The Immediacy Implications of Exchange Organization

Moser describes the development of modern futures clearinghouses as the culmination of a series of adaptations to credit risk problems.¹ Baer, France, and Moser extend this reasoning to show how contract margin requirements reflect the interests of exchange members who jointly minimize their credit risk exposures and their margin-carry costs.² Common to these papers is their application of a theory of efficient contract design to futures contracts. A contractual perspective on exchange membership is also useful. Viewed this way, exchange rules become terms for contracts of membership. In turn, those rules become subject to the same efficiency concerns as any other contract-design problem. This thought exercise gives insight into the economics that underlie exchange organizations. Just as members continually recontract to control price risks arising from their extant financial positions, they also adjust exchange rules affecting their membership standings. This paper models linkages between exchange decisions affecting contract performance and ability to meet customer demand for immediacy.

Immediacy is the time required to fill customer orders, and, in this sense, the term describes the performance of transaction service providers. The duration of order-fill processing creates exposure to price changes, an exposure that increases as duration of order-fill processing lengthens. This outcome is attributable to both information arrival and market liquidity. More straightforward is information arrival: informed traders want their orders filled before prices adjust to their information. Less straightforward is the added exposure to the price implications of liquidity. Liquidity is a conditional expectation of the association between the price response of a transaction and its size. As large transactions are more likely to move prices, liquidity is usually described in terms of the largest transaction having no expected price impact. Because long-duration order fills increase exposure to these price effects, poor liquidity elevates the importance of immediacy.

Immediacy needs are common to all exchanges. Securities markets are organized to facilitate brokered transactions with a combination of human and computer resources. Specialists holding limit order books provide a nexus for price discovery. Computerized handling of orders meets most immediacy needs by using algorithms to match the buy and sell sides of most at-market orders. Open-outcry futures markets are organized as continuous auction markets. Immediacy is provided by locals who track buy and sell interests on the floor; the transactions of locals serve to intermediate externally originating order flows.

Given the problems arising from lack of immediacy, exchange members have interests in taking steps to achieve immediacy. Increasing the number of members improves the number of opportunities to find a counterparty within a desired time span. Selecting from a homogeneous population of potential members, the choice is straightforward: add members until the immediacy problem goes away. However, potential members are more likely to be heterogeneous, particularly in their credit dimensions. Scarcity of strong credits among a population of potential members constrains immediacy improvements. This paper uses a queuing theory representation to quantify costs implied by inadequate immediacy and develops a tradeoff between these costs and the costs incurred when weak credits are accepted as members.

To see its relevance, consider how membership size affects an exchange member's interests. We readily see the benefit when our grocer opens another checkout line and decreases the portion of a Saturday spent standing in line. Likewise, adding an exchange member can decrease the time spent locating contract counterparties. This is to say that increasing the number of members improves transaction immediacy at a given price. From this, it follows that the cost for obtaining immediacy declines as membership size increases. From the perspective of individual members, every other member is a potential service channel and—like grocery checkout lanes—more service channels are preferred to less.

However, adding members has risk management consequences as well. Baer, France, and Moser show that monitoring members for their nonperformance prospects can substitute for collateralizing against losses.³ However, they find no evidence of differential collateral assessments as would indicate substantive reliance on monitoring. Collateral appears to be the primary risk management tool, and collateral requirements are the same for most members. This being...