Trading system competition and market-maker competition

Transcription

1 Tradng system competton and market-maker competton Mark Wahrenburg. Introducton The recent success of some alternatve tradng systems (ATSs) has had a strong mpact on the tradtonal stock exchange ndustry and many observers expect even more dramatc changes n the future. Ths paper nvestgates the nature of competton between stock exchanges and ATSs and argues that the ntroducton of ATSs weakens the level of competton between market-makers n the tradtonal exchange. Accordng to a popular argument, competng stock markets lead to a fragmentaton of the market and a reducton of lqudty whch n turn ncreases spreads and search costs for traders and threatens the effcency of the overall prce dscovery process. However, ths argument s vald only n a world wth hgh nformaton barrers. Wth functonng arbtrage lnks between markets the tradtonal fragmentaton argument breaks down. Ths paper takes another vew on stock market competton by lookng n more detal at the dfferent levels of competton. Stock markets offer a bundle of products and may best be descrbed as a vertcal producton chan. The frst element of the chan s the supply of mmedacy by market-makers or ndvdual traders. By provdng prvleges to certan members such as the specalsts of the NYSE, the Nasdaq market-makers or the Aktenbetreuer on the German stock exchange, stock exchanges actvely engage n the producton of mmedacy. The second element s the tradng system. Dfferent exchanges compete n techncal dmensons such as speed, relablty and nformaton servces as well as n desgn dmensons such as the detals of tradng rules. The thrd element n the vertcal producton process s the settlement and clearng operaton. Today, these functons may be provded by dfferent enttes. However, two of the three elements are often provded by one entty. For example, the German stock exchange s the owner of both the tradng system and the clearng system. Another example s the n-house systems of banks that usually encompass the market-makng functon and the tradng system functon. Most European ATSs are at least partly owned by securtes tradng frms, ndcatng that the tradng busness may be more proftable f tradng frms acheve control over tradng systems. Ths paper concentrates on the relatonshp between tradng systems on the one sde and the busness of makng markets on the other sde. The analyss shows that the two areas are nterrelated. Changng the level of competton n the area of tradng systems has an mpact on the level of competton at the market-maker level. Although the semnal work on collusve behavour by Nasdaq market-makers by Chrste and Schultz (994) has drected much attenton to the ssue of competton between market-makers, ths ssue has so far receved lttle attenton n the theoretcal lterature. The market mcrostructure lterature usually assumes ether perfect competton between market-makers or monopolstc market-makers. Ths strand of the lterature s not suted to studyng the determnants of the level of competton between market-makers. Kyle (989) models mperfect competton between nformed nvestors but does not focus on mperfect competton between market-makers. A paper by Dutta and Madhavan (997) shows that mplct colluson between market-makers may occur when they compete by choosng ntertemporal prcng strateges. The dea s that collusve equlbra may be sustanable f market-makers use tt-for-tat prcng strateges, e penalsng a devaton from the collusve equlbrum by quotng a low spread n later perods. However, colluson s only one out of many equlbra n ther model. It s therefore dffcult to draw conclusons on the mpact of ATSs on the level of competton. In a dfferent framework, Dennert (993) shows that competton Professor of Bankng and Fnance, Goethe Unversty, Frankfurt am Man, Mertonstrasse 7, D-60054, Frankfurt, Germany. E-mal: wahrenburg@ww.un-frankfurt.de. BIS Papers No 7 53

