Survey_JW_2

Abstract

We extend our model by considering listing decisions and OTC (Over-The-Counter) trading. We argue that vertical integration decreases the market coverage of listed securities for which firms have to be compensated by lower listing fees. Similarly, the larger the OTC market in respective asset classes the lower are the incentives for vertical integration. Furthermore, we use our framework to discuss major industry trends and policy initiatives. We argue that vertical integration is an instrument to protect an exchange’s home market against new competitors, such as Multilateral Trading Facilities, but new pricing schemes such as Maker-Taker pricing and the emergence of Algo-Trading might reduce the incentives to integrate vertically. To derive these results, we propose a stylized model that depicts the interrelation between the organizational design of financial-security service providers and the competition among them. The model incorporates economies of scope as well as network effects at the different levels of the value chain of the financial-security service industry. We delineate traders’ preferences for securities listed and traded on different exchanges by employing the Salop-model. Traders as well as exchanges are exogenously located on this circle depicting the concept of a natural affinity of certain traders for certain exchanges (e.g., due to language barriers, home bias, etc). We allow for competition among three exchanges. The securities listed on a certain exchange are settled in the associated (potentially organization-wise) independent CSD. We neglect custodian banks and therefore provide a barebones picture of the industry and the competition therein. We view vertical integration as a measure to implement a highly specific relation between an exchange and the associated CSD that makes trades routed through this link less costly but impose additional costs to trades that are settled outside the associated CSD or traded on another exchange but settled in the associated CSD. In that sense our idea of vertical integration is close in spirit to Grossman and Hart (1986). It also resembles the idea of vertical integration in the financial-security service industry as a decision for a closed rather than an open standard that makes external linkages partially incompatible with internal processes. Horizontal integration on the level of CSDs, in turn, is modeled as uniform cost-reductions displaying the concept of economies of scale and scope at this layer.