Market Integration and Metamediation: Perspectives for Neutral B2B E-Commerce Hubs

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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 num- ber 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 ac- complished 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 rep- resent 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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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 in- vestigation 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.

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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 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.

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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• Network externalities

Electronic markets in general exhibit (indirect) network externalities. These network externalities (Katz a. Shapiro 1985) primarily occur when products are ex- changed. 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 The good “offer” comprises the willingness to sell at price p^s, whereas the good “counteroffer” marks the willingness to buy at price p^b. 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.

5 The critical mass denotes the minimum network size that can be sustained in equilibrium, given the cost and market structure of the industry.

6 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.

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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 de- mand 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 Numerous different dimensions are found in literature (Bakos 1998; Strader 2000; Barrat a. Rosdahl 2002).

8 Note that when a buyer's information is multidimensional, no auction is generally efficient (Dasgupta a. Maskin 2000).

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Forward auction

Reverse auction Neutral

auction

Neutral exchange Matching

(Liquidity)

Forward aggregation

Reverse aggregation Neutral

aggregation Aggregation

(scale)

One-sided (Biased) Two-sided (Neutral)

Forward auction

Reverse auction Neutral

auction

Neutral exchange Matching

(Liquidity)

Forward aggregation

Reverse aggregation Neutral

aggregation Aggregation

(scale)

One-sided (Biased) Two-sided (Neutral)

Centricity of B2B hub

Sourceof ValueCreation

Figure 1. Taxonomy of B2B Hubs (Kaplan a. Sawhney 2000)

3 Market Integration

In finance literature aspects of fragmented markets are widely discussed but com- piling 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 imperfectly- integrated 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).

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(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 frag- ment 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 execu- tions obtained in it are different from the results that would have been obtained in a cen- tral, 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 evalu- ated in a number of studies (see Amihud a. Mendelson 1991; Amihud a. Mendelson 1995).

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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 mo- ment 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 opera- tors.

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.

Informational Integration

Intermediated Market Access Multiple

Market Access

(i) (ii) (iii) Intermediated

Price Discovery (iv)

Order Flow Information Flow

Market Participants Access

Intermediary Access Intermediary

and Price Discovery

Legend:

A B A B A B A B

Informational Integration

Intermediated Market Access Multiple

Market Access

(i) (ii) (iii) Intermediated

Price Discovery (iv)

Order Flow Information Flow

Market Participants Access

Intermediary Access Intermediary

and Price Discovery

Legend:

A B A B A B A B

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.

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Figure 2 introduces the different patterns of integration that will be demon- strated 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 Ger- man 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 con- straint²¹ (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 as-

17 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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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 ob- solete, 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 dissemi- nate 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 Note that the switching costs are not affected by the information linkage.

23 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).

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(NMS). At least professional traders usually have access to all of the markets and force spreads to diminish.

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.

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. Fuden- berg 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 un-

24 Not only the products but also the services provided by the markets are the same.

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certainty whether or not a single market will surpass the critical mass is still preva- lent.

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 evol- ving that primarily offer access to one or more markets.

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.

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

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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 oth- ers. 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.

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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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.

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 reve- nue.

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.

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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 frag- ment 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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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 dis- intermediation

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, war- ranty, 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 com- piling “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 tremen- dously 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

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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. Further- more, 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, my- opic 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 sig- nificance 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 relation- ships 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 presuma- bly 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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