2 between a lmted number of market-makers does not elmnate ther profts when they use lnear prce schedules. However, he does not nvestgate the relaton between competng stock markets and the level of market-maker profts. Kandel and Marx (997) show that a Bertrand equlbrum wth spread exceedng margnal cost may result from fxed mnmum prce ncrements. However, ths paper s also not concerned wth the ssue of competton between tradng systems. In a recent contrbuton, Hendershott and Mendelson (2000) analyse the nteracton of dealer markets and crossng networks. They show that the ntroducton of a crossng network may ncrease or decrease the equlbrum spread n the dealer market. However, ther model assumes Bertrand competton between marketmakers whch always ensures a zero proft equlbrum n whch prce equals average costs. Ths paper presents a new approach to modellng the prce settng behavour of market-makers wthn a smple one-perod framework. The paper devates from the usual noton of Bertrand competton by assumng that market-makers who do not quote the best bd and ask prces stll receve some order volume. Unlke Dutta and Madhavan (997), the approach yelds unque equlbra wth non-zero profts for market-makers and allows an analyss of the mpact of ATSs on equlbrum spreads and equlbrum market-maker profts. Wthn the popular press, opposng vews on the lkely mpact of ATSs on market spreads are expressed. Some commentators expect that ncreased competton among tradng systems through the advent of ATSs would help to tghten spreads. 2 On the other hand, concerns have been rased that the vertcal ntegraton of tradng servces through the entry of bank-owned n-house tradng systems wll n the end lead to a monopolsaton of the tradng ndustry. 3 The European regulatory authortes currently follow a comparatvely lberal polcy and beleve that a lassez-fare polcy s best suted to promote competton among marketplaces and acheve economc effcency. However, the European Commsson has recently expressed concerns that the trend towards vertcally ntegrated tradng systems could dampen competton and s consderng regulatory actons aganst vertcal constrants n the stock exchange ndustry. 4 The model presented here elaborates ths vew by showng how vertcal constrants n the form of order-preferencng arrangements between ATSs and market-makers may affect the level of competton between market-makers and ncrease the equlbrum spread n stock markets. 2. The regulatory stuaton The European securtes markets are charactersed by regulatory fragmentaton. Stock market regulaton n Europe s usually shaped by three dfferent knds of regulatory bodes:. Insttutons regulatng nsder tradng and the flow of nformaton from companes to nvestors (nsder regulaton). 2. Insttutons regulatng the captal adequacy of partcpants n the tradng process (captal adequacy regulaton). 3. Insttutons whch regulate stock exchanges or oversee the self-regulatory bodes of stock exchanges (stock exchange regulaton). As a new fourth body of regulaton, one should menton the competton authortes, whch have ust recently begun to become nterested n ssues of stock market competton. Unlke the stuaton n the Unted States, the bodes regulatng stock exchanges work on a decentralsed bass. Ths approach s sometmes called the slo approach to regulaton snce every authorty s concerned wth only one or few stock exchanges. An extreme example s the stuaton n Germany, where the local states have the duty of overseeng stock exchanges. Ths led to the curous stuaton of a local state government havng to approve the planned merger of the German stock Moskowtz (2000). Munz (200). Heusnger (200b). 54 BIS Papers No 7

3 exchange wth the London Stock Exchange - a decson whch obvously affects the nterests of much more people than the voters of the local state government. Due to the decentralsed nature of competton, the regulatory actons concentrate on the busness processes wthn the partcular regulated stock exchange. The competton between dfferent exchanges naturally les beyond the horzon of decentralsed authortes. In other words: no nsttuton s responsble for provdng a far level playng feld between competng stock exchanges. The relatons between competng stock exchanges are beyond the scope of today s stock market regulaton. 5 Regulatory councls such as the Federaton of European Securtes Commssons (2000), or the German Stock Exchange Councl (200) dscuss at length the extent to whch prncples of stock market regulaton should be appled to ATSs but are slent on the regulaton of competton between tradng systems. The dscusson s manly concerned wth the threats to market ntegrty and systemc rsk posed by the new tradng platforms. There s lttle or no dscusson on an economc role of protectng new tradng platforms aganst the domnant ncumbent exchanges or vce versa. The ssue of competton between tradng systems requres a broader scope of regulaton than currently practsed. In partcular, t rases the queston of external effects n other areas as the current focus of the varous regulators nvestgatons. Ths paper hghlghts one of possbly many external effects of tradng system competton: a weakenng of market-makng competton. Although the concluson wll show that t s hard to draw clear regulatory mplcatons from the analyss, some blnd spots n the current regulatory landscape are dentfed by the analyss. 