incompaibiliy (exchanges compeing 9

9 agains one anoher) o one of complee compaibiliy (where exchanges agree on implici merger and reciprocal remoe access) (1). The model yields a variey of ineresing implicaions wih regard o he compeing sraegies of exchanges, especially in Europe, and adaps o exchange compeiion in boh he compeiion and he implici-merger case; he nework effec allows he exisence of differen equilibrium oucomes. I is plausible ha, ceeris paribus, when firms decide o be lised on an exchange, hey choose he one wih more inermediaries and firms due o greaer liquidiy on he marke. The same sraegy is followed by he inermediaries ha wan o become members of ha exchange (unless regulaions prohibi his choice). When exchanges are no inerconneced (he incompaible case), only pure-corner soluions in equilibrium may arise, wih only one exchange surviving. This may lead o he end of he fierce compeiion among exchanges in Europe, where some exchanges are disappearing afer mergers. The presence of many exchanges in realiy is no incompaible wih his view, as exchanges were no compeing wih one anoher, a leas in Europe, unil a decade ago, due o differen regulaions and currencies ha le hem be monopolis in heir relevan markes. In fac, in each counry, eiher only one exchange exised or only one was dominan and absorbed he small regional ones (as in France, Ialy, Spain, and Germany). The firs finding of his chaper is ha implici merger is a clear sraegic opion for exchanges. In he presence of cross advanages in marginal coss (), his sraegy can give boh exchanges higher profis, wih some side paymens. In he absence of any coordinaion or policy guide, an implici merger will no arise. In any case, he exchange wih higher marginal coss (ha should be defeaed in normal compeiion) has an incenive o achieve a unilaeral implici merger, lising or rading securiies of he oher exchange. The second finding is ha implici mergers always sricly improve welfare when here are cross advanages in marginal cos of he exchanges. Regulaors should favor implici mergers, eliminaing all obsacles o lising and delising in exchanges and o rading, implemening full remoe access. The hird finding is ha here is neiher a privae nor a social reason o achieve an implici merger when an exchange is an efficien monopolis wih all coss lower han ohers. If compeiion leads o an efficien monopoly, welfare is already maximized. There is no need in each counry for eiher a naional exchange or a naional airline. Proecionis regulaions ha, for example, give ax exempions o naional firms ha lis only in he naional exchange and no in foreign exchanges are inefficien and more cosly for axpayers. (1) We define an implici merger beween exchanges as an agreemen beween wo exchanges such ha he securiies, originally lised in one exchange, are lised by he oher one, and remoe access is offered o he raders of each exchange, wih reciprociy and wihou furher requiremens. () I means ha one exchange has lower marginal cos in rading and he oher exchange in lising. 10

10 The fourh finding is ha oal consumer surplus is sricly higher wih implici merger, in all cases bu one. Even when an exchange remains monopolis, implici merger keeps alive some price compeiion; ha is he difference from having an explici juridical merger among he exchanges. The fifh finding is ha we may have in some cases a specializaion of exchanges where hey decide for complee compaibiliy (implici merger and remoe access). If here are differences in marginal coss, one exchange could jus lis he firms and he oher could accep inermediaries as members for rading. In an exreme case, he lising service may be done by raing agencies and he rading by exchanges. The model shows ha nework exernaliies may lock-in exchanges ino inefficien oucomes, due o a lack of coordinaion, even in perfec compeiion. This is a sandard finding in he lieraure. In hese cases, implici mergers improve welfare, consumer surplus, and oal profis. There is, even in his case, a srong incenive for exchanges o achieve compaibiliy. They only mus agree on some side paymens from one o he oher. These findings also help o explain he success of auomaic rading sysems. In fac, hese sysems can be seen eiher as exchanges ha specialize in rading or as exchanges ha unilaerally achieve compaibiliy wih oher exchanges, rading socks already lised in oher exchanges, and, hus, free-riding on he fixed cos of lising, borne enirely by he regulaed