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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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