Market Integration and Metamediation:
Perspectives for Neutral B2B E-Commerce Hubs
Dirk Neumann, Carsten Holtmann, Thomas Honekamp
Information Management and Systems (Informationsbetriebswirtschaftslehre),
University Karlsruhe
Abstract
B2B markets have been predicted to revolutionize traditional forms of interaction
and to be a milestone within the evolution of the network economy. But most of
these electronic markets are floundering. Due to the wide fragmentation, most of
them have not yet surpassed the critical mass. Failing to attract an adequate number of participants, these electronic markets never unfold their endemic potentials.
A consolidation process can be observed in the way, that markets either exiting
the “market for markets” or even taken over by competitors.
In this context, integration of markets can play an important role in alleviating
the fragmentation. Different patterns of linking and thereby integrating markets
are identified. As a consequence of integration, the liquidity of the entire market
network increases. Different from a single consolidated market this can be accomplished without loosing the innovation function incited by competition. New
forms of market design, intermediation and metamediation can further contribute
to the success of markets.
In the analysis, primarily financial markets are emphasized because these represent adequate models for the future shape of B2B markets. This is even more
likely when information as a product moves into the centre of trading.
Keywords
Market Integration, Neutral E-Hubs, B2B, Intermediation, Metamediation
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
1 Introduction
“If an order cannot move to its best market, the best
market will be moved to the order” (Harris 1995)
Web-based B2B markets such as e-Steel (www.e-steel.com), Ariba
(www.ariba.com), or Emetra (www.emetra.com) established themselves as new
intermediaries that enable trading of products and services among businesses.
From an economic perspective, electronic markets can speed up business processes, provide access to global buyers and sellers, reduce search costs, provide a
whole new array of transaction methods, increase efficiency, and reduce overall
transaction costs (Malone et al. 1987; Kauffman a. Walden 2001). Moreover, B2B
markets have been predicted to revolutionize traditional forms of interaction and
to be a milestone within the evolution of the network economy.
In fact, electronic networks have emerged that bring buyers and sellers from all
over the world together. But most of these electronic markets are floundering.
“They suffer from meager transaction volume and equally meager revenues, and
they face a raft of competitors” (Wise a. Morrison 2000). Why have these markets
failed to unfold the potentials that had been predicted by research institutes and
theory? Different lines of argumentation range from capital abundance during the
hype phase of the network economy to market microstructure considerations.
In a modern network economy buyers and sellers coordinate their activities
through markets. Hence, one could expect a network of closely linked markets; in
practice markets remain isolated from each other. As a consequence of this fragmentation, few markets will ever create the liquidity necessary to survive.
In this context, integration of markets can alleviate the fragmentation. The aim
of this paper is to discuss the patterns of market integration and their potential
benefits for the involved stakeholders. The paper emphasizes financial markets
because they represent an adequate model for the future shape of B2B markets
(Wise a. Morrison 2000).
Although one might argue that B2B hubs1 are far away from integration problems, lessons learned should be drawn from more mature industries. A closer investigation into financial literature offers insights for electronic markets, especially with respect to market regulation, competition, and integration.
The remainder of the paper is structured as follows. Section two gives a short
introduction into the topic of B2B markets by illustrating the primary characteristics of electronic markets. The presented taxonomy focuses on the special type of
neutral B2B hubs. Section three provides a definition of fragmented and consolidated markets for the finance area and introduces aspects of non-intermediated
and mediated integration. In section four findings are refined to illustrate the transfer of the integration alternatives to the B2B domain. Section five concludes with
an outlook to further research.
1
Although the term “hub” is not consistently defined in literature this paper treats hubs
and markets as synonyms.
Market Integration and Metamediation
69
2 Electronic Marketplaces
Electronic markets in general coordinate the flow of goods and services through
the competitive forces of demand and supply. Additionally, they facilitate the exchange of information, goods, services, and payments associated with the market
transaction. Web-based electronic marketplaces leverage markets to perform these
functions with reduced transaction costs, resulting in more efficient market outcomes.2
2.1 Characteristics of Electronic Markets
In this context, the primary characteristics of electronic markets, first compiled by
Bakos (Bakos 1991), are relevant to the discussion in this paper:
• Uncertainty about the current benefit
Since the benefit of participating in an electronic market depends not only on the
system (e.g. because of the information and communication costs) but also on the
participation of other users (especially network effects) the current benefit of participating is uncertain. This uncertainty can entail that potential entrants may postpone their market entry and wait for the experiences of other customers.
