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Liquidity and the Simple Industrial Organization of Stock Exchanges

Author

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  • Felipe Zurita

    () (Instituto de Economía. Pontificia Universidad Católica de Chile.)

  • Alexander Galetovic

Abstract

It is usually thought that network externalities, which are inherent to liquidity, make it desirable to concentrate transactions in one stock exchange. This paper shows that when the value of liquidity stems from the ability of potentially reach as many traders as possible, the market is integrated when every broker meets every other broker in at least one exchange. Thus, fragmentation is not about trades being executed in different exchanges but of connectedness among brokers. An implication of this distinction is that in an integrated market the network externality created by liquidity becomes pecuniary and the optimal number of exchanges depends only on the shape of the (physical) technology to execute trades—whether it exhibits increasing, constant or decreasing returns to scale—as in any standard industry. We characterize the planner's allocation and compare it with that reached by a monopoly. It is shown that when exchanges are natural monopolies a particular ownership structure of the exchange and allocation of voting rights over the exchange fee achieve the planner's optimum. With decreasing returns to scale the Walrasian allocation is eficient, provided that the market is integrated. Nevertheless, with few exchanges the price-taking assumption is suspect. If exchanges are not price takers, there are many other equilibria, all of them ineficient. Moreover, there are reasons to doubt that the market will become integrated. Fragmentation softens price competition between exchanges and may help a monopolist exchange to erect a barrier to entry even when he has no cost advantage.

Suggested Citation

  • Felipe Zurita & Alexander Galetovic, 2002. "Liquidity and the Simple Industrial Organization of Stock Exchanges," Documentos de Trabajo 211, Instituto de Economia. Pontificia Universidad Católica de Chile..
  • Handle: RePEc:ioe:doctra:211
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    File URL: http://www.economia.uc.cl/docs/dt_211.pdf
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    References listed on IDEAS

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    Cited by:

    1. Cantillon, Estelle & Yin, Pai-Ling, 2011. "Competition between exchanges: A research agenda," International Journal of Industrial Organization, Elsevier, vol. 29(3), pages 329-336, May.

    More about this item

    Keywords

    Brokerage; exchange fee; fragmentation; liquidity; network externality;

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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