Future of Securities Markets: Competition or Consolidation?

Although considerable consolidation has recently occurred among securities exchanges, the forces of competition remain strong because they have an ally in technology. Technology evens the playing field and makes the entry of new trading venues easier. Economies of scale and network externalities still have a centralizing tendency, but that tendency is weakened. Networks now extend beyond a single market, which allows venues to compete, and economies of scale can more readily be overcome by a technologically sophisticated competitor. Empirical evidence indicates that as markets become integrated, trading becomes dispersed.My thesis is that the forces of competition in the financial markets are stronger today than they have ever been because these forces have an ally in technology. Technology levels the playing field (i.e., makes the world flat). Technology allows competition by newcomers—Archipelago Holdings, the International Securities Exchange, BATS Trading, and as-yet-unknown entities. Ideally, the role of regulation is to provide a framework in which such competition can take place and in which exchanges can evolve most efficiently.The article first delineates factors that in the past have limited competition in securities trading: A securities exchange tends to be a natural monopoly; it enjoys economies of scale and network externalities that can make competition from new trading venues difficult. Furthermore, an established exchange often adopts anticompetitive rules to solidify its monopoly position. An established exchange also solidifies its position by maintaining external uncertainty about its prices and forcing traders to join the exchange to be able to observe current prices. I call this strategy the “Uncertainty Principle of Markets” (by analogy to the Heisenberg Uncertainty Principle in atomic physics) because traders do not know both the market price and the status of their orders. Next, the article describes the technological and regulatory forces that have led to increased competition in securities markets. And it provides a simple model to illustrate how technology has weakened the economies of scale and network externalities of established markets.Many investors fear that competition will lead to harmful fragmentation, but because of technologies that can link markets at low cost, fragmentation need not occur. An implication of the model developed in this article is that as markets become more effectively linked, trading becomes dispersed. Data on trading volume and quote quality support this conclusion. For example, the fraction of trading in NYSE-listed stocks done on the NYSE fell from 85 percent to 49 percent between 2002 and 2007. The remainder was dispersed among other markets. The fraction of time that the NYSE quote was alone at the inside decreased from 80 percent to 20 percent in this same period as competing markets matched, and sometimes improved, NYSE quotes.The next step in the development of markets—to integrate global markets in the trading network—will take some time and will require regulatory changes.