• Reduced information and communication costs
Since any search is associated with costs, not all partners will be reached, potentially creating a monopoly area (Stigler 1961). By aggregating buyers and sellers
within an electronic marketplace, those search (or information) costs can be significantly reduced. Information pertains to the products being offered/contracted
as well as the potential contracting partners. By posting buy and sell orders in a
virtual marketplace, market participants can no longer exploit their monopoly
area.
Furthermore, the use of an inter-organizational information system3 reduces the
communication costs. The common infrastructure also means the avoidance of
costly media disruptions. Overall, the reduction of transaction costs entails an improvement in operational efficiency.
2
3
This view is not comprehensive, though. Having in mind, that marketplaces are designed
and operated by profit maximizing firms that follow their own strategy, the aforementioned positive effects are diminishing. If electronic markets are analyzed, not only the
view of the customers but also of the operator has to be taken into account. This will be
done in more detail in section 3.
The term “inter-organizational information systems” (henceforth IOS) refers to information systems that cross organizational boundaries linking supply and demand. If an IOS
supports the exchange of information (e.g. offers or other messages) it is usually regarded
as an electronic market.
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
• Network externalities
Electronic markets in general exhibit (indirect) network externalities. These network externalities (Katz a. Shapiro 1985) primarily occur when products are exchanged. An exchange requires two complementary goods: “an offer“ and a
“counteroffer“.4 The more offers are attracted by the marketplace the more likely
it is that an exchange occurs increasing the benefits of an individual participant
(Economides 1993; Economides 1996). If a market fails to surpass the critical
mass5, the market is virtually doomed to drop out of the market for markets.
• Switching costs
Setting up the connection to an electronic market can be very costly. Hardware,
software costs or even employee training can be an obstacle for entering electronic
markets. These necessary investments are not easily revertible. Once a participant
decides to leave the market space his investments are lost. Markets that wish to
woo potential customers away from competing markets must either compensate
them for their switching costs or offer compatible interfaces to their system
(Farrell a. Shapiro 1988; Bakos 1991).
• Economies of scale and scope
Electronic markets frequently provide substantial economies of scale and scope.
Before an electronic market can be operated a great deal of money and time has to
be invested in the development and maintenance of the system. Once the system is
deployed, the costs of a transaction are in the absence of capacity constraints almost negligible, yielding substantial economies of scale. From a market operator’s
view, the experience and the software that is gained along the development and
operation of the electronic market can be transferred to a new marketplace that is
founded in a different domain.6
Since integrated market network resemble a simple market, the characteristics
are assumed the same. Nonetheless, the occurrence of the characteristics may differ depending on the integration patterns. Regardless of the patterns, it can be at
least assumed that reduced uncertainty of market participants and minimized information and communication costs result in increased market quality. Single
marketplaces have to contribute to exceed the critical mass of the entire market
network.
4
5
6
The good “offer” comprises the willingness to sell at price ps, whereas the good “counteroffer” marks the willingness to buy at price pb. By bringing together those two goods
the market produces a transaction, a new (composite) good. A single good (e.g. an offer)
without a complementary good (counteroffer) is, however, worthless.
The critical mass denotes the minimum network size that can be sustained in equilibrium,
given the cost and market structure of the industry.
For example xlaunch® aims at building and servicing electronic markets to trade standardized cash and derivatives products in financial and non-financial OTC and B2B markets. As xlaunch is a 100 % subsidiary of Deutsche Boerse AG, Frankfurt, it exemplifies
the effort of stock exchanges to transfer their financial knowledge to commodity markets.
Market Integration and Metamediation
71
2.2 Taxonomy of Electronic Markets
The notion of “electronic markets“ marks an umbrella term for several variations.
In order to analyze these variations in more detail it is necessary to categorize
them.7
Kaplan and Sawhney identify in their approach two different mechanisms that
create value for B2B markets (Kaplan a. Sawhney 2000).
1. Aggregation or catalog mechanisms pool a large number of buyers and sellers
thereby reducing information costs among the aggregated participants.
2. Matching mechanisms facilitate an automated price discovery. Furthermore, the
automated price potentially provides better outcomes to buyers and sellers. This
potential stems from at least two directions. Firstly, computer-based matching
is not burdened with personal constraints such as pride or culture (Raiffa 1982).
Secondly, auctions in particular create a competitive environment in which the
free market forces assure an efficient agreement.8
Centricity describes whether or not the hub privileges either the supply or demand market side. Accordingly, three cases can be identified. First, neutral hubs
intuitively abstain from serving any group of participants on the expense of another. Second, buyer-biased hubs favor either one specific participant or a group.
