A Positive Theory of Financial Exchange Organization with Normative Implications for Financial Market Regulation
Posted: 6 Oct 1998
Date Written: May 1998
Although there has been extensive research on the economic functions of financial exchanges and the properties of prices determined on exchanges, there has been little research on the organizational structure and governance of these entities. This article demonstrates that the heterogeneity of the suppliers of financial services that are members of financial exchanges explains salient features of exchange organization. Specifically, when suppliers of financial services are heterogeneous, one expects to observe exchanges organized as not-for-profit firms, especially if an exchange can enforce collusive agreements. Moreover, heterogeneity can lead to conflicts between members over rents, which necessitates the creation of formal governance mechanisms. Finally, if exchanges exercise market power or are protected from competitive entry (as is plausible), exchanges may adopt inefficient rules; the efficiency of exchange rules depends in part upon the distributive consequences of these rules (which depends in turn on membership heterogeneity) and the ability of exchange governance structures to enforce wealth-enhancing bargains among members with disparate interests. There is evidence consistent with these predictions. First, non-profit form is observed for traditional open outcry exchanges but for-profit is common for newer computerized exchanges; computerized exchanges typically have far more limited and homogeneous memberships. Second, exchange members earn economic rents (which is consistent with their adoption of inefficient, but profit maximizing rules.) This research is topical due to the rapid structural changes currently occurring in financial exchange markets. Several exchanges have evaluated changes for non-profit to for-profit form in recent years, and two have voted to make the change in the past twelve months. These changes coincide with changes in trading technology (specifically, a shift to computerized trading) that reduces the importance of heterogeneity. This research has both positive and normative content. It makes positive predictions about how exchanges are organized. Moreover, it has implications for the efficient regulation of financial markets. In particular, it implies that self-regulation by exchange members may not result in the adoption of first best rules governing the trade in financial assets and derivatives. This, in turn, raises the possibility that external regulation (e.g., the SEC) may improve resource allocation by imposing more efficient rules. Since a rent seeking calculus also affects regulators, however, it is impossible to determine a priori whether self-regulation by exchange members or external regulation is superior.
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