exchanges. This las explanaion would also be consisen wih he aggressive policy of he London Sock Exchange in he lae 1980s, when he LSE decided o rade he major socks lised in he oher European exchanges, or wih he U.S. case, which has a sysem of regional exchanges ha only have o apply o he SEC in order o rade in socks lised on oher exchanges. The chaper is organized as follows: Secion II. gives some background on he reasons for compeiion among exchanges in Europe and on he naure of exchanges as firms. In Secion II.3, he noion of nework effecs and heir applicaion o financial exchanges are presened. The model, he welfare analysis, and heir implicaions are in Secion II.4. Secion II.5 offers some concluding remarks. II. INTEGRATION AND COMPETITION AMONG EXCHANGES There was an era when exchanges were naural monopolies (Seil, 1996b), bu he srucure of securiies markes all over he world has changed dramaically during he las decades. The evoluion of new financial insrumens, he falling monopoly of banks as a source of direc funding o borrowers and of direc invesmen for invesors, he remendous improvemen in informaion echnology, and a greaer financial culure among common people as well as he flucuaions in ineres, price, and exchange rae due o he oil crises have caused he increasing imporance of securiies markes in he financial sysem, boh as regulaed exchanges and over 11

11 he couner (3) (OECD, 1996). New heories of financial inermediaion (Allen and Sanomero, 1996; Allen and Gale, 1997) underline he imporance of he markes in such a way ha all inermediaries (banks, muual funds, ec.) perform a risk-managemen aciviy in beween borrowers and lenders on one side and markes on he oher, providing a kind of risk insurance. In spie of ha, banks and markes can sill coexis (Boo and Thakor, 1997). The evoluion and ransformaion of securiies markes and of informaion echnology is becoming an imporan issue in Europe and in he U.S. for anoher reason: i makes exchanges comparable and more inegraed. The borders of he relevan marke ha invesors face are blurring. In his way here is an increasing compeiion among he sock exchanges (Pagano and Seil, 1996) and among exchanges and auomaed rading sysems (Domowiz and Lee, 1996). II..1 THE EXISTING COMPETITION Examples of compeiion among exchanges are no new a all, especially in he U.S.. They can be found, for example, from he iniial years of he NYSE. In 1885 he Consolidaed Sock Exchange (4) decided o rade NYSE-lised socks, charging lower commissions due o is lower coss because i used he NYSE quoes and did no incur he coss of esablishing he price-discovery mechanism (Mulherin e alii, 1991) (5). Blume and Goldsein (1997) analyze empirically he inegraion of he U.S. equiy markes in recen years. In more recen imes, he London Sock Exchange, deeply reformed in 1986 (6), decided unilaerally o rade on is inernaional segmen (SEAQ Inernaional) he mos imporan European socks. I gained such a significan marke share in oher European securiies lised on naional exchanges ha hey had o quickly updae heir markes (7). Nowadays, he LSE mus face he naional compeiion of Tradepoin. Afer is enry ino he marke in 1995 and he shif o i of he rades of hree ou of four inerdealer markes, he LSE slashed is fees by more han (3) OECD (1996) disinguishes over-he-couner exchanges in proprieary-rading sysems and inernal-crossing sysem. (4) The Consolidaed Sock Exchange was creaed in 1875; hen i absorbed he American Mining & Sock Exchange, he Naional Peroleum Exchange, he Miscellaneous Securiy Board, and he New York Peroleum Exchange & Sock Board (Mulherin e alii, 1991). (5) Laer in he paper we will discuss his sraegy, which is really a unilaeral compaibiliy decision. (6) The Exchange was originally consiued in 180 and reformed in I was incorporaed under he Companies Ac of 1985 as a privae limied company in 1986 under he name of The Inernaional Sock Exchange of he Unied Kingdom and he Republic of Ireland Limied ( The Exchange ). The Exchange changed is name o London Sock Exchange Limied in 1995 following he separaion of he Irish Sock Exchange as a resul of EC legislaion (LSE, Annual Repor, 1997). (7) Pagano and Seil (1996) give an excellen review of he empirical lieraure. Some auhors find ha SEAQ-I did no really seal rades bu on he conrary simulaed more rades on he naional exchange; ohers find ha in any case SEAQ-I was a price aker wih respec o naional exchanges. 1