They aim at streamlining the supply processes along the entire (supply) network.
Third, seller-biased hubs refer to seller centric markets which act as a distribution
channel.
As illustrated in Figure 1, four segments can be identified. The upper two segments refer to catalog mechanisms. An integration of catalog systems is rather a
technical than an economic problem. In the case of the lower two segments the issue of market integration is more sophisticated.
The paper focuses on neutral hubs only because these resemble financial
exchanges. As market microstructure theory is a theory of exchanges it can be
perceived as a promising starting point. Having depicted possible forms of the
analysis of market integration, the findings are transferred to B2B markets (see
section 4).
7
8
Numerous different dimensions are found in literature (Bakos 1998; Strader 2000; Barrat
a. Rosdahl 2002).
Note that when a buyer's information is multidimensional, no auction is generally efficient (Dasgupta a. Maskin 2000).
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
Centricity of B2B hub
Two-sided (Neutral)
One-sided (Biased)
Forward
Source of Value Creation
aggregation
Aggregation
(scale)
Neutral
aggregation
Reverse
aggregation
Neutral
auction
Forward
auction
Neutral
exchange
Reverse
auction
Matching
(Liquidity)
Figure 1. Taxonomy of B2B Hubs (Kaplan a. Sawhney 2000)
3 Market Integration
In finance literature aspects of fragmented markets are widely discussed but compiling the opinions of experts is rather difficult, taking into account that arguments
do not all go in the same direction (Cohen et al. 1985). Because of this complexity
the topic will only briefly be covered and is reduced to the most intriguing aspects.9
3.1 Fragmentation vs. Consolidation
Fragmentation and consolidation mark two bipolar extremes of a market structure.
The continuum between these extremes is called a segmented, an imperfectlyintegrated or imperfectly-consolidated market.10
Consolidation of orders traditionally refers to two different meanings, being
spatial consolidation11 in a single trading arena, and temporal consolidation
9
In fact, the discussion of this topic regards aspects as the maintenance of price priority,
the maintenance of secondary priority rules, inter-dealer competition, the desirability of
servicing the disparate needs of different traders, fairness, the public-goods nature of
various services provided by a securities exchange, the consolidation of information concerning the order flow, inter-market competition (Cohen et al. 1985). The latter two are
focused.
10 This definition is in agreement with the understandings of (Cohen et al. 1985; Harris
1995; Kirchner 1999).
Market Integration and Metamediation
73
(Cohen et al. 1985). Both are important when market microstructure is analyzed.
Temporal consolidation deals with the question depending on which situation
whether continuous or batched price determination is more appropriate. The spatial consolidation deals with the question whether or not multiple markets for the
same good can coexist. A market is called consolidated “when all of the orders to
buy or to sell […] are funneled to a single location to be combined into transactions” (Hamilton 1989). Thus, a consolidated market is defined to be the one and
only trading opportunity for a given product that attracts the whole order flow.
Fragmentation of market refers to the case that multiple marketplaces for a
given product are not linked at all. Participants acting on a specific market can
neither send orders to another market nor do they obtain information feedback
from those.12
Since this paper elaborates on the issue of market integration, consolidation is
used in the remainder of the paper as spatial consolidation.
3.2 Perspectives of Market Integration
Markets primarily consolidate because traders search for liquidity. Markets fragment because traders differ significantly in the types of trading problems they are
faced (Harris 1995).
Recall, that in organized markets bundles are sold: one part is the (standardized) product (e.g. security) and the other part is the set of services13 provided by
the market (Cohen et al. 1985). Although consolidated markets are adequate in the
sense that the whole liquidity for the product is concentrated within one single
place, they also implicate the problem of market monopolization. As a consequence, the lack of competition creates severe problems such as
• higher transaction cost for the investors (monopolistic pricing),
• unbalanced market services, i.e. the services focus primarily on the needs of the
most important investor groups, and
• the absence of service innovations provided by the market.14
The existence of multiple integrated markets promises to overcompensate the
disadvantages of the extreme poles and the existing trade-off. Harris (1995) states
11
In securities markets this trading takes additional two forms: (a) trading of securities
cross-listed on two or more exchanges, and (b) off-exchange trading (Cohen et al. 1985).
This distinction is of minor interest in this context.
12 Amihud and Mendelson denote a market to be fragmented, “if the results of order executions obtained in it are different from the results that would have been obtained in a central, single […] market” (Amihud a. Mendelson 1995).
