A Theory of Financial Exchange Organization

Abstract

Although there has been extensive research on the economic functions of financial exchanges and the properties of prices determined on exchanges, there has been little research on their organization and governance. The heterogeneity of the suppliers of financial services who are members of financial exchanges explains salient features of exchange organization. When suppliers of financial services are heterogeneous, one expects to observe exchanges organized as not‐for‐profit firms, especially if an exchange can enforce collusive agreements. Moreover, heterogeneity can lead to conflicts between members over rents, which necessitates the creation of formal governance mechanisms. Finally, if exchanges exercise market power or are protected from competitive entry (as is plausible), exchanges may adopt inefficient rules; the efficiency of exchange rules depends on the degree of member heterogeneity, the distributive consequences of these rules, and the ability of exchange governance structures to enforce wealth‐enhancing bargains among members with disparate interests.