12 60% o undercu Tradepoin (8), which recenly inroduced remoe access for U.S.-based insiuions and, hrough Bloomberg, for Hong Kong-based insiuions. Meanwhile, he LSE decided o move from a quoe-driven sysem o an order-driven sysem for he FT100 Index (9) leading shares, o beer compee wih he order-driven European exchanges. The major move of LSE was he sraegic alliance wih he Deusche Borse (July 1998) in order o harmonise he markes for heir leading securiies and, ulimaely, o develop a join elecronic rading plaform. Exchanges are facing even sronger compeiion from quasi-exchanges, like auomaed rading sysems (ATS), where i is possible o rade securiies generally lised on exchanges. ATS compee wih exchanges even if heir naure is no clear from a regulaory poin of view. While, in fac, he exisence and naure of exchanges once were no conroversial as hey were easily idenified and characerized, compuer echnology has led o he birh of hese new MONSTERS (Marke-Oriened New Sysems for Terrifying Exchange Regulaors) (Lee, 199). This maer may give rise o regulaory compeiion among auomaed rading sysems and regulaed exchanges (Insine versus NYSE, for example). The endency in Europe seems o be o ry o classify as regulaed exchanges even markes like Tradepoin, which seem more similar o auomaed rading sysems han o exchanges. In general, auomaed rading sysems free-ride on he process of lising, given ha hey generally rade only securiies lised on oher exchanges; furhermore, hey someimes free-ride on he price-discovery process given ha members of exchanges may direc rade on ATS o make some arbirage or o operae in offregular hours. Bu he main cusomers of ATS seem o be insiuional invesors ha generally are no allowed o rade direcly on exchanges. In he U.S. his opic is imporan for wo reasons (SEC, 1997): he exponenial growh of rading sysems ha presen comparable alernaives o radiional exchange rading and he developmen of auomaed mechanisms ha faciliae access o foreign markes from he U.S.. Therefore, he SEC is reconsidering is approach o he regulaion of exchanges and oher markes and has provided a concep release on his opic, soliciing commens (Macey and O Hara, 1997). In fac, auomaed rading sysems also compee wih exchanges on a regulaory basis as hey are ofen regulaed in a differen way; he regulaory arbirage may even lead some of hem o ask o be regulaed as broker-dealers (Domowiz and Lee, 1996). (8) The new price srucure, effecive from Ocober 0, 1997, includes for rading ouside he order book, he maximum charge is cu from 10 o.50, bringing he charge for an average 50,000 rade down from 7.50 o.35. A minimum charge of 5p is currenly going o be mainained for smaller rades, and for rading on he new order book, charges are cu o 6p per 1,000 compared wih 15p under he previous pricing sysem, wih a maximum charge of 10 per order. For example, a 50,000 rade will now cos 3 (less han half he previous charge of 7.50) (FIBV, Press Release, Augus 1997) (9) The new sysem sared Ocober 0,

13 There is also non-price compeiion (process and produc innovaion, adverisemen), which may be summarized in repuaion and qualiy and led many regulaors and/or exchanges o reform heir governance srucure, rading sysems, and surveillance rules (10). Compeiion, in fac, akes place on many grounds, as Ferrarini (1996) noes, such as he provision of immediacy, price discovery, low price volailiy, liquidiy, ransparency and ransacion coss. Moreover, compeiion is a subsiue for regulaion. Indeed, he more compeiion here is, he more likely i is ha exchanges hemselves will adop rules ha benefi and proec cusomers. There is, finally, derived compeiion, parially real and parially poenial, by inermediaries acing as brokers (bu looking like markes) ha ry o exploi he Inerne o offer cusomers he chance of rading direcly on exchanges for very low fees (11). This evoluionary process has recenly acceleraed in Europe due o he implemenaion in many counries of he Invesmen Service Direcive (ISD, no. 93//CEE). Wih respec o exchanges (1), ISD sipulaes ha no more resricions can be effecive and all auhorized invesmen firms (including banks) mus be allowed o become members of, or be given access o, all regulaed markes in any sae, home or hos (13). Finally, being a regulaed marke does indeed represen a compeiive advanage wih respec o non-regulaed markes such as auomaed rading sysems. In fac, regulaed markes are eniled (ar. 15.4) o provide rading screens o invesmen firms based in oher member saes