3. The mpact of alternatve tradng systems on market-maker competton The followng model tres to explore the effect of ntroducng an ATS on the competton between market-makers. It s a very smplfed and stylsed, based on the followng assumptons:. The market conssts of two types of ndvduals: traders and market-makers. There s no asymmetrc nformaton about the value of stocks. All traders are thus lqudty traders. 2. Intally, stocks are traded n a pure dealer market (the ncumbent market), n whch two market-makers compete for order flow. Both market-makers smultaneously choose bd and ask quotes and commt to execute an unlmted order volume at ths prce. 3. Market-makers act as Bertrand compettors n the ncumbent market, e ther acton varable s the quoted spread. The market s n equlbrum when no market-maker wants to alter hs own spread gven the spread of hs compettor. 4. When an ATS s ntroduced, every trader chooses one partcular tradng platform before he places hs order. 5. In order to attract order volume, the ATS provdes a best prce guarantee, e traders receve the same transacton prce on both markets and thus are ndfferent between both markets. 6. Traders cannot place lmt orders wthn the spread on ether the dealer market or the ATS. 7. Before the start of tradng, a contract s sgned between the ATSs and the market-makers whch commts both market-makers to assume and execute all orders routed through the ATSs. For smplcty, we assume an equal dvson of the tradng volume between both market-makers. 6 Note that the contractual allocaton of the ATS s order flow to the ndvdual market-makers takes place before the orders are placed by traders. It s ths sequence of events whch drves the man results of the model. By commttng to buy a porton of the 5 6 The Commttee of Wse Men (2000) of the European Unon has dentfed the urgent need to develop transnatonal regulaton. However, gven the legal and nsttutonal barrers n the area of stock market regulators, the paper proposes to rely on competton polcy as a complementary source of regulatory acton. The model abstracts from any payments made to the ATSs for acqurng the order flow, whch would lead to a redstrbuton of profts between the two partes but leave unaffected the overall profts. Examples are the German Quotrx system and the planned tradng system of Knght. See Heusnger (200a). BIS Papers No 7 55

4 ATS s order flow before tradng n the ncumbent market takes place, the market-makers are able to precommt to pursue a less compettve prcng behavour n the latter tradng sesson. Intutvely, followng aggressve prcng strateges n the ncumbent market becomes less attractve because lowerng the spread, ceters parbus, leads to a smaller ncrease n volume as compared to the stuaton wthout the ATSs. 8. Market-makers cost functon s lnear n turnover. The constant margnal cost may be nterpreted as order-handlng costs followng the usual mcrostructure lterature. 9. For smplcty, transacton costs are assumed to be zero for both markets. 0. In an mportant devaton from the usual Bertrand model, we assume that a market-maker quotng a lower spread does not lose all tradng volume. In tradtonal market mcrostructure models, the market-maker quotng the best bd or ask prce attracts all tradng volume. Ths assumpton has the consequence that Bertrand competton drves down the spread untl the spread equals margnal cost. A market spread exceedng the market-makers margnal cost cannot be an equlbrum because every market-maker would have an ncentve to slghtly undercut hs compettor(s). He loses lttle n terms of the spread reducton but gans a lot n terms of order volume because he s able to attract 00% of the tradng volume. It follows that the only equlbrum s a symmetrc equlbrum n whch all market-makers set the same spread equal to margnal cost. Ths extreme reacton of tradng volume s unlkely to be a good descrpton of real world markets. Although prce prorty rules ensure that lmt orders wth better prces are served before any other order wth worse prces at any pont n tme, strct prce prorty s not a good market descrpton when we are concerned about modellng spread settng strateges over somewhat longer tme ntervals. Suppose a market-maker s an employee of a securtes tradng frm and gets the order to follow a partcular spread settng strategy, e he wll keep a spread of 00 base ponts. Suppose another market-maker workng for another securtes frm has an order to quote a 0 base pont spread. Standard theory predcts that the second market-maker