Survey_RR_2008

Abstract

Our goal is to model the decisions of agents in financial markets regarding whether to honestly represent the interests of their clients, and the impact of an exchange’s objectives (i.e., its ownership structure) on these decisions and responses. Specifically, we consider agents whocarry out their clients’ wishes to trade on organized exchanges. In doing so, we model clients and exchanges as rationally anticipating the behavior of agents given the reward schedule. In the United States and elsewhere, many of these exchanges are self-regulatory organizations, whereby the exchanges enforce rules about permissible trading behavior by customers’ agents. We employ a stylized model of this environment to evaluate how investors respond to the potential for dishonest agents and how the SRO chooses an enforcement policy. There are three kinds of parties in this model: investors, i.e., customers, agents, who conduct trades on behalf of these investors, and the exchange (SRO) on which the trading takes place. Following DFH, we focus on a single exchange. A customer does not route a trade to this exchange unless she expects to at least achieve an exogenous reservation utility level, D. One could interpret D as the customer’s expected utility from transacting on an alternative trading platform, with greater competition across trading venues captured by a larger D. We assume that there are many agents ompeting for each customer’s business on the exchange, so that customers have all the bargaining power when contracting with agents. In this environment, a customer hires an agent to carry out a trade by offering a contract that maximizes the customer’s surplus from trading, subject to the agent’s receiving non-negative profits. At the same time, however, policies set by the exchange influence the share of the overall surplus from trading that each category of participant (customer, agent, exchange) can expect to earn.