March 12, 2021

Bringing financial markets together

Securities are typically traded separately from one another. Would it be better to combine those transactions?

A paper in the American Economic Journal: Microeconomics examines the effects of connecting disconnected financial markets.

Bigstock/Chris Fleisher

As recently as a decade ago, a kind of organized chaos still reigned in New York and Chicago trading pits. 

Stocks were swapped in an elaborate exchange of hand signals and yelling between frantic traders on a floor, just as they’d been doing for more than a century and a half.

Computers changed that. The action moved to digital exchanges that were infinitely more efficient, but some things remained the same. Securities were still mostly traded in isolation—the prices set by what an individual bond or stock could fetch from a buyer rather than what someone might pay if they were bundled together.

Milena Wittwer wondered whether everyone would be better off if these disconnected markets were somehow linked. 

“In financial markets you typically don't see this kind of connection,” Wittwer, a PhD candidate at Stanford, told the AEA. “This is weird because you would expect that many traders have preferences over different securities.”

Wittwer’s paper in the American Economic Journal: Microeconomics considers whether connecting financial markets would be more efficient. Would connecting orders for one security to the price movement of other securities improve financial markets, or was there some reason to keep them separate?

Her research underscores the importance of market design. In a connected market, participants are allowed to make the demand for one good contingent on the price of another good; traders are allowed to ask for packages of goods.

Imagine, for example, walking into a supermarket to buy ingredients for a cake. The price of each item isn’t going to change based on what’s in your basket. You’d pay $3.59 per gallon of milk regardless of how much the eggs and flour cost. 

Now imagine that you were able to connect the market for these goods by bundling them together for a single price. As a consumer, this would allow you to better communicate your preferences to the seller. You’d be saying, “I’m baking a cake and the value of these ingredients to me is interconnected. The flour’s value is related to also having the eggs. Therefore, I’d like to set a price for this bundle of goods.” Perhaps the seller would offer you a better deal.

Financial markets, of course, are much more complicated than grocery stores, but it’s still technically possible to connect them. The Federal Communications Commission auctions broadcasting licenses in bundles in a tremendously complicated connected market. (For more on how FCC auctions work, watch the video by PBS below.)



It’s also possible to trade sovereign bonds at the same time, and sometimes on the same platform. However, it’s not common to interlink the demand for a German bond and a French one, so that the price for one directly affects the other.

Wittwer wondered whether there were scenarios in which it would improve overall efficiency and welfare to link them. She modeled the effects and found the answer depended on three factors—price correlation, the size of the market, and whether traders had enough leverage to impact price. 

Price correlation turned out to be key. Imagine trading government bonds, such as Treasury bills. The market for 3-month T bills and 6-month T bills is disconnected, yet the prices for each move up or down nearly in lockstep together. 

“If the prices of the different securities are perfectly correlated, then it doesn't matter if the markets are connected or disconnected,” Wittwer said. “We end up with the same allocation. We have the same level of efficiency and we don't need any type of market intervention to connect the markets.”

The second factor that mattered was market size. Unless the prices for two goods were perfectly correlated, the only way that both a connected and disconnected market would achieve the same result is if the market got so big that everybody became a “price-taker.” One person can’t walk into a large supermarket and expect to negotiate a lower price for milk. 

But if individual traders had more leverage to affect prices, like in a smaller market, then the market would be more likely to have different clearing prices for the same goods. That would result in different quantities traded.

That is not to say one market design is better than the other. But Wittwer wanted to examine the winners and losers from combining disconnected markets. In theory, connected markets could be the most efficient. By design, they make it easier for buyers and sellers to be clear about what they want. It would give them more options to make different types of trades, which increases efficiency.

But it doesn’t always work out that way. Having a “more expressive bidding language” in a connected market makes it easier for strategic traders to take advantage of less sophisticated investors. That, in turn, opens up the possibility for them to manipulate the price and quantity of goods sold, leaving some people worse off. 

Connecting Disconnected Financial Markets?” appears in the February issue of the American Economic Journal: Microeconomics.