wll not be able to do a sngle transacton. However, he can expect a non-zero turnover n real world markets for a number of reasons not acknowledged by the standard theory: At any specfc pont n tme, competng market-makers may post dfferent bd and ask quotes because of dfferences n ther current nventory postons. Both market-makers may quote dfferent bd and ask prces as they have dfferent expectatons about the far (md-market) value of the asset traded. After a transacton has erased an order from the order book, the market-maker wll need some tme to place a new quote there. Wthn ths short tme perod, another market-maker, who s quotng a hgher spread, may attract tradng volume. Every market-maker must contnuously update hs bd and ask quote n order to adust to changng market prces. If ths adustment does not take place exactly smultaneously, a market-maker wth a hgher spread wll at some ponts n tme quote the best bd or ask quote. All these arguments support the vew that the reacton of transacton volume to spread changes s less extreme n real world markets as compared wth the usual Bertrand models. A good model of marketmaker competton should have the property that expected tradng volume s a smooth and decreasng functon of the quoted spread, e a market-maker quotng aggressvely receves more, but not all tradng volume. In order to formalse ths dea, assume that aggregate demand for dealer servces s nelastc such that the aggregate tradng volume s gven by a constant X. Furthermore, the share of tradng volume that a market-maker attracts s a smooth functon of hs own spread and the spread quoted by hs compettor. For smplcty, assume that the fracton of tradng volume attracted by each market-maker x s a lnear functon of the spreads s and s quoted by each market-maker: x = ½ - s + s When both market-makers set the same spread, they both receve 50% of the tradng volume. If one of the market-makers lowers hs spread, he s ganng market share but not the complete market and vce versa. Note that x and x sum up to one. 56 BIS Papers No 7

5 Fnally, the cost functon of market-makers s assumed to be lnear wth constant margnal cost of c per unt of trade. Each trader sets the proft maxmsng spread gven the spread set by hs compettor. We are nterested n the equlbrum spreads of ths Bertrand competton for order flow. The profts of trader gven the spread chosen by trader, s gven by F x X *( s s 2 c) s X *( s c) The market-maker sets the proft maxmsng spread. The frst order condton s F X 2s s 2 c 0 The two frst order condtons of the market-makers defne the two reacton functons of the game: s s s c s c The symmetrc equlbrum s gven by the ntersecton of the reacton functons. In equlbrum, the spread exceeds margnal cost: s s c 2 Equlbrum proft for each market-maker s gven by F F X ( c c) X Bertrand competton n ths settng does not erase market-maker profts. Due to the assumed market mperfectons, market-makers are able to realse a proft margn n equlbrum. Now, suppose that an ATS s ntroduced nto ths settng. The ATS convnces a fracton α of traders to drect ther trades away from the ncumbent market. It offers a best prce guarantee statng that the trader pays the same spread as he would have receved n the ncumbent market. Due to the best prce guarantee, traders are ndfferent between both markets. The ATS then sgns a contract wth both market-makers n order to ensure the promsed order executon. For smplcty, assume that the ATS charges the market-makers no fees for the rght to execute the ATS s orders. Ths mples that any rents earned n the tradng busness stay wth the market-markers and are not approprated by the ATS. For smplcty, we assume a symmetrc settng, e both market-makers contract for half of the order volume generated by the ATS. Each market-maker s proft now has two components: the profts earned n the ncumbent market and the profts earned on the contracted ATS s order flow. The proft earned on the ATS s orders depends on the benchmark prce from the best prce guarantee. When the two market-makers quote dfferent prces, the dervaton of the benchmark prce s not trval. We assume that the best prce guarantee has the purpose of makng traders ndfferent between both markets. In order to ensure ndfference, the benchmark prce must be equated to the expected spread that the trader pays n the ncumbent market. The benchmark prce wll be ether s or s, dependng on whether trader or trader s settng the spread at the moment when a lqudty trader enters hs trade. Snce both cases happen wth probabltes x and x, we can compute the expected spread on ATS s orders earned by the market-makers: BIS Papers No 7 57