13 This set of services comprises for example the degree of participation of intermediaries
and in the role they play in the market (Economides 1995).
14 The costs of fragmentation and the benefits of intermarket competition have been evaluated in a number of studies (see Amihud a. Mendelson 1991; Amihud a. Mendelson
1995).
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
that market diversity does not necessarily entail inferior price formation and high
transaction costs. Benefits of consolidation may be obtained in a fragmented market; Fisher even argues that overall “liquidity can be increased, as, for example,
when the total cost of trading comes down” (Fisher 1995). The law of one price
shows in this context that “[...] perfect market integration means that at any moment a stock would trade at the same price in any of the several marketplaces”(Hamilton 1989).15
Two perspectives have to be taken into account: The integration of multiple
markets has to overcome the disadvantages for the market participant (investors)
without destroying the basis for sustainable business models of the market operators.
The next sections will be used to introduce different kinds of integration that
may help to overcome the current problems of the fragmented B2B market landscape.
3.3 Alternative Patterns of Market Integration
Prior research clearly demonstrates that linking electronic markets in an imperfectly consolidated market has the potential for increasing integration (Hamilton
1989). Linkages between markets can be based upon information and multimarket access (according to Harris 1995) but they can also be implemented
through (re-)intermediation.16 This will be illustrated by an example and out of the
participants’ as wells as out of the operators’ perspective in the next subsections.
(i) Informational
Integration
A
Legend:
(ii)
Multiple
Market Access
B
A
B
(iii) Intermediated
Market Access
A
B
Market
Participants
Order Flow
Access Intermediary
and Price Discovery
(iv) Intermediated
Price Discovery
A
B
Access
Intermediary
Information Flow
Figure 2. Alternative Patterns of Market Integration
15
As the prices in a market value the bundle of the (standardized) product and the market
service (mechanism) it is possible that the law of one price does not hold for the bundle
in case that the employed services differ between markets.
16 See figure 2 for a graphical illustration of the following integration patterns.
Market Integration and Metamediation
75
Figure 2 introduces the different patterns of integration that will be demonstrated throughout the section.
(i) Informational Integration
Description
In its most simple way integration of markets may be achieved via information
messaging. If information is disseminated across markets, participants of one market can observe information from other markets and vice versa.17 Hence, overall
market transparency18 is increased.
Example
A good example for an increased pre-trade and post-trade transparency is Island
(www.island.com). Island is an Electronic Communication Network (ECN)19 that
was one of the first markets in the U.S. that allowed anyone to watch their current
limit order book in real time and for free over the Internet. Although, most German investors are not permitted to trade directly on Island, the provided market
data can be a good guide for investments in U.S. stocks being traded in a German
parallel market.
Effects from an investor’s perspective
From an investor’s perspective, the information linkage provides them with (aggregated) information about both markets. Accordingly, information asymmetries
among the participants of different markets are reduced using the price system.
Referring to Hayek, the price system inherent to a market communicates dispersed
knowledge of the relevant facts to all participants (Hayek 1945). Hence, buyers
and sellers need not to know the concrete determinants of demand and supply but
the prices to make a rational decision. The price system enables participants with
common knowledge to act as an expert. By the linkage information of another
market will be disseminated to the market improving the price quality. Since a direct trade in the linked market is not supported, it is possible that the prices on the
(informational) linked markets differ from each other. A systematic price bias20 is,
however, unlikely to occur. This holds even in the case that the participants cannot
switch the markets – because such a situation would violate the participation constraint21 (Wilson 1993): It is better to keep away from the market than to incur a
worse price that is attained in the other market. If the single market access as17
It is assumed that investors cannot choose between different places of execution for their
orders in the short run, i.e. transaction-wise. In the long run they are assumed to switch
from one to the other market if their expected profits exceed the switching costs.
18 Different degrees of transparency can be distinguished: post-trade transparency denotes
the case, when information concerning trades (e.g. price, amount, etc.) is disseminated,
pre-trade transparency means that information concerning the trading interests – current
orders or quotations – is published.
19 Electronic non-exchange/ over-the-counter trading system
20 A systematic price bias refers to price differential between two or more markets offering
the same good/service.
21 Participation constraints are also called individual rationality constraints.
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
sumption is relaxed, the investors are switching the markets if the expected benefits outweigh the switching costs.22
Effects from an operator’s perspective
From an operator’s perspective, the impact of information linkages on the operators’ positions is more subtle. As a result of matching offers and counteroffers a
price is determined. This (market) price can be perceived as an output of a marketplace. It is used by all market participants in subsequent (buy or sell) decision
processes.
