The Quest for Monopoly

This week in Napkin Math we have something special: a guest post from Marc Rubinstein of Net Interest. Net Interest is a weekly newsletter covering the financial sector and Marc is a former hedge fund manager with over 25 years of experience in and around banks and the financial sector. I think you’ll enjoy this post and highly recommend you check out his newsletter.

A few weeks ago the CEOs of the four large tech companies - Facebook, Apple, Amazon and Google - sat in front of Congress to testify. They’d been summoned to a hearing to address the issue of online platforms and market power. It was a big event. For over three hours the four men faced a grilling from legislators over their market dominance. The chair of the subcommittee overseeing the hearing set the tone:

“American democracy has always been at war against monopoly power.”

Over the course of the proceedings various analogies were thrown out there—Rockefeller’s oil empire, the railroads, Microsoft. One that didn’t receive much attention was the stock exchange. Which is ironic because while the men were speaking, billions of dollars of their stock was trading hands on a platform subject to its own monopoly scrutiny.

The stock exchange analogy is an interesting one because it highlights the fluid nature of monopoly structures. What started as a fragmented industry over two hundred years ago - first monopolised, then fragmented again - has monopolised once more. At every turn policymakers have sought to influence the outcome but consequences have not always been as anticipated.

This piece looks at how to sustain a monopoly, through the lens of the New York Stock Exchange.

From Fragmentation to Monopoly

Stock exchanges operate as simple two-sided platforms, matching buyers and sellers. Like other platforms, they benefit from network effects. The more people that transact, the greater the value of the platform to others. As traders say, “liquidity begets liquidity”. 

In the days before electronic communications, it took a while to realise this benefit. In the first half of the nineteenth century, securities trading was largely local; most large cities had their own exchange. The first stock exchange in America was in Philadelphia and although New York had a slight edge as a bigger centre of trade, there wasn’t that much between them.

As technology improved in the second half of the century, that slight edge compounded. Telegraphy broadened New York’s reach and major companies in Boston, Philadelphia and elsewhere increasingly wanted to list there. Trading gravitated to New York and by the end of the nineteenth century about two thirds of all domestic stock trading took place on the New York Stock Exchange. Philadelphia was left in the dust, with a 3.5% share. 

For the next 100 years the New York Stock Exchange maintained its dominant position.

There are many ways to sustain a monopoly—network effects, economies of scale, proprietary technology, branding, government license. The New York Stock Exchange flaunted most of them. Network effects started things off, but economies of scale kept the wheels spinning. As it grew, the exchange was able to spread its fixed costs over more and more trading volumes. Until technology costs dropped, few others could afford the US$2 billion that NYSE spent on new technologies over the 1990s.

And as for branding—there’s nothing more iconic in finance than the sight and sound of the opening bell being rung on the floor of the New York Stock Exchange.

These characteristics allowed the exchange to become quite profitable. It made money by taking a small fee on every trade. In the mid 2000’s it clipped around nine cents for itself on every share traded. It was owned by its members — customers who used the exchange — and so profit maximisation wasn’t central to its existence. But those clippings were enough for it to make a generous return on capital and pay its CEO even more generous sums. (A controversy erupted in 2003 when CEO Richard Grasso was revealed to have been paid US$140 million.)

Yet the world never stands still and beneath its foundations the sands of Wall Street were shifting.

From Monopoly to Fragmentation

Over the 1980’s and 1990’s, the customer base of the New York Stock Exchange had begun to consolidate. Once a ragbag of small partnership firms, customers incorporated and merged into a smaller number of stronger firms. This was reflected in the membership structure of the exchange. In 1955, second-tier firms had an aggregate capitalization equal to about 80% of the capital maintained by the top 10. By 2000, this ratio had declined to less than 10%. The flipside is that power became concentrated in the hands of a few large firms—firms like Merrill Lynch, Morgan Stanley and Goldman Sachs. 

[Source]

At the same time, technology lowered the cost of establishing new, electronic venues on which to trade. Goldman Sachs for one had been spending billions on technology and by the end of the 1990’s had more than 20,000 personal computers backed by eighty trillion bytes of storage. Its size also meant that it sat on a much bigger share of trading flow than any small partnership would have had in 1955. Why pass that on to the stock exchange? Goldman could simply match buyers and sellers internally among this vast flow and avoid paying fees to the exchange.

Exploiting cheaper, faster technology, a number of alternative exchanges began to crop up. In the summer of 1999 electronic trading experts at Goldman Sachs met with the founder of one of these start-up exchanges, a company called Archipelago:

Duncan Niederauer [a fast-rising star at Goldman]… stepped to the front of the conference room and picked up a dry-erase Magic Marker. After a few introductory words, he walked to a whiteboard, wrote “NYSE,” and drew a circle around it.