6 s ATS x s x s s s 2 s s 2 s s After the ATSs has been founded and the order flow has been contracted, the tradng sesson starts and each trader agan has to set a proft maxmsng spread. When settng ther spread, the proft functon of market-makers has changed as compared to the stuaton wthout an ATS for two reasons: they compete only for the remanng fracton of overall tradng demand (-α)x and when settng a prce, they have to take nto account the effect on the benchmark spread on the precontracted ATSs tradng volume. The new proft functon s: F = ( = ) X s s ( s c) X s 2 2 ATS c The frst order condton after ntroducton of the ATSs becomes: F X 2 2 = 2Xs Xs Xc X 2s 2s = 2 Solvng for the new equlbrum as above, we fnd the new equlbrum spread: s ATS = c 2 4(, = ) For the specal case α = 0 (no tradng volume contracted to the ATS), the equlbrum spread concdes wth the above result for the market wthout ATSs. For postve α, the spread ncreases and s a monotonc functon of α. Thus, market-makers are able to rase ther spread n equlbrum due to the exstence of an ATS wth best prce guarantee. The effect of ntroducng an ATS nto the dealer market s a reducton of the level of compettveness. The ATS allows market-makers to quote spreads whch are closer to the monopoly stuaton. (As α approaches, the spread grows wthout bound. Ths result s due to the assumed nelastc demand for market-maker servces whch enables a monopolstc market-maker to demand an arbtrarly hgh spread.) Whle the model s hghly stylsed and smple, the basc ntuton for the spread ncrease after ntroducng an ATS s straghtforward and contnues to hold n many possble extensons of the model. When a trader calculates the margnal gan of lowerng the spread n a stuaton wthout an ATS, he has to consder three effects. Frst, he earns a lower proft margn on hs tradng volume. Second, he enoys an ncrease of tradng volume because he attracts a larger market share. Thrd, he has to take nto account the reacton of hs compettor. Snce the reacton functons have a postve slope, the compettor wll also decrease hs spread, resultng n a declne of tradng volume. After the ntroducton of an ATS, the stuaton changes. Concernng the tradng volume left n the dealer market, the same effects are present. However, the trader now has to take nto account the addtonal effect on profts from hs ATS s tradng volume. Snce the volume has been contracted n advance, there s only the prce effect left: lowerng the spread thus unambguously decreases the profts from the ATS. The fact that he cannot gan more market share n the ATS s market makes a reducton of spreads less favourable ceters parbus. In other words: the ATS serves as a precommtment devce whch weakens prce competton n the later tradng stage by lowerng the returns from decreasng the spread. Note that the model has a unque equlbrum that allows a clear-cut analyss of the effect of ntroducng an ATS. In a related model, Dutta and Madhavan (997) show that order-preferencng arrangements ncrease the potental gans from colluson for ndvdual market-makers. But ther model has multple equlbra and colluson s ust one of them. Ther model s also consstent wth the emprcal hypothess that ATSs do not have any mpact on the spread. Kandel and Marx (997) also analyse the mpact of order-preferencng arrangements wthn ther model, whch s qualtatvely equvalent to ntroducng an ATS. They conclude that order-preferencng does not change the spread as long as the margnal market-maker has no preferenced orders. Ths result does not contnue to 58 BIS Papers No 7

7 hold n the context of our model. Even f only one market-maker receves all ATS tradng volume, the equlbrum spread n the market would ncrease as one of the two reacton functons shft. The result of Kandel and Marx depends on the usual Bertrand assumptons and therefore has lttle robustness when the ndvdual demand curves become downward-slopng and smooth as assumed here. 4. Concluson As we have demonstrated, the ntroducton of alternatve tradng systems may have the undesred sde effect of decreasng competton at the market-makng level when ATSs use best prce guarantees n conuncton wth order-preferencng arrangements as often seen n European securtes markets these days. If regulators try to ntensfy tradng system competton by recognsng or promotng ATSs, they may have to trade off the effcency gans through ntensfed competton at the tradng system level wth a decrease of competton at the market-makng level. If one tres to compare both effects n terms of practcal mportance, there