Objective
• The theories we develop in this course for
financial markets apply to many other markets
– not just financial markets.
• Looking at many different market systems
sharpens our understanding of why most
financial markets are organized as exchanges
and what other forms are possible.
• In this regard, e-markets are particularly
relevant as many different microstructures –
including well known forms and completely
new forms - have emerged.
Microstructure of e-Markets
Posted Prices and Exchanges
MSc Finance & Economics
Theory of Finance 1
Autumn 2005
Arup Daripa
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Examples
e-Markets
• The eBay model - sell single units, several
buyers for each unit. Auction.
• The OffRoad model – sell multiple units.
Multi-unit auction. Raises equity funds for
companies in development stage.
• The FreeMarkets model – The product is a
component specified by the buyer.
FreeMarkets runs procurement auctions in
which several suppliers participate. Reverse
auction.
• The NASDAQ model – standardized product,
many buyers and sellers. Double auction.
• Lower transaction costs
• Increased market reach
• Does not require buyers and sellers to
be at the same place at the same time
• Ease of information processing
• All of these imply that many different
pricing models can be used
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Examples
Auction
• The priceline model – sell standardized
service products and use auction to price
discriminate
• The Grainger model – sell large
volume. The seller posts price and may
bargain with customers on blanket
discounts
• Very well known selling method.
• Scope hugely increased online.
• Economists know a lot about the theory
of auctions, and have advocated the use
of auctions to efficiently solve several
allocation problems
• We will discuss auctions in greater
detail later – this note focuses on posted
prices and exchanges
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Catalogues and Discounts
Posted price e Markets
• Despite the popularity of auctions, many
sites still use a posted price method.
• Limitation of a single posted price: must
exclude low value buyers – leading to
excess capacity
• To overcome this, a common feature in
posted price markets is the use of
devices for price discrimination
• A second common feature is product
differentiation
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• This business model is usually applied
when:
– the value of each purchase relatively small
– large number/volume of purchases
• Example: Office supplies from
Grainger.com
• Bargaining over each purchase would be
very costly
• Blanket discounts overcome the
limitation of a single posted price
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Dynamic Pricing
Airlines
• Posted prices can be changed frequently
• e-Markets have an unlimited capacity for
dynamic pricing
• Websites can calculate a new individual
price in a few seconds
• This helps price discrimination
• Airline reservation systems are among
the most sophisticated posted price
systems
• Prices change frequently in response to
bookings, rivals’ prices, expected surge
in demand (e.g. holiday season) etc
• Airlines also give blanket discounts to
corporate clients
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Limitation
Priceline
• However, even such sophisticated
posted price systems suffer from the
problem that there are many flights with
empty seats
• In other words, even a sophisticated
posted price system is unable to carry
out sufficient price discrimination to
eliminate excess capacity
• To overcome this problem, priceline has
developed an interesting pricing model
• Objective: sell at higher as well as lower
prices, but keep the high value buyers
away from buying at lower prices
• Further, keep the best price hidden
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Priceline Mechanism
Priceline
• Ask customers to bid what they are
willing to pay
• Accept offers above a secret minimum
• Must wait for a period of time before
knowing whether offer is accepted
• For airline tickets: offer only on price,
and customer has little control over
departure/arrival times, low flexibility
once ticket is bought, could have long
waiting times to get connections
• The disadvantages keep business customers
away from buying tickets through priceline
• At the end of 2000, 6% of all US airline tickets
were sold through priceline
• Priceline’s opacity (best price is secret) helps
to lower price without sacrificing sales at high
posted price
• Priceline’s opacity also helps competition
(transparent prices can be matched easily by
rivals and this hinders competition)
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Excess Demand
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Secondary Markets
• Resale of airline tickets is prohibited by
law (the airlines lobby is strong,
otherwise this restriction makes little
sense)
• For games and concerts, no such
restriction applies
• Secondary market for tickets for popular
games and concerts have moved online
• Example: eBay ticket auctions
• Priceline helps solve the problem of
excess capacity
• A further problem of a posted price is
that customers willing to pay a higher
price might not be able to buy
• This is often the case with tickets for
games and concerts
• What is a solution to this problem?
