3 Electronic Market System Framework
3.1 The Institutional View on Electronic Markets
3.1.2 Institutions
3.1.2.3 Extended Institution
The EMS framework concentrates on the operational level of the analysis. Thus, only rules are regarded that directly affect the agent behavior. This also implies that the legal framework imposing rules on the rule-setting behavior of an electronic market is left out, being on a
deeper level. The extensions of the EMS framework, consequently, affect only institutional rules that pertain to the same operational level. The institutional rules of an electronic market can stem from five sources (Holtmann, Neumann et al. 2003):
• Resource Allocation
As the electronic market embodies a resource allocation process, the institutional rules defined by the microeconomic system framework also apply to electronic markets. To avoid misunderstandings between the institution definition of the microeconomic system framework and the extended institution of the electronic market, the former institution comprehending a language, choice, transfer and adjustment process rules is redefined as trading rules.
• Medium
The medium that forms the trading venue imposes also institution-like rules – henceforth media rules – upon agent behavior.
• Market Firm
The market firm is the central player in the EMS framework. In essence, the market firm can either define the resources that are being traded or restrict access. More importantly, the market firm must somehow earn money to cover the expenses that are associated with running the electronic market. The corresponding institutional rules are denoted as trading object definition, participation rules, and business rules.
• Social norms
While the market firm needs to design the former rules, social norms evolve spontane-ously. Extending the microeconomic system framework by social issues, it requires the inclusion of those norms.
• Enforcement
Basically the EMS framework also accounts for the fact that agents may fail to comply with their obligations. The enforcement machinery comprises all rules that are associated with assuring the trade to occur as agreed upon.
In the following those rule-extensions are discussed in more detail.
3.1.2.3.1 Trading Object Definition
The microeconomic framework assumes that there “[…] exists a list of commodities” (Reiter 1977, 227). This assumption makes further considerations about the nature of commodities obsolete. Extending the microeconomic system framework to electronic markets requires a closer analysis of the resources that are allocated. In order to document the transition from the traditional to the electronic market view, the resources that are allocated are denoted as trad-ing object. The market firm can decide what objects are traded over the electronic market.
Apparently, the market firm does not invent some new physical object; instead is he providing a “definition” as trading object innovation. In other words, the market firm converts physical or immaterial resources into a tradable object.103
The trading object definition principally contains two types of rules. The first type is con-cerned with an immaterial description of object. As such, it specifies the characteristics an object must have, i.e. quality, age, etc., in order to qualify for trade. The second type of rules refers to the definition how the object is traded. For example, the size of the trading lot, i.e.
the normal unit of trading, the settlement time and so forth, needs to be specified. Both rules together contain information about the object detached from the original object. What is really
103 In finance this conversion of assets such as loans into securities that may be traded is dubbed securitiza-tion.
exchanged in the market process is the information about the object, not the object itself.
Nonetheless, at the end of process the transfer of the (physical) objects is also processed.
The trading object definition is obviously part of the institution. By the possibility to define the trading object, the market firm has a powerful strategic instrument at hand to address or even to create a particular customer group. The trading object definition, thus, may answer the important question of “How do you define your market?” (Fennell and Allenby 2003b) that is subsequently being served. Clearly, there are many ways to define the trading object, which is essentially an information good. The market firm has principally four possibilities at hand:
• Describing existing resources
The market firm can simply issue a description of an existing resource either physical (e.g.
bushels of corn) or immaterial (stocks). This description standardizes the object, which is the prerequisite for double-sided markets, i.e. competition on the buyer and the seller side.
• (Re) Disassembling bundles
Actually re- and disassembling of bundles also refers to describing existing resources. The clue is, however, to attain new trading objects by assembling new bundles or split bundles into components (Kalagnanam and Parkes 2003). Assembling bundles of resources can virtually be the value-added of an electronic market, as the agents may demand only the bundle, but not the single components. For example, trading financial portfolios in one venue reduces the risk that the agent only receives part of the financial portfolio, which has less desirable properties.
Put it to an extreme, a special form of market firm – the so-called metamediary – aggre-gates bundles in the view of customer activities. Customer activities such as a car pur-chase can be extremely complex. When purchasing a car, the buyer may also be interested in insurance and financing. Offering all three goods in a bundle may satisfy the customer’s needs along his activity (Sawhney 1999b; Neumann, Holtmann et al. 2002b). If all three goods are offered on separate electronic markets, the metamediary can offer them in a bundle.
• Generic trading object definition
The market firm can also forgo the exact specification of the trading object. Instead the market firm can pass the definition over to the participating agents. In business-to-business electronic markets, the participating agents commonly conduct the trading object definition. This is especially the case if the resources are very heterogeneous (e.g. a ma-chine). The agents can either contract out a need or advertise a selling position.
