April 03, 2006

The subtleties among market structures - auction, order-book, over-the-counter, open outcry, crossing - are enough to make scholars tongue tied. However, the way markets are structured significantly impacts the way corporations borrow, investors lend, investment banks raise capital and dealers trade.

But what is the proper market structure? Is any single market structure perfect?

There are a number of different market structures, from open (e.g., ECNs) to closed (e.g., intermediated dealer markets). All serve a purpose. Highly liquid markets tend to be more transparent, while less-liquid markets tend to be more opaque. But is transparency good and opaqueness bad? I'm not so sure.

Transparent markets certainly are more, well, transparent. Investors not only can see limit orders, but interact with them as well. While transparency is good for trading 100 shares, however, is it good for buying 1 million? Does the price of 100 shares even matter when acquiring 10,000 times that amount?

Conversely, the mortgage market is three times the size of the equity market and even sophisticated investors have difficulty finding prices and determining value. Does that mean that we need a continuous market for 2.7 million mortgaged-backed securities (MBS) pools? Who would want to price all of those securities? Who would want the risk? Not me.

So, what causes liquidity to pool? Why are there exchanges, and why are there OTC markets?

There seem to be six key market structure determinants. First and foremost is product complexity. The simpler the product, the easier it is to trade. As complexity increases, products need to be defined, analyzed and sold. Equities always will be easier to trade than complex derivatives - they are just easier to understand.

Second is offering size. The more product, and the fewer instruments, the easier it is to find the other side. If only one person wants to trade, another must be enticed to step in.

Data transparency is third. If pricing is readily available, valuation becomes easier. How would you like to enter the supermarket and ask for prices on everything you wanted to buy? Not a very efficient way to shop - and not unlike an OTC market.

Clearing risk is fourth. If the clearing mechanism is not risk-free, then firms need to premium-price less-robust counterparties. This was especially true for FX, pre-continuous-linked settlement (CLS), when each FX transfer was made independently in the country of payment.

Fifth, liquidity cannot be too dealer-centric. Dealer liquidity dominates many OTC markets. If the majority of trading is dealer-induced, then there is not enough customer liquidity to find the other side of the trade without using a dealer. As buy-side trading increases, the buy side gains transactional control and nondealer-oriented exchanges can succeed.

If you look at the FX market, from 1992 through 1998, dealer liquidity diminished from 66 percent to 61 percent of turnover. However, from 1998 through 2004, dealer FX turnover declined to 50 percent. Coincidently, we have seen the launch and success of exchange-type FX matching systems (HotspotFX and EBS Prime) and an increase in DMA and algorithmic FX trading.

Last, regulation guides market structure. The SEC's 1997 Order Handling Rules, decimalization, Sarbanes-Oxley, MiFID and a host of other regulations directly impact the way markets function. Market regulation can benefit a market, but it also can stifle it. This balance between openness and restrictiveness is critical for efficient markets. Markets need regulation, as they can be manipulated or corrupted; however, too heavy a hand chases liquidity away.

While market structure is arcane, it is important. Open and honest debate is necessary, and choice is imperative. As technology and connectivity become less expensive, the creation of new structures and models is enabled. This lab of new models is extremely important to the well functioning of our financial markets as competition drives creativity and ingenuity.

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. ltabb@tabbgroup.com


Market Structure Determinants

1. Product complexity

2. Offering size

3. Data transparency

4. Clearing risk

5. Liquidity providers

6. Regulation

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based ...