Competition and Vertical Integration in Financial Exchanges

Craig Pirrong, Dec 22, 2011

Financial exchanges have come under increasing antitrust scrutiny of late. Competition authorities-especially those in Europe-have focused critical attention on the integration of trade execution and post-trade services in a single “silo.” This hostility is predicated on a belief that integrated exchanges are immune to competitive entry.

The conditions in financial trading markets do not match those that the “post-Chicago” literature has shown can make integration anticompetitive.

Moreover, the cost and demand conditions in trade execution and post-trading services make integration efficient as a means of reducing double marginalization problems and transactions costs. In particular, the liquidity network effects tend to lead to consolidation of trading on a single venue, and risk sharing considerations give rise to extensive economies of scale and scope in post-trade services like clearing. Integration reduces the double marginalization and opportunism problems that would arise if dominant trading and post-trade venues were operated as separate firms.

Liquidity network effects can be mitigated by order handling rules like RegNMS in the United States, but the issues with post-trade services are far less amenable to regulatory remediation.

Thus, the hostility to vertically integrated exchanges is misguided. Moreover, even if order handling rules that reduce market power in execution are adopted, post-trade services are likely to present chronic competitive concerns.

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