Market prices are not ordinary private goods since the principle of exclusion
does not apply. The participants on the one market can “consume” the public good
information for free. On the reference market the participants have to pay for this
public good. The operator only collects fees from those participants who trade on
his platform. But the output market price can be utilized by investors out of the
other market who cannot be charged for it.23 One strategy would be to charge a fee
for the information link. Note that information can be reproduced at low marginal
costs; it is difficult to charge for it. Since market prices are rapidly becoming obsolete, it is possible to bring real-time/ delayed access to information as a part of
the operator’s business model to market.
Synthesis
Considering the pros and cons, the answer whether or not such a linkage is desirable depends on whose perspective is taken. For investors the linkage reduces information costs and has thus positive impact of participation. On the other hand,
the market prices as an output are only paid by one group, whereas the group in
the other market can free-ride. For market operators it may be useful to disseminate market data as an additional product or for signaling market quality.
(ii) Multiple Market Access
Description
A second way to integrate markets is to have persons trading on more than one
market. All or at least some of the market participants may be able to send orders
to either market A or market B – depending on the information they get out of the
markets these participants will direct their order flow. It is not necessary that each
investor gets this opportunity: “the marginal traders are sufficient to equate prices
among the marketplaces” (Hamilton 1989).
Example
A typical example for this kind of integration is the German stock market with its
seven regional exchanges or also the U.S. market with its National Market System
22
23
Note that the switching costs are not affected by the information linkage.
A more severe problem creates price piracy, i.e. a market (crossing systems) use the price
of a reference market to execute their orders. These parasite systems weaken the price
quality of the reference market and thus diminish liquidity. The reaction of stock exchanges is that they restrict information access reducing the overall transparency
(Economides 1995).
Market Integration and Metamediation
77
(NMS). At least professional traders usually have access to all of the markets and
force spreads to diminish.
Effects from an investor’s perspective
In this case the investors can trade on one market and arbitrage with the other.
This means that the two linked markets would collapse into a single market
(Pagano 1989). Hence, the law of one price will prevail in both spatially separated
markets taking the low transport costs of capital into account. Taking part in both
markets implies that the investors have to pay access fees for both markets. If an
investor abstains from participating in two markets saving one participation fee,
free-riding on the market prices is still possible.
In a realistic setting, specialized firms, so-called arbitrageurs, will emerge that
utilize price differentials for arbitrage. By their (arbitrage-) trading the prices on
both markets are balancing.
Linking markets permits to exploit network effects. Connecting market increases ceteris paribus the probability to find a corresponding offer. This can further attract potential participants augmenting the overall liquidity of the markets.
Effects from an operator’s perspective
From the operator’s perspective the question arises how a multiple market access
will affect the flow of orders among the loosely linked marketplaces.
The answer is controversial: In financial literature, it is often argued that one
market attracts all order flow whereas the other markets fail. The situation that two
markets can coexist is at most “knife-edged” (Pagano 1989; Chowdhry a. Nanda
1991). In contrast to that Ellison and Fudenberg derived in their simple model of
competing auctions (e.g. eBay versus Amazon) situations under which two competing markets of different size can coexist in equilibrium without the effect that
the larger market attracts all of the smaller markets’ customers (Ellison a. Fudenberg 2001).
The aforementioned models all assume identical markets; accordingly the markets are substitutes24 – that does not hold in reality. In many cases the markets differ not only in size but also in the employed trading services or mechanisms. As
each trading mechanism “provides a different vector of execution attributes and
services a different clientele” (Macey a. O'Hara 1997) the markets are not necessarily substitutes. Empirical data gives evidence that installing linkages improves
price quality but has rather little impact on order flow among the markets as long
as those markets employ different trading mechanisms (Hamilton 1989).
Synthesis
Summarizing, multiple market access appears to be a challenging way of linking
markets. Information and communication costs can be reduced without a pending
redistribution of order flow among the linked markets. Instead, a multiple market
access allows to exploit network externalities which in turn can induce additional
liquidity (Fisher 1995). Enhancing the liquidity generates higher economies of
scale. Multiple access does not mean that all market will grow like weed, the un24
Not only the products but also the services provided by the markets are the same.
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
certainty whether or not a single market will surpass the critical mass is still prevalent.
