Efficient markets make money for market participants, but not for market makers. That is something the enthusiastic promoters of B2B exchanges have yet to understand.
The prospect of flotation or merger requires that a value be set on the London Stock Exchange. The figure is around £500m. This is less than the market capitalisation of one of the Exchange’s more recent entrant companies, the on-line auctioneer QXL. But QXL’s turnover is a fraction of a percent of the turnover of the London Stock Exchange, and the Exchange has an almost unassailable market position and a near monopoly of trading in UK securities. Surely some mistake?
The economics of marketplaces is a complex business. Understanding it is not only important for those who are putting together the new iX stock market but for those who are promoting the other iX’s – the internet exchanges that arouse so much current interest. A marketplace is a natural monopoly. Buyers will want to go where there are most sellers, and sellers where there are most buyers. So the largest market attracts most custom and enhances its position.
This has been true for centuries. In Thomas Hardy’s Far from the Madding Crowd, Bathsheba went to Casterbridge to sell her produce at the Corn Exchange, and she employed Gabriel Oates after they both attended the hiring fair. The natural monopolies of traditional marketplaces emerged from custom and practice. Market day came into being because more merchants were in town on Thursday, and that encouraged still more buyers and sellers to go to town on Thursdays. Insurers took their refreshments at Thomas Lloyd’s coffee shop. That encouraged other people who wanted to trade in the markets to drink coffee there as well.
As markets became more complex and sophisticated, market places tended to evolve in one or other of two ways. Some marketplaces, like the London Stock Exchange, acquired a central organisation. Others, like the foreign exchange market, did not. What we call the foreign exchange market is simply the interacting and inter-related activities of many independent players. There is no committee or council and there is nothing that an investment bank could float or sell.
Central organisation usually developed because of the need for regulation. The London Stock Exchange acquired its authority because players needed assurances of the integrity of processes and participants, and it also helped to standardise procedures and practices. Local authorities took control of street markets because someone had to impose order on the chaos and congestion that ensued in the town. In this way, the management of marketplaces fell into the hands of mutual organisations, such as the Exchange, or public authorities.
There are many hybrids, such as Covent Garden Market Authority, a statutory body controlled by market participants and there to represent their interests. Some of the organisations simply manage the logistics of the market as with local authority control of street markets. Others, such as most of the recognised securities exchanges, impose economic regulation of the activities that once occurred on their premises and today take place under their auspices.
But many other markets have no comparable organisation. Hollywood is a marketplace for the world film industry, but no-one owns it. And when we talk of the foreign exchange market, or the London residential property market, we mean something different. In all of these marketplaces – as at Casterbridge – many participants make markets. But if we talk of a single market, as we do of Casterbridge or in the foreign exchange market, it is because the actions of different participants are so closely inter-related that it is as if there was one central organisation setting the price.
The Stock Exchange has its official list, but newspapers can and do report “the price” of the Euro or of livestock at Casterbridge simply by having a reporter to watch what is going on. The London residential property market is a much looser federation but co-operation between agents and their watchfulness of each other means that there is effectively one market.
In all these marketplaces, there are companies which provide common services to participants. Reuters and Bloomberg feed information to the foreign exchange markets, and the various payments systems enable settlement to take place. Although the organisational difference between securities trading and forex trading is fundamental, it is not really perceptible to final users.
The economics of natural monopoly apply in all markets. Estate agency is a natural monopoly. Almost every home buyer must have thought that it would be simpler if there was one place where every property was on display. Given the advantages of scale and liquidity it would seem that the agent with the largest market share would enjoy an impregnable position. But in practice estate agency is a very fragmented business. Although there are real advantages of scale in making markets, they are not large. It is not very costly for buyers to consult several market makers. And the ease of entry into market making is such that as soon as you exploit the benefits of scale they disappear. Larger estate agents do have advantages but so do their competitors. The structure of the property market is a constantly changing balance between the two.
So some marketplaces have mutual or publicly owned central organisations with a trading monopoly: others reflect the spontaneous interaction of competitive private firms. The intermediate outcome – privately owned central organisations which sustain and exploit an effective monopoly on market making – rarely comes into being and if it does rarely survives. The only important continuing example I know is de Beers control of the world diamond market, and diamonds are such an extraordinary commodity as to constitute the exception that proves the rule.
Neither of the common solutions are ideal. Public or mutually owned monopolies suffer the inefficiencies and governance problems common to mutuals, public ownership and monopoly. The most successful new marketplaces – such as Nasdaq and Deutsche Borse – have won ground by challenging incumbents who have fallen victim precisely to these difficulties. Fragmented privately owned marketplaces often fail to establish the simplicity and transparency or the public confidence which a single organisation can provide.
But privately owned, central organised monopolies usually offer consumers the worst of both worlds, which is why they do not succeed. Efficient markets make money for market participants, but not for market makers. That is something the enthusiastic promoters of B2B exchanges have yet to understand.