COMPETITION AMONG EXCHANGES* TANO SANTOS AND JOSE´ A. SCHEINKMAN Doescompetition among nancialintermediaries lead to excessively low standards?To examine this question, we construct amodelwhere intermediaries designcontracts toattract tradingvolume, taking intoconsideration that traders differin credit qualityand may default. When credit qualityis observable,inter- mediariesdemand the “ right”amount of guarantees.A monopolistwould demand fewerguarantees. Private information about credit qualityhas an ambiguous effectin a competitiveenvironment. When the cost of default is large (small), privateinformation leads to higher (lower) standards. We exhibitexamples where privateinformation is present and competition produces higher standards than monopolydoes. I. INTRODUCTION In spite ofthegeneral acceptance of the competitive mecha- nismas an allocationscheme, many observers consider nancial intermediationan exception.Competition is thoughtto lead toa “raceto the bottom” in which nancial intermediariessettle for excessivelylow levels of contractualguarantees in anattemptto increasevolume. Evaluating futuresexchanges, a jointreport fromthe Treasury and theFederal Reserve Board, writtenin the wakeof the1987 crash,states that “[T]hereis sufcient possibil- ity that at somepoint SROs [Self RegulatoryOrganizations] mightestablish marginsthat wereinconsistent enough to present marketproblems or setthem at levelsthat mightpresent poten- tial coststo other parties that regulatoryapproval should be established in all markets.”1 In this paper weexaminethe characteristics of thecompeti- tiveequilibrium in amodelof nancial intermediation,where tradersmay default and differ intheircredit quality. In particu- lar,we investigate whether competition among exchanges leads toexcessively low standards. In ourmodel, investors’ endowments have observable and *Wethank Fernando Alvarez, Ulf Axelson, Alberto Bisin, Marcio Garcia, ChristopherCulp, Douglas Diamond, Luis Garicano, Mark Garmaise,Claudio Haddad,Robert Litterman, Robert Litzemberger, Merton Miller, Kazuhiko Ohashi, CanicePrendergast, Adriano Rampini, David Robinson, Gideon Saar, Carol Si- mons,James Stoker, SureshSundaresan, Kip Testwuide,and Luigi Zingales for helpfulremarks. Andreia Eisfeldt and Christopher Hennessy provided excellent researchassistance. This research was supported by grant SBR-9601920from the NationalScience Foundation. The current versiongreatly bene ted from detailed writtencomments by Edward Glaeserand three referees. 1.This quote is taken from Gammill [1988]. © 2001by thePresident and Fellowsof Harvard Collegeand theMassachusetts Institute of Technology. The Quarterly Journal ofEconomics, August 2001 1027 1028 QUARTERLY JOURNALOF ECONOMICS unobservablerisks. The observable risk averages out across agents,and hencecan potentially behedged. In addition, each agenthas asmallprobability ofan unobservablenegative idio- syncraticshock. We call traderswho have a lower(higher) prob- ability ofan adverseidiosyncratic shock high (respectively,low) quality traders.These different probabilities mayresult from otherrisks already assumedby thetraders, which are left outside themodel. Traders’ quality maybe observable or hidden private information.When traders default, societyimposes a nonpecuni- ary punishmentproportional to the amount defaulted. Potentialexchanges compete by settingcollateral require- mentsand assetpayoffs. An exchange’s prot depends onthe payoffs promised,and onthedefaults that occur.To simplify the analysis, wepostulate that eachexchange issues a singlecon- tract,and eachagent must trade in asingleexchange. However, investorsare allowed totake any longor short position, and exchangesdemand marginsthat areproportional to the absolute sizeof positions. Whenquality is observable,competition among nancial in- termediariesleads toa (constrained) optimal amountof contrac- tual guarantees.Here, our results formalize the intuition of Telser[1981] and Miller[1988], whoargue that futuresex- changeschoose margin requirements to balancethe reduced risk fromdefault against thehigher costs brought by theextra degree ofprotection. In contrast,a monopolistwould demand fewer contractualguarantees. This follows because a monopolist’s pric- ing policyinduces traders to take smaller positions. As aresult, theex post incentivesto default arelower, and this allows the monopolistto economize collateral. Westudy theeffect of theunobservability of atrader’s qual- ity onthe competitive equilibrium, and showthat this effect depends onthe level of the exogenous bankruptcy penalties. Whenthese penalties are high, if quality isobservable,low qual- ity tradersprefer the terms offered to the high quality traders.As aresult,when qualities arenot observable, the higher quality tradersface