Beside the effects that are captured by the illustrated forms of integration the
emergence of intermediaries (other than electronic markets) points at further potentials for electronic markets. In general intermediaries can be classified by the
bundle of functions they offer within the market transaction. Classical intermediary functions comprise information dissemination, matching and price discovery,
transformation of assets, etc. (Breuer 1992). In the context of market integration
two types of intermediaries are depicted in more detail.
(iii) Intermediated market access
Description
Multiple market access as previously discussed (see ii) requires from the investor
to establish and maintain multiple interfaces to those marketplaces. This can be
extremely costly for the individual trader. Therefore it is not astonishing that specialized firms ease this interface problem. The intermediary offers a single point
of access, collects the orders and routs it to several market places.
Example
In financial markets most buyers and sellers traditionally do not have the opportunity to choose between (direct) bilateral trades and trades with the intermediary
(Cosimano 1996). In recent years discount brokers, e.g. e*Trade25, have been evolving that primarily offer access to one or more markets.
Effects from an investor’s perspective
Investors no longer have to establish and maintain multiple interfaces to several
marketplaces. Instead they need only a single point of access to the intermediary
who manages the interfaces to the other markets. This reduction of operating costs
can be complemented by supplementary intermediation functions such as intelligent order routing: By offering an intelligent order routing, the intermediary identifies the most adequate point of execution. Here, the intermediary’s property as a
trusted-third-party plays a primary role since the investor surrenders control over
the order execution. This surrender, however, can further reduce the information
costs of the individual investors whereas the intermediary attains economies of
scale in the information management process.
Effects from an operator’s perspective
From an operator’s perspective the pooled order routing also means a sacrifice of
the direct interface with the investors. As previously mentioned stock markets for
private investors are only accessible by brokers alleviating this argument.
Effects from an intermediary’s perspective
Order routing is characterized by substantial economies of scale and scope. While
the intermediary pools the orders he can offer access to multiple markets at lower
costs than the individual investors can. Furthermore, the intermediary can realize a
broad spectrum of economies of scope. For example the direct interaction with the
25
www.etrade.com
Market Integration and Metamediation
79
investors allows the intermediaries to build up a profound knowledge basis of the
customers. The intermediary can utilize this knowledge to optimize his own service portfolio. Moreover, he can act as a catalyst between the markets and the investors by translating the (informal) investor’s needs into (formal) market structure changes.
Synthesis
Summarizing, access intermediation appears to be a reasonable alternative for
both investors and intermediaries, as long as the additional (explicit) transaction
costs for the intermediary are compensated by the savings they provide.
(iv) Intermediated market access and price discovery26
Description
Fierce competition among direct brokers (intermediated market access) forced the
commissions to fall drastically. Induced by this price competition the direct brokers extended their services in the attempt to differentiate their portfolio from others. In addition to their routing functionality they have started to conduct the price
discovery, as well. The rationale behind offering distinct price discovery mechanisms stems from the insight that different mechanisms services a different clientele (O'Hara 1997). Private investors for example have different needs than institutional.27
Example
A vivid example is XETRA Best28 (www.xetra.de). It has been determined that
private investors particularly admire the best execution factors29 “immediacy” and
“best price”. XETRA Best allows banks (as intermediaries) to match the orders of
their customers against a special type of quote that is provided outside the XETRA
limit order book. This quote guaranties an immediate order execution with price
improvement compared to the actual XETRA spread.
Effects from an investor’s perspective
Distinct market mechanisms favor the individually addressed clientele. They are
designed to help investors to execute their trading strategy in a more comfortable
26
Model (iv) can be further split up into intermediated price discovery on the market (Xetra
BEST) and off the market (internalisation) which are different models from a operator's
perspective – this aspects will not be analyzed in detail in the remainder.
27 Institutional investors who trade in large blocks prefer anonymous trading in order to
hide those blocks in the market by splitting it into small orders. In transparent market
hiding the block is not as easy since the orders can be traced to the trader and thus exhibit
adverse price signals. On the other hand private investors like to expose their offers since
a wide exposure allows to fill their orders quickly at the best price available (Harris
1995).
28 The development of XETRA Best has been announced in February 2002; the concrete
implementation of the system and its roll out is predicted for October 2002.
29 For a deeper insight into best execution as well a description of best execution factors see
(Budimir et al. 2002).
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
way30 or at lower transaction costs. The latter case is given, if internal order execution can be performed at lower costs than on the traditional market. Reasons are
for example high commissions or clearing and settlement fees on the market.
