Following what we learned in lecture, the number of traders and the interaction between traders is extremely important in determining how markets are structured. This is evident when a particular market could be structured to grant the trader a monopoly with 100% of the profit of the transaction while another market could be structured with perfect competition and no profit going to traders. Furthermore, we were told to think of traders in the context of stock exchanges. This brings forth questions regarding competition between stock exchanges and related companies and if regulation is needed. In 2002 Cara Schwarz-Schilling and Mark Wahrenburg wrote an interesting paper, Regulating Competition between Stock Exchanges, which in part identifies some of the complexity involved in the competition between stock exchanges.

The major stock exchanges, such as the NASDAQ, have a complex relationship with alternative trading systems (ATS). These include electronic communication networks (ECNs) that work with the stock exchange to execute trades and thereby help to facilitate the exchange business via methods like inhouse systems. Yet, the exchanges use these ATS at a cost and often have a complex relationship with the ECNs because they are competitors taking away trading volume. These ECNs are responsible for a large percentage of trading volume at the major stock exchanges and have grown in number, company size and prominence. One of the most notable ECNs, Instinet, formerly owned and operated by Reuters but now a public company, is a fair example of an agency broker (what we would think of as traders).

The inclusion of these firms is thought to be good for the customer (investor) and the market as a whole because transaction costs are reduced and the market is more efficient (at least in theory anyway) because sophisticated technology links buyers and sellers. However, the market makers at the major exchanges can use this technology to their advantage:

“Market makers use ATS to precommit to pursue a less aggressive pricing strategy in the incumbent market, by committing to buy a part of the overall order flow and committing to execute them at equilibrium prices later derived in the incumbent market. Intuitively, following aggressive pricing strategies in the incumbent market becomes less attractive because lowering the spread ceteris paribus leads to a smaller increase in profits due to a smaller reaction of trading volume as compared to the situation without the inhouse system. The introduction of alternative trading systems may thus have the undesired side effect of decreasing competition at the market-making level.”

As the paper suggests, the customer might also be disadvantaged because there could be less transparency in the cost structure when ATSs are involved:

“The overall cost of trading includes brokerage fees, fees and commissions for settlement and related services and finally the spread paid to market makers. While fees are an obvious and transparent cost of transacting, many investors have only a limited understanding of the amount of money they pay for market-making services in the form of the bid-ask spread. The shift of trading volume away from traditional exchanges towards ATSs may result in a general shift of transaction costs away from transparent items such as brokerage fees towards non-transparent items such as the spread. Future regulation should ensure that customers have access to all necessary information in order to make an informed decision between trading systems.”

To not only aid the investor but bring the market greater efficiency as well, the paper calls for regulation and oversight by government agencies such as the SEC. While regulation issues may touch upon politics that I did not intend to address, it is important to think that possible regulation will relate to the competitiveness of stock exchanges. In essence, the government is structuring how traders interact and how markets are set to match buyers and sellers. Agree with it or not, the markets are being formed and watched over in this manner.