Scholars assess electronic markets

Professor foresees argument for end of brokerage services

January 19, 2001|By ASCRIBE NEWS SERVICE

UNIVERSITY PARK, Pa. - The organization of the stock market trading services industry is changing rapidly, with electronic financial markets leading the way, according to Pennsylvania State University scholars.

Research by Ian Domowitz and others at Penn State's Smeal College of Business Administration, suggests that there is little room for the role of traditional brokerage in an electronic environment,

Domowitz, who is a former member of the NASD's Bond Market Transparency Committee and a consultant to various financial organizations, will present a paper, titled "Liquidity, Transaction Costs, and Strategic Trading in Electronic Markets," during a conference on financial e-trading sponsored by the Federal Reserve Bank of New York. The conference, "Financial E-Commerce," is co-sponsored by the Federal Reserve Bank of New York and the Journal of Financial Services Research. It takes place Feb. 23-24.

Domowitz's paper explores the potential of electronic markets to lower costs to the trader and the implications of that potential in the development of trading markets. His research suggests new roles for brokerage and exchange operations, and competition between the two.

Cost reductions

The adoption of automated trading technology contributes to trading cost reductions and lower development and operating costs. In addition, electronic order books reduce the costs of market monitoring, allow quick assessment of liquidity and provide the means by which trading transactions cost savings may be realized, Domowitz said.

"The rise of computerized market structure raises a variety of issues with respect to the industrial organization of the trading services industry. Low costs of direct trading through electronic markets, for example, may be an argument for the elimination of brokerage services," Domowitz said.

"The potential for liquidity and cost management through facilities provided by electronic market design suggests a changing role for the exchange as intermediary. The combination of these perspectives blurs the line between brokerage and exchange services," he said.

Exchange competition leading to some degree of fragmentation, search considerations, and liquidity demand create the need for reorganization of electronic trading markets, especially at the brokerage level, Domowitz said.

If an established market intermediary is forced out due to structural change, reorganization becomes necessary for that institution to be re-established in the new environment, he said.

Market reorganization can induce competition between brokerage and exchange services, Domowitz said. "It is a small step to add automated execution services to electronic dealing and search functions, for example. In today's environment, one need not build such functionality independently," he said.

Technology-driven changes

Examples of progress using alliances and acquisitions are already available. ConSors, Europe's second-largest online broker, is negotiating with the Berlin Stock Exchange to jointly build an electronic retail trading market.

In support of market-making activity, ConSors has purchased Berliner Effektengesellschaft, a group that controls the largest broker on the Berlin Exchange.

Europe's leading discount broker, Comdirect, has announced plans to launch a retail-oriented exchange in partnership with its parent, Commerzbank, this year.

At the institutional level, brokers put orders together, searching for counterparties. If two orders do not match exactly, brokers can attempt to bring the parties close enough to make a transaction possible. For automated markets, the existence of such a situation is sometimes called the "near match" problem.

"Solutions to this problem through an electronic negotiation process constitute a new frontier for trading system development," Domowitz said.

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