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Exchanges
Stock Exchange: Nasdaq
• In some markets the product is
standardized, there are many buyers and
sellers, and immediacy is very important
• In such cases exchanges develop
• Traders post offers to buy and/or sell
• Prospective customers search offers to
sell to find a suitable one
• Prospective suppliers search offers to
buy to find a suitable one
• Such a market is also called a “double
auction”
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• Nasdaq is an electronic system linking
numerous agents: market makers,
dealers, electronic exchanges called
Electronic Communication Networks
(ECN)
• Brokers/dealers manage relations with
investors who are generally not
professional traders
• Dealers make money by buying at lower
prices and selling at higher prices
Stock Exchange: Nasdaq
ECNs on Nasdaq
• Dealers also function as market makers
• Market makers are providers of
immediacy - they post offers to buy/sell
at all times
• There are approximately 550 market
makers in Nasdaq
• ECNs serve large pension and mutual
funds and dealers
• ECNs are pure exchanges – they do not
hold any inventories of stocks
themselves
• Revenue of an ECN comes from small
commissions per trade
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Stock Exchange: Nasdaq
Front Running
• Montage screens show the best quotes
from various systems on Nasdaq
• Given the presence of large number of
buyers and sellers, the best buy quote
and the best sell quote are close to each
other
• One is likely to buy or sell at more or less
the same price however one trades a
small number of shares
• However, for large trades abuse is
possible
• Suppose you want to sell 100,000
shares of some.com
• You place an order with a dealer
• The dealer sells his own stock of shares
of some.com to drive down the price and
then buys your 100,000 shares
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Front Running
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Stock Exchange
• To prevent such abuse, large customers
tend to have own dealers and monitor
their activity closely
Dealer sells
price
Sale order placed
Order executed
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Exchanges: Discounts
Exchanges
• As before, posted price exchanges have
some limitations
• How to price discriminate?
• Discounts provide one way
• Who gets discounts?
• Typically uninformed traders who trade
large volumes
• Example: pension funds
• Nasdaq evolved in the reverse of the order
likely to be seen in new e-markets
• Originally, nasdaq had only traders - dealers
and customers
• ECNs came later
• However, e-Markets based on exchanges
come first
• Dealers then begin to operate in such markets
• eBay has created a large community of
dealers
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Half.com
B2B e-Markets
• Half.com is a part of eBay
• Trades used books, videos and CDs
• Sellers post offers (price offer for any
object cannot exceed ½ of its list price
when it was new)
• Buyers pick suitable offers
• Even though this is a posted price
exchange-like system, the fact that there
is competition among sellers imply that
this is also like a reverse auction
• e-Markets are very unlikely to invade
supply chain for technical products
where quality matters and is hard to
measure
• e-Markets are highly developed for MRO
(maintenance, repair and operations)
products, and other products where
quality is less of a concern
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Efficiency Gain
Efficiency Gain
Examples:
• British Telecom has reduced external
procurement costs from $113 to $8 per
transaction
• Online brokerage fees have fallen to below $5
in comparison with traditional discount
brokerage fees exceeding $50, suggesting a
decrease in costs in back-office operations
and brokerage transactions with financial
exchanges
• Lehman Brothers: financial transactions are
$1.27 for teller, $0.27 for ATM, $0.01 online
Expectations about productivity gains
from B2B e-commerce can be usefully
divided into four areas:
• automation of transactions
• potential economic advantages of new
market intermediaries
• consolidation of demand and supply
through organized exchanges
• changes in the extent of vertical
integration of companies.
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B2B Intermediaries
B2B Intermediaries
• Intermediation is more efficient
• By using intermediaries a firm can
outsource more efficiently
• Specialized intermediaries can reduce
cost of a firm by removing the need to
meet with suppliers
•
•
•
•
•
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Four types of intermediaries:
Brokers
Auctioneers
Dealers
Exchanges
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B2B Brokers
B2B Auction Example: Freemarkets
• Brokers match buyers and sellers for a
fee. Some brokers offer referral services
that resemble yellow-page directories ,
but with more comprehensive
information and search facilities.