However, internal execution often suffers from reduced feasibility of supervision
and monitoring of an appropriate order execution. The reduction of information
and communication costs for the investor might be exceeded by an increase in cost
of supervision – resulting in overall increased transaction costs. Therefore, the
benefits of these offerings often depend on the trustworthiness of the providing intermediary. 31
Effects from an intermediary’s perspective
Serving specific investors’ needs by distinct mechanisms often creates liquidity
niches that are fairly profitable. Internal execution may be cheaper for the intermediary than order routing and execution at the traditional market.32 Profits can be
generated when these cost reductions are not completely shifted to the customer.
Intermediaries may attract additional customers because of their services and can
cross-subsidize the offering of price discovery with other offerings.
Effects from an operator’s perspective
Operators of the traditional market will deprecate internal matching and price discovery as illustrated, because the order flow does not reach their systems. As less
transactions are executed within the market revenues tend to decline.33
Additionally, most internal matching systems free-ride on the prices that are
generated by the markets; they offer a kind of parasite pricing (see i). Nonetheless,
the example of XETRA Best demonstrates that this kind of integration can be
beneficial for the market: By maintaining, operating, and supervising an internal
matching system for the intermediaries, Deutsche Boerse accrues additional revenue.
Synthesis
A synthesis is in this case difficult to draw since the concrete outcomes depend on
the particular setting. Hence, a universal assessment of this pattern appears to be
impossible. The recent announcement of the upcoming XETRA Best has triggered
a vivid discussion on the scientific and political level.
30
Referring to the example above this is done by pinpointing immediacy and the best price
guaranty.
31 In the example above, the system for internal matching and order execution as well as the
market supervision itself is provided by the regulated exchange as a trusted third party.
32 Reasons may be efficient internal systems in contrast to costly market or clearing and settlement fees. The chance to realize arbitrage trades between the markets may be another
point.
33 The problem is even more subtle when specialized markets focus on private investors
and, thereby, direct uninformed orderflow away from the traditional markets.
Market Integration and Metamediation
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4 Findings and Discussion
Different aspects and ideas for integrating isolated markets have been presented.
Finance literature gives much deeper insights into them and is not reduced to the
presented ones, but in this context an overview seemed satisfactory. Instead, some
problems should be pinpointed to evaluate which parallels could be drawn for
B2B markets. Note that we addressed the landscape of existing but fragmented
markets, ruling out political or legal issues and, moreover, focused on neutral
markets.
Finding I: Market integration tends to increase overall market quality
The general idea of integrating markets seams promising in financial as well as in
other markets. When information freely flows between market segments and traders can trade in more than one market, disadvantages of fragmentation can be
overcome (Harris 1995). Market linkages provide a useful concept as they address
the above mentioned aspects of electronic markets for the market participants.
•
•
•
•
Uncertainty
Information and communication costs
Network externalities
Switching costs
On the other hand they allow for economies of scale and scope for the market operators.
Using the concepts of arbitrage it seems possible to increase the overall liquidity of the markets and thereby to reduce transaction costs without the problems of
one single market: “[…] even if the markets were only 85 percent consolidated, it
still could be 90 percent integrated, or 99 percent, or 99.9 percent, depending on
the effectiveness of arbitrage” (Hamilton 1989).
Finding II: Market consolidation by integration seams more promising than a single consolidated market
In contradiction to the various merger projects of market participants, financial literature predicts no inevitable tendency to a consolidated market. “Markets fragment because traders differ significantly in the types of trading problems that they
confront. Traders therefore may support a variety of trading systems for trading
the same fundamental asset” (Harris 1995). The differences in market participants’
needs concerning the services that have to be provided by the market favor heterogeneous market designs – there is no “one size fits it all mechanism” (Wurman
et al. 1998). Although B2B literature fails to give evidence that the needs of the
participants concerning B2B market design are heterogeneous, it seems more than
likely that those needs are also heterogeneous.
In contrast to the consolidated setting, competition is forced in linked markets.
The different operators do have to compete for the order-flow. Hence, the creation
of specialized market designs that focus on the participants’ needs and that reduce
the participants’ transaction costs is the key to survive for the operators. Like the
investors that compete on the market for products, operators do have to compete
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
on the market for markets. Finally, the selection of the best fitting market designs
and services is left to competition. Therefore, it seems even more important, to
overcome times of off-the-shelf-market mechanisms (Wise a. Morrison 2000) and
to move ahead to fundamental domain expertise and an engineering of markets
(Neumann et al. 2002).