wihou having o seek approval from he relevan foreign auhoriy: This provision of he Direcive is popularly viewed as he European single passpor for screen-based rading sysems (Seil, 1996b). Some exchanges have already permied remoe membership (14) ; ohers, like Paris and Brussels, are abou o. Compeiion led some exchanges o sign sraegic alliances (15), o merge (16), o launch akeovers (17), o compee in marke archiecure (18), o allow remoe membership, o modify (10) The example of he deep reforms on NASDAQ in 1996 is he mos obvious. (11) A price war characerized he las monhs of 1997 among Fideliy (which cu is commissions wice in wo monhs, now down o $14.95 per rade), Charles Schwab, E-Trade, Quick & Reilly, Amerirade, and oher inermediaries (Ialia Oggi, Ocober 10, 1997). (1) A deailed and criical descripion of he ISD and is impac on marke srucure is in Seil (1996b). (13) In some saes, here were resricions o access for naional eniies eiher because membership was necessary for access or because cerain kinds of eniies were no allowed (for example, in Ialy unil 1996, banks and all foreign eniies were obliged o buy or creae an Ialian sockbroking firm o have access). (14) By June 1997, here were remoe members in Helsinki (four from hree foreign counries), Frankfur (10, hree), Milan (hree, hree) and Sockholm (13, five). (15) The mos imporan agreemen is he sraegic alliance of he London Sock Exchange wih he Deusche Borse (July 1998) in order o harmonise he markes for heir leading securiies and, ulimaely, o develop a join elecronic rading plaform. The Swiss Exchange (Swx) and Paris Bourse (Sbf) signed on January 9 h 1999, an alliance which should lead o an implici merger (croos membership and cross lising) by he end of In he US he AMEX merged wih NASDAQ and he Philadelphia Sock Exchange joined he alliance, oo. 14

14 prices and rading hours (19), and o sign cooperaion and echnological agreemens (0). In many cases he exchanges changed heir juridical forms and ownership srucures (1). Some of hem () lised heir shares. Many of he agreemens have failed afer some ime (3), due o problems in he governance srucure and o echnical reasons on he clearing and selemen par. In his framework, foreign-lising and volunary or compulsory dual-lising are increasing he inegraion among markes. Firms ofen choose o be lised on exchanges differen from heir naional one or on boh he naional and foreign ones (Werner and Tesar, 1997). Someimes hey are lised unilaerally wihou heir consen; his happens when an (16) For example, he Helsinki Sock Exchange and he Finnish Opions marke (SOM) signed a merger agreemen (July 1, 1997) o form a new company, HEX Ld. (Helsinki Sock and Derivaives Exchange Clearing House). Under he exising cooperaion agreemen beween SOM and he Swedish exchange, OM Sockholm, SOM producs will be raded in Sockholm and a he marke operaed by OM s London-based exchange, OMLX. On he oher hand, he producs of OM will be raded in Finland (FIBV, Press Release, July 1997). (17) The Paris Bourse, which was conrolling 3% of he Maif fuures Exchange, launched a akeover of i on Sepember 17, 1997 (Financial Times, Sepember 17, 1997). OM, which, afer he privaizaion of he Sockholm Sock Exchange, held a share of i, increased laer is shareholding. (18) The example is LSE, once again, which passed o a quoe-driven sysem in Ocober 1997 even hough, according o Seil (1996b), he London dealer marke injeced vial privae liquidiy ino coninenal markes dominaed by illiquid public aucion markes. (19) In Augus 1997, LIFFE decided ha i would begin rading is German govermen bond fuures 45 minues earlier each morning in order o gain rades from Germany s DTB (The Economis, Sepember 0, 1997). (0) A clear example is he cooperaion beween he Chicago Board of Trade (CBOT) and he London Inernaional Financial Fuures and Opion Exchange (LIFFE) ha sared May 9, The wo exchanges decided o rade on heir markes some conracs raded on he oher in order o give cusomers wider ime opporuniies o rade hese conracs (respecively he T-bond and he Bund) (Il Sole 4Ore, May 10, 1997). The cooperaion beween he compeing exchanges led, in early Sepember 1997, Deusche Borse, based in Frankfur, and he Swiss Exchange in Zurich, o merge heir derivaives exchanges ino a single marke, EUREX, launched in summer The French Maif will join EUREX, oo, afer he inroducion of an elecronic rading sysem (The Economis, Sepember 0, 1997). The venure will operae as a single marke