a highercollateral level than theywould if quality was observable,while the low quality tradersface exactly the sameterms that theywould faceif quality was observable.Here collateralis beingused as ascreeningdevice, and private infor- mationabout quality generatesstandards that aretoo high rela- tiveto the observable quality case.On theother hand, if the exogenouspenalties are low, the high quality agentsprefer the COMPETITION AMONG EXCHANGES 1029 termsof trade offeredto the low quality tradersin theequilib- riumwith observablequalities. As aresult,in theequilibrium with private informationabout qualities, the lower quality trad- ersface a lowercollateral level than theywould in thecompeti- tiveallocation under observable qualities, while the high quality tradersface exactly the same terms that theywould faceif qual- itieswere observable. In this case,the presence of private infor- mationresults in alowerstandard. Forintermediate levels of penalties,the equilibrium with observablequalities survivesthe presenceof private information,and thereis nodeparture from theconstrained optimality. Whencredit quality is notobservable, it is moredif cult to comparethe behavior of amonopolistwith acompetitiveequilib- rium,because a monopolistmust take into account the effect that achangein acontract’s termshas onthe demand forany other contractthat heis simultaneouslyoffering. Nonetheless, as we arguein SectionIV, thereare many cases where it is possibleto establish that amonopolistwill demand fewercontractual guar- anteesthan would prevail undercompetition. Todiscuss theimpact ofliquidity in asimpleframework, we postulatethat thereis axed costto operate an exchange.These xed costsassure that, ceteris paribus, exchangeswith more participants can offerbetter terms. These better terms can be thoughtof as ameasureof liquidity. Weshow that when xed costsare present and competitionprevails, agents of onequality maybene t fromthe establishment of minimum collateral re- quirementsby aregulator,at theexpense of agents of the other quality, evenif theseminimum collateral requirements are bind- ing forall qualities.The agents who pro t fromthe establishment ofthesetougher standards areexactly those who, in theabsence ofregulation,choose to trade in theexchange with highercollat- eral.Hence, this modelprovides a candidate positivetheory to explain thefrequent demands by moreestablished exchangesfor commonstandards in nancial markets. In ourmodel, collateral is deposited as aperformancebond against contractualobligations. The margin requirement speci- esthe collateral required. This is motivatedby therole that marginsplay in futuresmarkets. Although many of ourmodeling choicesare inspired by thecharacteristics of futuresmarkets, we believethat ourapproach canbe used tounderstand thebehavior ofother nancial intermediaries.While our model is necessarily special,we argue that manyof the conclusions would survive 1030 QUARTERLY JOURNALOF ECONOMICS different specications and highlight,throughout the paper, the economicforces that drivethe conclusions. Wealso have a moreabstract motivationfor this paper— incorporatingquestions of credit quality intothe literature on securitydesign. 2 Thisliterature examines the characteristics of securitieswhen market imperfections prevent the existence of a completeset of securities. Frequently, costs of issuing securities areassumed exogenously. If asymmetricinformation is treated,it is typically assumedthat thedesigner of thesecurity has private information.Our contribution is toanalyze asituationin which securitiesare competitively designed by intermediaries,and wherethese intermediaries must consider the characteristics of theagents that theyattract. Theremainder of the paper is structuredas follows:in the nextsection we present an overviewof some of the evidence on competitionamong exchanges. Section III containsthe model and amoredetailed defenseof the assumptions. In SectionIV we presentresults for the case of no xed costs.The fth section looksat theproblem of liquidity, and SectionVI containsthe conclusions.All proofsare found in theAppendix. II. SOME EXAMPLES In this sectionwe discuss someof the evidence that motivates ourmodeling choices. A.Collateral Is Costly Whenan exchangechooses higher margins, it lowersex- pectedlosses from defaults, but increasesthe costs of trading. Facedwith highercollateral requirements, some traders will opt totrade elsewhere,others will simply trade less.As aconse- quence,the exchange becomes less liquid and losesrevenues. Hardouvelisand Kim[1995] studied theimpact ofmargin changeson volume.They examined eight metal futures contracts fromthe early 1970s toOctober 1990 —asamplethat contains over500 marginchanges. For each margin change, they con- structeda benchmarkgroup