European Economic Perspectives 22

Inside Information

As new technology reduces transaction costs, what does the future hold for Europe’s security markets? Thomas Gehrig explains how the nature of financial information will influence which national exchanges survive in an increasingly competitive industry.

The London Stock Exchange’s ‘Big Bang’ in 1986 initiated a process of rapid change across the whole European securities industry. Formerly protected national equity markets have been forced to compete for internationally mobile investors and entrepreneurs. All the major financial exchanges have introduced an electronic trading system and implemented policies to reduce trading costs substantially. Protective regulations and transaction taxes have been abolished or reformed: for example, trading in financial futures has been legalized in Germany after a ban lasting almost a century. And since January of this year, the euro has eliminated currency risks for financial market participants within euroland.

Europe’s security markets have become rapidly integrated as a result of these developments. It is now technologically and legally possible to trade UK stocks in Milan and bund futures in London at almost identical prices to those quoted in these assets’ traditional markets. It is even possible to buy and sell securities via the internet. What do these developments imply for the structure of European security markets, particularly for the existing financial exchanges? Will they be completely replaced or consolidated? Will some exchanges survive? And if so, which ones are more likely to stay in business?

In a recent CEPR Discussion Paper, Thomas Gehrig attempts to answer some of these questions. He suggests that by analysing the ‘centrifugal’ and ‘centripetal’ forces that drive agglomeration and dispersion in financial markets, predictions can be made about which financial activities will ultimately become ‘de-localized’ – with trading no longer dependent on physical location and instead centralized in one electronic market – and which will remain fragmented – continuing to take place across a range of different centres.

It has been argued forcefully that geography will become increasingly irrelevant for financial markets everywhere. Some evidence seems to support this claim: for example, trading in major currencies is already completely de-localized – it all happens across global computer networks. And international money markets are extremely footloose: euro-deposits can be made virtually anywhere in the world at very low cost. Hence, participants in these markets can avoid costly national regulations by shifting their activities to low cost locations.

On top of these changes in the currency and money markets, the number of stock exchanges has declined markedly: from 22 in 1935 to 10 in 1985 in the United States; from 8 in 1990 to 1 in 1997 in Switzerland; and from 21 under the Weimar Republic to 8 in 1998 in Germany. So the vision of a single completely integrated electronic market without geographical frontiers does not seem too unrealistic at the end of the second millennium.

But there is a counter-argument. Some studies find that banks that are active in one of the major financial centres have invested substantial resources to increase their networks of branches and subsidiaries across the other major centres. This suggests that a physical presence at specific locations has become more valuable for financial intermediaries despite advances in information and communication technology. Apparently, geography still matters – at least for the largest financial intermediaries. But why?

A study by Gehrig, Stahl and Vives, published in the 1994 CEPR volume The Location of Economic Activity, argues that it is the production and aggregation of local information that largely determines the attractiveness of financial centres to international intermediaries. When information on securities that is relevant to their valuations cannot be disseminated by widely available accounting statistics and newspaper columns but requires interaction with informed specialists and experts, financial centres benefit from the agglomeration economies generated by the physical presence of experts. This is especially true for ‘informationally sensitive’ securities, such as stocks and their derivatives, where any information – even rumours – about future returns are relevant to their valuations. In these cases, stock markets and derivatives markets are the natural places for information exchange and dissemination.

As this kind of information becomes more valuable to intermediaries, their presence in stock and derivatives markets will increase. But while a presence at an exchange can be valuable for the acquisition of information relevant to security valuation, it is not necessarily important for trading at the best price. Once someone has decided to buy or sell a security, he or she can place an order from anywhere. Geography does not matter for trading per se. But it may matter for the underlying decision to trade, which typically depends on sensitive information, or for customer advice.

The information requirements for valuing currencies, euro-deposits and even corporate bonds are substantially lower than for stocks and their derivatives. Pricing currencies depends for the most part on publicly available information and pricing bonds demands little more than calculating default probabilities. These activities require substantially less information than pricing the future income streams of ordinary stocks. Accordingly, the geography of trading is significantly less relevant in the case of bonds and particularly in the case of currencies.

As information and communication technologies advance, will the role of geography eventually fade for informationally sensitive securities too? Not necessarily, according to Gehrig (1998), who argues that the answer depends decisively on the nature of the relationship between complex sophisticated information and plain standardized information. Complex sophisticated information is difficult to communicate and typically requires the physical proximity of the person receiving it. Plain standardized information, which, in contrast, consists of readily understood accounting numbers and statistical measures, can be instantly disseminated by electronic media.

When complex and plain information are complementary, technological advances are likely to enhance the importance of geography. For example, as information about foreign companies becomes more readily available, investors’ interest in foreign securities is stimulated and they increasingly demand detailed additional information about overseas firms. As a result, intermediaries find it worthwhile to specialize in information production about foreign companies. In this sense, the availability of public information may stimulate the demand for more complex and specific information – the two variants of information are complements.

On the other hand, when complex and plain information behave like substitutes, the vision of one big electronic market may become reality. As plain information can be communicated more easily, complex information loses value and geography becomes irrelevant.

Based on these considerations, we might expect the survival of financial centres that are successful in attracting informationally sensitive activities. And when local information about local firms is concentrated in different regions or countries, we might expect several centres of information production to co-exist and the structure of securities markets to remain fragmented. So, the co-existence of several large European exchanges is likely as long as these exchanges remain the prime sites for information aggregation about national securities.

But within informationally homogenous regions, competitive pressure will increase for co-existing exchanges. One way for these exchanges to ease that pressure is to provide differentiated products and target different clienteles. The US experience, for example, suggests the possibility of vertical differentiation between several national exchanges: dominant exchanges specialize in listing the most attractive segment of nationally active and hence larger companies; while the smaller exchanges compete for the smaller regionally active firms by reducing listing standards and/or listing fees. But if listing requirements are regulated by national law, such niches for fragmentation may not exist, and, under competitive conditions, regional exchanges may be forced out of the market.

What does this analysis imply for Europe? To the extent that Europe remains informationally fragmented across countries, we might expect the co-existence of the major national exchanges, while the smaller regional exchanges might be driven out of existence (unless protected by national regulations). But as information differences vanish – with accounting standards harmonized and bigger companies becoming more and more active and well known across the whole European market – competitive pressures will grow and some national exchanges may find it difficult to survive. We are already seeing the first strategic alliances between formerly national exchanges as they seek to position themselves for that future.

This article draws on ‘Cities and the Geography of Financial Centres’ by Thomas Gehrig, CEPR Discussion Paper No. 1894 (June 1998), subsequently published in Thisse and Huriot (eds), The Economics of Cities, 1999. Gehrig is Professor of Economic Theory and Director of the Institut zur Erforschung der wirtschaftlichen Entwicklung at the University of Freiburg, and Research Fellow in CEPR’s Financial Economics and Industrial Organization programmes.

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