wih a common produc range, a single selemen sysem, and a unified screen-based rading faciliy. This new iniiaive follows he decision made in July 1997 by he hree markes o cooperae on European equiy indexes. This planned cooperaion opens he way o a fullfledged alliance also inegraing he cash markes in he fuure (FIBV, Press Release, Sepember 1997). (1) The Ausralian Sock Exchange, Helsinki, Amserdam, and Milan, became, parially, companies wih shares freely radeable. () The Ausralian Sock Exchange is he firs exchange lised on iself: is shares raded from Ocober 14 h 1998 ouperformed he index by 100% in hree monhs. Tradepoin is also lised bu on he Vancouver Sock Exchange, from March 1993 even if is value downperformed dramaically he index from 1996 on. The shares of Amserdam Exchanges will be lised from 00, and are now raded on Reuers pages. (3) For example, he CBOT-LIFFE open oucry linkage (see above) was suspended on December 17 h, 1997; he CBOT members voed also agains he alliance wih Eurex, in January 1999, due o a change in he managemen of he US marke. 15

15 exchange or an auomaed rading sysem decides o regularly rade some shares. Amihud and Mendelson (1996) srongly objec o his pracice as he rading regime of a securiy affecs is liquidiy, and consequenly is value; hus, non-requesed mulimarke rading may produce negaive exernaliies ha harm securiy holders collecively. In shor, exchanges are behaving much more as sandard firms han as exchanges, or, more precisely, are now firms ha creae markes. Policy makers mus adap heir radiional regulaions o deal wih hese ransformaions. II.. THE EFFECTS OF THE INCREASING COMPETITION AMONG EUROPEAN EXCHANGES The effecs of he increasing compeiion among exchanges are difficul o evaluae in erms of he fuure marke srucures in Europe. On he one hand, in he long run, as in any oher indusry, only he mos efficien exchanges should survive, rading socks from all he oher European counries and offering he mos innovaive and compeiive financial insrumens (especially derivaives). As Seil (1996b) noes, he exisence of hree dozen European sock exchanges - almos all of which are operaing wih he same basic rading mechanism (he coninuous elecronic aucion) - is, a he very leas, duplicaive and waseful of resources. The expansion of remoe membership access afer 1996 will undoubedly go a considerable way owards faciliaing cos-effecive crossborder rading, and hereby eliminae significan barriers o creaing a common and expanded pool of equiy marke liquidiy. A single European currency would serve o inegrae he marke even furher. The firs model in his paper is consisen wih his explanaion; only one exchange (bu no necessarily he mos efficien) should survive. On he oher hand, i is possible ha a unique exchange will emerge only for highly sandardized and/or raded producs, especially afer he inroducion of he Euro (4) (like governmen bonds, derivaives, and socks of he bigges firms). In fac, remoe access makes useless any compeiion among he differen exchanges a leas if hey are a he same echnological level; furhermore, he informaive advanages on naional firms (especially small and medium-size firms) by heir naional exchanges and inermediaries will remain imporan. Finally, all he pas projecs or aemps o creae a unique European sock exchange (PIPE, Euroquoe, ec.) were unsuccessful (Cybo-Oone, Di Noia and Murgia 1999). In any case, he raionale for a coexisence of many markes, in differen naions, rading he same socks, could easily be given by differen rading sysems (as coninuous aucion favors ransparency and marke making favors liquidiy). The launch of he Euro could conversely srenghen smaller (4) Obviously, wih he adopion of a unique currency in Europe, all socks, governmen and privae bonds, and derivaives will no be affeced by exchange-rae risk. 16