s a clear ndcaton that market-maker competton should be much more mportant than tradng system competton: commssons for usng a tradng system are an order of magntude lower than the bd-ask spread n most markets. Ths poses the queston of the rason d être of ATSs: do these systems exst because they can successfully compete aganst neffcent and costly tradng systems of tradtonal exchanges? Or are they better descrbed as vehcles to ncrease market-maker profts by lmtng the ex post competton for orders by usng order-preferencng arrangements? The model outlned here suggests that the second motve may be a vald reason for foundng ATSs. Ths vew s supported by the fact that the owners of ATSs are almost always securtes tradng frms or banks actvely engaged n securtes tradng. In conversatons, some representatves of European ATSs openly admtted that the spread ncome made by sellng the order flow to securtes frms s much more mportant than economes realsed n operatng a cost-effcent tradng system. If the second motve of operatng ATSs should be the domnant one, t s stll an open queston whether customers are worse off after ntroducton of an ATS and whether regulators should ntervene n the competton between tradtonal exchanges and ATSs. As long as there s free entry nto the market-makng ndustry, any profts made on order-preferencng arrangements wth ATSs should be competed away, presumably by the usual practce of payng the ATSs for the access to ther order flow. Competton between market-makers should therefore ensure that profts are passed over to the operators of ATSs. However, there s competton between ATSs for customer order flow. Ths competton wll ensure that the payments receved by market-makers are passed over to brokers and fnally reduce the commssons pad by customers for tradng stocks. If one follows ths vew, the gans from monopolsaton of the market-makng process are passed back to the customer and help to lower the fxed transacton costs of placng orders. Two fnal remarks on ths chan of reasonng are n order. Frst, t s questonable whether competton on all levels works smoothly and ensures that the extra fee pad by customers for market-makng servces wll n the end flow back to them n the form of lower brokerage costs. Frctons and rgdtes n the vertcal chan may well leave part of the rents wthn the securtes ndustry. Second and more mportant, the argument hghlghts the mportance of understandng the multdmensonal nature of transacton costs pad for securtes tradng servces. The overall cost of tradng ncludes brokerage fees, fees and commssons for settlement and related servces and fnally the spread pad to marketmakers. Whle fees are an obvous and transparent cost of transactng, many nvestors have only a lmted understandng of the amount of money they pay for market-makng servces n the form of the bd-ask spread. The shft of tradng volume away from tradtonal exchanges towards ATSs may result n a general shft of transacton costs away from transparent tems such as brokerage fees towards non-transparent tems such as the spread. Future regulaton should ensure that customers have access to all necessary nformaton n order to make an nformed decson between tradng systems. BIS Papers No 7 59

8 References Chrste, W and P Schultz (994): Why do Nasdaq market-makers avod odd eghth quotes?, Journal of Fnance, vol 49, pp Commttee of Wse Men of the European Unon (2000): Intal Report on the Regulaton of European Securtes Markets, November. Dennert, J (993): Prce competton between market makers, Revew of Economc Studes, vol 60, pp Dutta, P and A Madhavan (997): Competton and colluson n dealer markets, Journal of Fnance, vol 52, pp Federaton of European Securtes Commssons (2000): The regulaton of alternatve tradng systems n Europe, September. German Stock Exchange Councl (Börsensachverständgenkommsson) (200): Empfehlungen zur Regulerung Alternatver Handelssysteme, May. Hendershott, T and H Mendelson (2000): Crossng networks and dealer markets: competton and performance, Journal of Fnance, vol 55, pp Heusnger, R (200a): De Marktmacher kommen, Börsenzetung, 6 March. (200b): Mont rüttelt am Börsen-Slo, Börsenzetung, 4 Aprl. Kandel, E and L Marx (997): Nasdaq market structure and spread patterns, Journal of Fnancal Economcs, vol 45, pp Kyle, A (989): Informed speculaton wth mperfect competton, Revew of Economc Studes, vol 56, pp Moskowtz, E (2000), The rse of ECNs wll push tradtonal exchanges nto a sngle electronc tradng network, Red Herrng, 4 December. Munz, T (200): Absage an bankegene Börsen, Börsenzetung, 8 May. 60 BIS Papers No 7