• FreeMarkets – largest online
procurement company – handles
procurement for large companies for
products such as chemicals, packaging,
metal fabrications
• Identifies potential suppliers, specifies
needs of a client, and runs procurement
auctions
• Auctions run for 10-20 minutes for each
lot, with an extension of 1 minute if bids
come in at the last minute
– Buzzsaw (construction) and Bakery Online
(bakery supplies)
• Brokers can also act as catalogue
aggregators
– iProcure (office supplies) and Chemdex
(laboratory chemicals)
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B2B Auction Example: Freemarkets
B2B Dealers
• The auction is an English auction, but
since it is the seller’s who bid, it is often
called a “reverse English auction”
• The lowest bidder is not necessarily the
winner – the client considers quality and
delivery performance as well
• Dealers buy from suppliers and resell.
• Dealers post ask prices for buyers and
bid prices for sellers. They earn returns
from the bid ask spread.
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B2B Dealers
B2B Exchanges
• Grainger.com
– distributor of supplies for MRO founded in
1927, has made its catalogue of hundreds
of thousands of items available for online
ordering.
– each customer views a customized set of
prices (through negotiation) after logging on
• EnronOnline
– online extension of Enron’s business of
buying and selling contracts for natural gas
and other commodities
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B2B Exchanges
• Exchanges are double-sided markets
• Similar to existing markets for financial
instruments and some commodities
(such as those traded on the Chicago
Mercantile Exchange).
• We discussed financial exchanges
earlier
• B2B firms promise to extend such
markets to a variety of new products,
including manufactured goods, primary
inputs, and services.
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B2B Exchanges
• Trading rules can be structured so that buyers
and sellers expect to receive the best
available price for their transactions.
• Typically, buyers and sellers can observe the
prices of transactions as they occur.
• Centralized clearing reduces transaction costs
because buyers and sellers need only settle
with the exchange based on their net position
at the end of the day, rather than settling each
transaction individually.
• Exchanges provide various services:
– rules for trading
– price transparency
– centralized clearing
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B2B Exchanges
B2B Exchanges
• B2B exchanges typically deal in
unregulated forward contracts
• Differs from financial futures exchanges,
governed by the Commodity Futures
Trading Commission.
• Examples of B2B exchanges:
– AlmondEx (almonds), Altra Energy (oil and
gas), e-Steel (steel), and PaperExchange
(paper and pulp).
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B2B Exchanges
• Cantor Fitzgerald set up eSpeed.com
• Cantor Fitzgerald operates about 50% of the
global wholesale market for fixed-income
securities (treasury securities, corporate
bonds, municipal bonds)
• eSpeed - B2B market maker on fixed-income
securities
• Offers electronic trading alternative to
established bond trading traditionally carried
out by telephone conversations
• Example of a company establishing an online
service that will cannibalize its existing
business.
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Buyer Sponsored B2B Exchanges
• eSpeed operates a patented system
• Participants who are first to make a bid
or offer (and first to act on the bid or
offer) get priority in the subsequent trade
• This rewards market participants for
maximizing liquidity and driving the
market towards the best price.
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• Many exchanges are buyer sponsored
• Examples:
– Sears, Carrefour and several other major
retailers started GlobalNetExchange to
organize purchases from over 50,000
suppliers
– Boeing, Lockheed Martin, BAE Systems
and Raytheon formed an exchange for
aerospace parts and services with 37,000
suppliers
– Covisint (auto industry exchange – GM,
Ford, Daimler-Chrysler)
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B2B Exchanges
References
• However, not all firms are attracted to
independent exchanges
“…many old-line manufacturers…view B2B sites
as cost-effective tools to improve and cement
[existing] business relationships… rather than
as a way to attract an entirely new set of
buyers…they have balked at aggressively
participating in independent trading sites that
also feature the wares of rival
suppliers…Instead, [they] are focusing on
building up their own, company-specific sales
platforms and techniques, and then helping
longstanding customers adapt smoothly to
them.” Wall Street Journal, May 21, 2001
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• Hall (2001) Digital Dealing, Texere
• Lucking-Reiley, D. and D. Spulber (2001)
“Business-to-business electronic commerce,”
Journal of Economic Perspectives.
Available at:
eller.arizona.edu/~reiley/papers/B2B.pdf
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