16 bourses as oday, porfolios [...] end o concenrae on large markes and large currencies, (5) mainly because of he ease of dealing in heavily raded currencies and he percepion ha less familiar currencies are riskier. Many differen exchanges, evenually conneced, could form a sor of web (6). The coexisence of more han one exchange is consisen wih he second model in his paper. II..3 WHAT IS AN EXCHANGE? The saring poin in order o undersand compeiion among exchanges is o define wha hey are. There are a leas hree views of sock exchanges: he exchange as a marke; he exchange as a firm; and he exchange as a broker-dealer. Normally an exchange is hough o be an organized marke of securiies. This marke view of he exchange is shared, for example, by he American Securiies Exchange Ac (secion 3.a.1) which defines an exchange as any organizaion, associaion, or group of persons, wheher incorporaed or unincorporaed, which consiues, mainains, or provides a marke place or faciliies for bringing ogeher purchasers and sellers of securiies or for oherwise performing wih respec o securiies he funcions commonly performed by a sock exchange as ha erm is generally undersood, and includes he marke place and he marke faciliies mainained by such exchange. Bu he generally undersood meaning of exchange led Domowiz (1996) o give a more precise definiion: An exchange is a rading sysem ha mus: provide rade execuion faciliies; provide price informaion in he form of buy and sell quoaions on a regular or coninuous basis; engage in price discovery hrough is rading procedures, rules, or mechanism; have eiher a formal marke-maker srucure or a consolidaed limi order book, or be a single price aucion; cenralize rading for he purpose of rade execuion; have members; exhibi he likelihood, hrough sysem rules and/or design, of creaing liquidiy in he sense ha here be enry of buy and sell quoaions on a regular basis, such ha boh buyers and sellers have a reasonable expecaion ha hey can regularly execue heir orders a hose quoes. (5) O. Lefebvre, chairman of he Brussels Bourse (The Wall Sree Journal Europe, Ocober 8, 1997). (6) Hagel (1996) analyzes webs as clusers of companies ha collaborae around a paricular echnology. 17

17 The marke view is shared also by he ISD, which defines a regulaed marke (ar 1, par. 13) as a marke for financial insrumens (defined in he annex of ISD) which: appears on he lis of regulaed markes (7) ; funcions regularly; is characerized by he fac ha regulaions issued or approved by he compeen auhoriies define he condiions for he operaion of he marke, he condiion for access o he marke and, where [...] applicable, he condiions governing admission o lising; requires compliance wih all he reporing and ransparency requiremens laid down pursuan o wo aricles of he Direcive. The firm view of exchanges concenraes on he producion side. Mulherin e alii (1991) sress he definiion of a financial exchange no as a marke, as usually is done, bu as a firm ha creaes a marke in financial insrumens and hus has he propery of he price informaion produced. Furhermore, a securiy marke can hen be seen as a firm ha produces a composie good, he exchanging of securiies, which may be formed of differen elemens (Padoa-Schioppa, 1997): price formaion, counerpar research, insurance for a good clearing, and he sandardizaion of he good exchanged. In shor, he producion cycle (Cybo-Oone, 1997) is divided ino hree pars: lising, rading, and selemen. These hree differen sages of he producion cycle lead o he formaion of differen goods ha he exchange can sell: lising services, rading services, selemen services, and price-informaion services. In his paper, we omi he selemen service as many of he exchanges do no have i (8) or are dismissing i (9). We consider he exchange as a producer of a combined good formed by lising and rading services, given ha we wan o concenrae on he nework exernaliies effecs among lised firms and inermediaries. Even acceping he firm view, i is imporan o noe ha he exchange produces a special good as a sor of public uiliy, even if he firm has a privae naure. In fac, inefficiencies in each par of he cycle fall upon he whole communiy (negaive exernaliy), no only on he eniies ha acually rade. Low qualiy informaion ends o form wrong prices ha conribue o a bad allocaion of resources; inadequae clearing and selemen procedures can hreaen he sabiliy of he whole financial sysem. This is why he efficien funcioning of an exchange can be viewed parly as a public good (Padoa-Schioppa, 1997), even when i is privaely managed. The exchange owners, in oher words, should saisfy all he ineresed eniies: inermediaries, issuers, insiuional invesors, and privae invesors. The efficiency of he marke is necessary o (7) This is quie a peculiar and circular (Seil, 1996b) definiion. (8) In Ialy, for example, clearing and selemen is done by hree eniies: a clearing house (Cassa di Compensazione e Garanzia), a naural legal monopolis (Moneioli S.p.A.), and, in par, by he Bank of Ialy. (9) The LSE has recenly moved from he proprieary selemen sysem Talisman ino he new elecronic share-selemen service provided by CRESTCo (in which he exchange is a hree percen shareholder). 18