Finding III: Innovative types of intermediation are more promising than disintermediation
Not only is the integration via direct linkages and arbitrage reasonable, (re-) intermediation – besides the price determination – may also lead to further benefits
in this context. The appearance of innovative forms is very likely. Intermediaries
that focus on providing access to diverse markets (like online-brokers in the finance area) and the often cited trusted third parties (combination of them respectively) are only two possible alternatives. The concrete function of these institutions is almost as vague as their form of appearance. One might think of them as
real-world for-profit organizations, as IT concepts like software agents but also as
abstract visions.
One of the latter concept that exceeds the original aim of this article – to integrate parallel markets for the same product – is presented by Sawhney (Sawhney
1999): Metamediaries integrate markets for different products. Sawhney suggests
a more marketing oriented view and refers to product bundling: Metamediaries are
“trusted third-parties that provide a single point of contact between a community
of customers and a community of suppliers in a metamarket” (Sawhney 1999). In
this definition, metamarkets are clusters of cognitively related activities that customers engage in to satisfy a distinct set of needs. In other words, the metamediary
identifies the set of goods and services the customers really demand. For example
when the customer wants to purchase the complex product “car”, he wants to buy
the core product car, and also get complementary products such as financing, warranty, inspections, insurances etc. Different to current approaches which primarily
adopt the supplier perspective, metamediation aggregates bundles in the view of
customer activities.
Recall that current complex products are bundled by suppliers or a supply network, respectively. This bears the danger that the supplier subsidizes the core
product with gains from the complementarities which entails an inefficient allocation. Thus, a neutral metamediary can alleviate these detrimental effects by compiling “basic products” on behalf of the customers. One could argue that the
metamediary can act as a supplier, leaving the allocation unchanged. If the customers can buy the basic products on their own account, the margin for the
metamediary is reduced to the information costs the customers face. Otherwise the
customer is better off not employing the metamediary. Hence, metamediation in a
pure sense, requires the existence of underlying markets that sell the basic products. By metamediation information costs for a complex product can be tremendously reduced.
The metamediary can attain substantial economies of scale and scope and
moreover attract more customers by a customer-centric view. As a result, the
Market Integration and Metamediation
83
metamediary meets the customers’ needs without incurring inefficient allocations
which are founded on vertical subsidizes.
5 Conclusion
The illustration of the market integration patterns yields that market integration
can increase the overall market quality. Market integration is even more promising
than a single consolidated market. Single consolidated markets can be regarded as
monopolists that may postpone innovations and charge higher prices. Furthermore, the strategy of operators to separate their markets and hence create a lock-in
situation is considered harmful for the entire market. This view is, however, myopic since the potential market participants also take the switching costs into account before they enter the market.
The key findings suggest that integration is overall desirable and intermediation
services beyond (price) efficiency can open up new market segments. Services
such as metamediation require an integration of different markets.
Note, that these findings are only valid for particular assumptions, namely the
exclusion of political and legal issues. Compared with financial markets, the significance of the key findings considering B2B markets is rather limited. Unlike
securities, the goods and services traded over B2B markets are not fully standardized. In fact, there is a need to negotiate issues beyond the price such as delivery
time, payment methods, etc. This is particularly the case when long-term relationships are formed. As such the employed market mechanisms on B2B markets often allow for negotiations beyond price34. Trading multi-dimensional goods or
services, therefore, aggravates the possibilities to integrate markets considerably.
Furthermore, multi-market settings in B2B markets are unlikely to have the
same price. Recall that arbitrageurs balance the prices in both markets. This requires that the arbitrageurs are willing to trade on both markets. In other words,
the arbitrageur will have to be compensated for his service. Hence, arbitrage profits mark a lower bound on the costs of gluing fragmented markets together (Harris
1995). In the B2B context the assumption of low transport costs can not be sustained unless pure information goods are observed. In the case of physical goods,
it is more than likely that the law of one price is distorted to some extent.
Considering the evolution of an information society, these reductions presumably vanish. As B2B markets mature, the emphasis of trading shifts from the commodity itself to the information about the commodity (Wise a. Morrison 2000).
This suggests that tomorrows B2B markets tend to be closer to the financial markets. Nonetheless, the special characteristics and requirements of these markets
and the particular application domains will have to be investigated. This will make
the assumptions more applicable to B2B markets and will emphasize the benefits
of integrating market networks.
34
For example Ozro (www.ozro.com) provides online threaded negotiations.
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Dirk Neumann, Carsten Holtmann, Thomas Honekamp
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