• Defining exotic objects
Lastly the price of a market, which exhibits valuable information about the economic en-vironment, can become the trading object: Those new exotic objects are often giving rise to so-called speculative markets. These markets are in a sense speculative as they allow the participants to place a bet on future prices by buying or selling today in the hope to even up the trade with a profit in the future. The (electronic) market aggregates all the dis-persed private information among the agents into the price.104 Most innovative product de-signs are entwined around this information aggregation property of decentralized resource
104 Essentially everyone taking part in the market is invited to correct the current market price. Any trade shifts the current price closer to the conjectured future price. For example the current price for a share of stocks is worth € 10. Agent A believes the accurate price would be € 15. As such it is profitable for him to buy stocks for € 10. By his trade the current price goes up and is pushed closer to the conjectured price. As there are many agents with different beliefs the aggregated estimation of the stocks will even-tually emerge. Accordingly, the incentive for the agents to reveal their private information lies in price system (Hayek 1945; Hanson 2003).
allocation mechanisms, e.g. double auctions. As the price reflects all bets on beliefs and internal knowledge, the aggregated information revealed by the price can be product. All what the market firm has to do is to pool the information into a common tradable resource (Hanson 1999). Those common tradable resources could be estimates concerning tomor-row’s weather condition or future crime rates conditional on allowing hidden guns (see Example 3.1-8).
Example 3.1-8: Prediction Markets
Prediction markets are the prime example of innovative products. In these markets the value of the traded contracts depend on the future outcome. Accordingly, the price that will emerge yields an aggregated prediction about the outcome (Berg and Rietz 2003;
Spann and Skiera 2003). Prediction markets are currently almost “growing like weeds”.
The Athletic Stock Exchange trades virtual shares of an athlete. The price of the shares solely depends on demand and supply situation. Dividends on the shares are paid in direct proportion to an athlete's performance in relation to the rest of the athletes on the ex-change on a daily basis (Athletic Stock Market 2003). As such, the price of the shares re-flect an aggregated forecast of the performance of athletes.
The Foresight Exchange Prediction Market enables agents to set bets on a range of events, from the voting out of Californian Governor Gray Davis by October to the cure of cancer by 2010 (Foresight Exchange Prediction Market 2003).
The Chicago Mercantile Exchange trades weather derivatives. Here, weather predictions are also formed. However, by means of weather derivatives industries whose production or sale is dependent on the weather can hedge their risk of unfavorable weather condi-tions. For example, agricultural firms can hedge their risk of bad harvest due to bad weather. In summary, prediction markets have the ability to form aggregate predictions.
Those predictions or estimates can be used to hedge risks or to support decisions (Hanson 1999; Kambil and van Heck 2002).
In summary, the trading object definition denotes the institutional rules governing the admis-sible resources that can be traded over the electronic market. Not the object itself stands in the center of the market process, but the information about it: “While the transfer of physical goods may remain the end result of a business transaction, the information that shapes the transaction […] can now be separated and exchanged electronically” (Wise and Morrison 2000, 89).
3.1.2.3.2 Participation Rules
The microeconomic system framework assumes the number of agents to be part of the eco-nomic environment. That means they are simply there. However, this is a quite unrealistic assumption. Rather can the market firm decide, which agents to participate in the electronic market. Restricting the access to the electronic market has two partially contradicting effects.
On the one hand, restricting access exerts a positive effect on the electronic market as uncer-tainty can be significantly lessened. Unceruncer-tainty can occur on both sides, either on the sell or buy side. The vendor of a resource runs a risk that the corresponding partner fails to meet his obligation to pay. Likewise is the buyer at risk that the vendor is not providing the resource.
This so-called opportunistic default105 can be diminished – though not eliminated106 – by re-stricting the participants to confidential agents (DiMaggio and Louch 1998). For example,
105 Opportunistic default is an inherent risk in any transaction the other party in an agreement will default.
106 Elimination is only on the basis of the user selection not fully possible. At this point it is referred to the enforcement machinery, which will be addressed in chapter 3.1.2.3.6.
stock exchanges frequently admit only financial institutes for their trading arena. The degree of confidence can stem from many sources such as their assets, endowments or personal char-acteristics like past trading history. A related source of uncertainty is the quality of the ex-changed resource. Now, the buyer is in danger that the vendor duly delivers the resource, but the resource is of inadequate quality. This defective performance is often a concern in busi-ness-to-business markets and may prevent firms from participating in electronic markets.
Nonetheless, limited access can also alleviate this malpractice.
On the other hand, issuing participation rules also incurs negative effects. The negative effects stem also from restricting the number of agents. With the number of admitted agents is also the number of possible transaction possibilities107 associated: The more agents are participat-ing, the more likely it is that a corresponding offer at acceptable conditions exists. Pruning the number of potential participants accordingly decreases this probability. Similarly, auction design deems access to auctions as on of the issues “that really matters” (Klemperer 2002).