18 increase savings, o proec hem and, finally, o expand producion and employmen. Thus, social marke uiliy canno be measured only by he profis of he sock exchange company because here is no necessarily a direc correspondence beween cos and (social) revenues, given he social service of he marke. Privae managemen and ownership may give greaer efficiency o he exchange given he srong compeiion among hem; he welfare problems are generally ackled by public supervision on he marke and by organizaional srucure such o reduce conflics of ineres. I is obvious ha, in he long run, an inefficien exchange would lose is marke share in favor of ohers (Fishel and Grossman, 1984), bu in he shor run i can cause losses o invesors. Anoher view is he exchange as a broker-dealer, recognizing ha he exchange is a kind of inermediary among inermediaries. In fac, a problem underlined by Domowiz (1996) and by Domowiz and Lee (1996) is he blurring disincion among broker-dealers, regisered exchanges, exemp exchanges, and securiies associaion. Eniies ha perform very similar aciviies are someimes regulaed in fully differen ways. In his sense, he exchange can be seen as, simply, a broker-dealer ha, like many banks or securiy houses, gahers rading orders and supplies he way of execuing hem. An example of an exchange regulaed as an inermediary is EuroMTS, he wholesale Euro-denominaed governmen bond marke, which has recenly asked he auhorizaion in UK as an inerdealer broker and no as a regulaed marke. II..4 EXCHANGES AS FIRMS I is difficul o define compeiion among exchanges because i is difficul o undersand clearly wha is he indusry and wha is he relevan marke. On he oher hand, an exchange can be seen as a large corporaion ha compees wih oher firms and is forced o produce he bes price-quaniy-qualiy combinaion feasible (Fishel and Grossman, 1984). From an indusrial organizaion poin of view, he firs hing ha makes exchanges differen from normal firms is ha, due o ownership srucures, some of he cusomers may be he owners of he firms as well. The managemen of hese exchanges may no necessarily wan o maximize profis (30) ; in fac, he exchange s price for, a leas, one of is producs (rading fees, for example) can influence he shareholders value (31) no only hrough he firm s profi bu (30) Chaper 3 sudies he problem of cusomer-conrolled firms, wih paricular aenion o sock exchanges. (31) In all cases where inermediaries are, even minoriy, shareholders. 19

19 also hrough heir consumpion of he exchange s good as long as he firm is no perfecly compeiive (3). These problems are addressed in Chaper 3. If exchanges compee agains one anoher o gain cliens, i means ha hey are operaing, a leas in par, in he same indusry, he marke of exchanges. In his sense he borders of he relevan marke (in an anirus sense) are blurring due o echnological developmen. The geographic concep has less and less meaning due o he progressive inegraion of financial markes, insrumens, and inermediaries even if a cerain amoun of marke power of exchanges is sill presen wih respec o small and medium firms ha wan o be lised, as hey are relucan o go public on foreign exchanges. There are differen sides of he compeiion among sock exchanges. Wih respec o firms, exchanges may compee in rying o lis hem exclusively or, a leas, o dual lis hem. The original lising fees are gained in any case by he exchange even if he annual lising fees, if based on he rading volumes, could be lower in case of dual lising, given ha he rading is spread over more han one exchange (33). Wih respec o inermediaries, compeiion is similar even if he srucure of he fees is reversed (he original fees are lower han he average amoun of rading fees for each inermediary). The exchange is hus ineresed in maximizing he amoun of rading volumes; he exclusiviy of he connecion of each inermediary may influence he number of rades conveyed o he exchange. However, wha is he demand ha exchanges are facing and wha are hey supplying? Firs of all, in order o undersand he demand ha a firm is facing, he easies hing o do is o look o is balance shee and check where he revenues come from. In his way he good ha is produced should be clear. From one of he few analyses of he balance shee of he European exchanges (34), i emerges ha he revenues come from hree major sources plus wo evenual or minor sources: rading fees (boh membership and rading fees) (35); lising fees (boh iniial and yearly lising fees) (36) ; (3) Acually, he inermediaries-shareholders may no even agree on he firm s bes decision in such cases. This is a sandard exbook definiion of one of he excepions o he profi-maximizaion rule (Tirole, 1988). (33) In case of dual lising, i is normal ha he greaes par of he rading volumes is formed on he naional exchanges. (34) Based on balance shee of 11 European sock exchanges (Baggiolini, 1996). (35) For example, he srucure of he rading fees for inermediaries rading shares on he Ialian sock exchange was he following, in 1996: here were fixed annual fees of 60 million ITL ($35,000) and a nominal fee per ransacion of,00 ITL ($1.3) (Consiglio di Borsa, 1997). In general, i may be rue o sae ha exchanges wan o inroduce conracs (lised socks, bonds or derivaives) which maximize he oal volume of rade (Fishel and Grossman, 1984, referring only o commodiy derivaives). (36) Lising fees are generally of wo kinds: original and coninuing annual. On he NYSE a foreign company lising 15,000,000 shares a a price of $41 per share would pay an iniial lising fee of $130,100 and an annual lising fee of $4,60 (Werner and Tesar, 1997). For he Ialian case, before he privaizaion of he exchange, he original fee was % of he value of he company (segue...) 0

20 informaion and price-disseminaion fees (37) ; selemen fees, even if lile by lile exchanges are ransferring his aciviy o specialized eniies where exchanges are, in general, among he shareholders; oher revenues may come from he developing and selling of proprieary sofware and informaion echnology. One problem, no solvable wih available public daa, is o undersand correcly how he coss are allocaed. In fac, no all he coss conribue direcly o he producion of he hree main goods sold. There are he coss for he regulaion and supervision of he marke ha make i more efficien, and hus more aracive, for issuers and inermediaries o ener. There are R&D coss and markeing coss, and here could be an implici cos in charging low or zero fees o raders and issuers (38). These revenues do no really define eiher he good or a good sold by he exchange, bu hey show ha an exchange sells rading services ha are srucured in hree differen pars: he objec raded (issued by some eniies ha generally pay a fee o have i lised) (39), he means of rading (rading faciliies, compuers, a compuerized floor, selemen); and price disseminaion. The cusomers of exchanges can be divided ino direc and indirec cusomers: Direc cusomers are he direc purchasers of exchanges services. The mos imporan are issuers who usually (40) pay fees in order o be lised on an exchange; inermediaries (41) who usually pay fees in order o be admied o rading (4) ; and informaion vendors who pay fees o have he righ o disseminae price informaion of he marke. Indirec cusomers are all he eniies ha send orders o inermediaries o be execued on an exchange: insiuional invesors and all oher financial inermediaries (if no allowed o rade direcly), single cusomers, boh physical or juridical persons. These cusomers have wo ( cerificao periale ); he coninuing annual fee was calculaed in wo pars based on he nominal value of he firm (10 million ITL up o 0 billion and 100,000 ITL for every billion ITL over 0 billion) and on he yearly rading value of he previous year (for every million ITL of rading, he firm owes he exchange 130 ITL up o 00 billion and proporional lower fees for higher rading value) (Consiglio di Borsa, 1995). (37) Mulherin e alii (1991) provide an excellen descripion of he propery righs on prices formed on he exchange, which can be sold or given ou o non-member firms. (38) Or, in any case, charging less han he cos of evaluaing he firms o lis. (39) In he case of derivaives, he issuer is he exchange iself. (40) They usually pay a fee, bu in some exchanges, like Seaq Inernaional or in many auomaed rading sysems, i is he exchange iself ha decides unilaerally o lis a firm or is bond. In some circumsances i could be he regulaor iself ha decides o lis financial insrumens, when here are, for example, many rades (or an organized rading) effeced ouside regulaed markes. (41) Leaving aside marke microsrucure differences, inermediaries operae on markes o saisfy orders coming from ouside cusomers and on heir own accouns. (4) Trading revenues and risk-managemen fees play a very imporan role in he balance shee of inermediaries. 1