As restricted access reduces the number of bidders, it also reduces the degree of competition.
Less competition yields in lower allocative efficiency and also in lower revenues for the seller.
In summary, participation rules in general determine the number of participants, their charac-teristics and endowment, as well as the condition they facing entering the electronic market (Ostrom 1998).
3.1.2.3.3 Trading Rules
As previously mentioned, an electronic market embodies a resource allocation mechanism. As such, all the institutional rules that were defined throughout chapter 2.1.3 also apply to elec-tronic markets. Any resource allocation process needs accordingly a) a language to express their preferences or the strategies concealing their preferences, respectively, b) a choice rule that computes the allocation, c) a transfer rule that specifies the corresponding prices, and, d) adjustment process rules that determines under what circumstances which messages can be submitted, modified or withdrawn.
Those four rules are enough to define a resource allocation process. However, such a process is simply a one-time allocation. At a specific time offers are collected and only once the allo-cation and corresponding prices as outcomes are determined. In other words, the resource allocation process only accounts for a single, unrepeated, and from the rest of the world un-coupled process: The current owner of the resource must sell (or keep the resource), and that the buyer of a resource keeps the resource throughout his life (Gârleanu and Pedersen 2003).
In many situations, however, neither the sale decisions are exogenous nor are the buyers stuck together with the resource forever. Instead are sale decisions endogenous, they can depend for instance on the attainable price and on the alternatives. Furthermore, buyers can anticipate later resale, which changes the preferences (Haile 2003). For example, most financial securi-ties are often turned over many times before they mature.
Apart from the theoretical assumption of one-time allocation, the electronic market can offer sale and subsequent resale possibilities right away. In fact, electronic markets can embody more than one resource allocation process.
107 In financial literature, the number of transaction possibilities is subsumed under the concept of liquidity, which is introduced in chapter 3.1.3.
Example 3.1-9: Xetra trading rules - Stocks: An excerpt
The electronic market of the German Stock Exchange Xetra employs for their segment stocks the following trading rules as their skeleton. After the pre-trade phase, trading starts with a call double-auction in the morning. Subsequently commences the phase of continu-ous double auctions. The trading day ends with a closing call double-auction. During the day around noun the continuous double-auction is halted and another call double-auction is performed.
Example 3.1-9 epitomizes a trading structure that consists of many resource allocation proc-esses that are arranged in a sequence. That is an electronic market embodies not only a single, but also multiple resource allocation processes in an array.
Time
Messages
Message Exchange AD
Phase PD
AD = Allocation determination PD = Price determination
Process Transition rules
Opening Auction Intermediate
Auctions Closing
Auctions
Messages Messages
PD AD PD AD
Message Exchange
Phase PD
AD
PD AD PD AD PD AD PD AD
PD AD PD AD Message
Exchange Phase
Message Exchange Phase
Message Exchange Phase Message
Exchange Phase
Figure 6: A stylized Electronic Market Process
Figure 6 illustrates the sequencing of four different resource allocation processes, where the single processes are symbolized by their anatomy108. Note that the two middle processes are not sequentially but simultaneous taking place. Nonetheless, the electronic market process defined as the array of resource allocation processes often consists of many more processes.
For example, a continuous double auction allocates corresponding buy and sell offers right away. As the allocation and pricing closes the resource allocation process, a continuous dou-ble auction consists of several distinct resource allocation processes.
Apparently, electronic markets embody multiple resource allocation processes. This, however, creates the need for a fifth type of rules that was not covered by the microeconomic system framework, the process transition rules. The process transition rules basically state the condi-tions how the sequencing of different processes is governed. Accordingly, the process transi-tion rules can be seen as an overlay over the remaining trading rules. As such, they determine how the opening and closing rules of a resource allocation process can be set. The main dif-ference between process transition rules and the other trading rules is the scope. While proc-ess transition rules are concerned with inter-procproc-ess issues the other trading rules govern the intra- process issues.
Comprising, the trading rules can be defined as follows:
108 The anatomy of a resource allocation process can be looked up at Figure 3.
Definition 11: Trading Rules
The trading rules determine the languages, the choice and transfer rules, the adjustment process rules and process transition rules.
The introduction of an electronic market process as a composite of several resource allocation processes has two major ramifications.
• Firstly, the electronic markets are not independent one-shot events but embedded in an array of multiple resource allocation processes. That also means that the agents’ strategies are not only dependent on the current allocation process but also on previous and future processes. Experiences that the agents gain along the process and expectations concerning upcoming processes can be used in the actual resource allocation process. Jehiel and Moldovanu nicely describe it as follows:
“If the auction’s allocation influences the equilibrium of an ensuing interaction, bidders will take this effect into account at the bidding stage. Thus, the channel of influence be-tween auction and future interaction goes both ways: the auction’s outcome through the resulting allocation of assets, and the future interaction influences the auction’s outcome through the participants’ expectations about their payoffs in various future constella-tions” (Jehiel and Moldovanu 2003, 281).
There are several problems involved with the effect that previous and future processes have on the current process. The bidding strategy of the agents not only depends on the current process but also on the expectations what will happen in the post-process phase.
Furthermore, the agents incorporate their previous experiences in their strategy formation.
This may, however, entail that a process can have several equilibria with different alloca-tions (Jehiel and Moldovanu 2003). Apparently, the outcomes of the processes are diffi-cult to predict, making the design of trading rules extremely diffidiffi-cult. This may explain why endogenous sale decisions and resale motives have received only little attention in literature although both topics are important in practice (Gârleanu and Pedersen 2003).
• Secondly, the resource allocation processes are not arranged one at a time but simultane-ous. That means it can happen that the same resource is offered in two different processes.
This competition of mechanisms raises the complexity of the bidders’ deliberation about the strategy. The reason stems from the fact that the bidder has to decide in which process to participate (Peters and Severinov 1997; Peters 1999). The theory of competing mecha-nisms that is tackling those problems is currently in its infancy.
In summary, extending the trading rules to cover an array of sequentially or simultaneously occurring resource allocation processes has two major effects on the bidding strategy. Firstly, previous and future processes will also affect actual bidding behavior. Secondly, participating agents have a choice among alternatives. Competition of mechanisms may also change the bidding strategy compared to one at a time mechanisms.
3.1.2.3.4 Media Rules
From an incentival point of view, a resource allocation process is expressed by a mechanism.
The term mechanism appears to be apt, as “it conveys the image of a device constraining and guiding the choices that individuals make” (Kiser 1980, 1). Participants in the mechanism are shown what behavior is feasible and, furthermore, with which behavior of the other participat-ing agents they most likely have to deal. From an informational point of view, a resource allo-cation process is considered as a huge information processing system. Information is transmit-ted, i.e. communicatransmit-ted, between the agents and processed by them through computations,
which result in decisions (Hurwicz 1997). And exactly here is where the concept of media steps in. Basically, the media denotes the abstract platform through which information is transmitted and processed. The notion of media was introduced by Schmid and basically comprises three distinct components (Schmid 1997):
1. Channels
A media naturally provides a system of connections between the agents that actually fa-cilitates the transport of messages. Those connections denote a channel. A channel must hence be capable to firstly support the information to be transmitted and secondly to con-vey those over time and geographical distances. An example of a communication channel is face-to-face or the Internet.
2. Logic
Channels are not sufficient for media, because a common logic between transmitter and receiver is necessary. Hence, media requires syntax that allows coding and decoding of messages. Beside the syntax successful communication requires semantics, such that transmitter and receiver can similarly interpret the language of the messages.
3. Processes
Having pinpointed the channels and the language, a media also requires working rules to determine how process with coded information.109
In the words of Marschak it is a communication engineer, who is responsible for the media, as he constructs “channels for the fast and reliable transmission of signals. He is therefore in-terested in devising appropriate codes which translates ordinary English into signals and signals into English” (Marschak 1968, 10). Similar to Schmid’s media concept Marschak identifies three components for communication a channel, translation logic, and a code for processing. With those three components the media, i.e. the infrastructure, that underlies the market process, can be adequately framed.110 Different media impose different restrictions on the market process. For instance, an electronic media can process information, say bids, faster than a non-electronic market. Then, there is a direct link on the behavior, as the agents may place bids at an earlier time. This time advantage may open up the possibility for new superior strategies: Say an agent is interested in one good that is offered in two different auctions. Both auctions take place at the same time at different places. Non-electronic media thus makes a simultaneous bidding strategy infeasible, whereas electronic media permits such a strategy. In any strategy where time matters, e.g. arbitrage strategies, media rules – defined as the institu-tional rule imputed by the media111 – are the binding institutional rules.
The concept of media is apparently a very abstract description of the underlying infrastruc-ture. Media rules are those institutional rules derived from the used media. As such, media rules capture a variety of issues that can due to the space limitations not exhaustively be dis-cussed. Five important issues that are frequently mentioned in literature are presented in the following.
Information carrying Capacity
Media rules further affect the agent behavior by the capacity limitations of the channel. In-formation carrying capacity of the channel governs to which extent messages can be sent to the receiver at a time, i.e. the bandwidth can be limited. Especially in peak loads limited bandwidth can become the crucial factor. Messages are then delayed although the trading
109 As mentioned in Schmid the definition of processes also presupposes a system of roles (Schmid 1997).
110 Schmid even extends the concept of media to all types of communities either at an operational or an in-terplant level (Schmid 1997; Klose and Lechner 1999).
111 It is also possible to call the media institution-substitute.