A Simplified Look at Electronic Communication Networks
When looking at network models of markets with intermediaries, one real-life example that quickly comes to mind is the financial market. Many of the assets available in the overall financial market, such as stocks and currencies, have historically been traded between two counterparties with the help of an intermediary (a trader). This model is not new by any means, but in recent years the financial services industry has innovated in the way it trades many securities.
I would like to take a look at the trade of assets, such as stocks and currencies, through electronic communication networks (ECNs). ECNs are “electronic trading systems that automatically match buy and sell orders at specified prices.” These ECNs are valuable trading tools since they are capable of increasing competition between traders, and lowering transaction costs for buyers and sellers. The only ones that can allow these trades to go through, however, are institutional traders (broker-dealers, market makers, etc.). For individuals to use this tool, they need have an account with one of these institutional traders.
Note that if a buyer wants to purchase a security but there is no equivalent offer in the ECN, the tool will not execute the transaction until an equivalent offer shows up. Thus, this network offers an equilibrium between bids and asks. The traders, or intermediaries, are not making bids to sellers or asks to buyers – meaning there is no spread. With ECNs, the market for traded securities becomes similar to the network model with intermediaries under perfect competition.
However, there is one catch: the institutional traders do in fact make a profit with these trades, despite the transactions generating no spread. Since individual investors need these traders to access the ECNs, the traders then have the opportunity of charging a small fee for the use of their network. That way, the institutional traders can make a profit while offering buyers and sellers a market under perfect competition with a large amount of liquidity. Here is what this entire network would look like:
The dark lines represent the direct link – all trades occur between the ECN, buyers and sellers. The dashed links represent the indirect connections buyers and sellers have with institutional traders. The values displayed under each counterparty represent the price of the security they either want to purchase or sell. As the figure shows, the ECN is able to match buyers and sellers perfectly – like in the case of perfect competition. The link with the traders represent the medium through which investors have to go through to use the ECN, as well as the stream of fees the traders collect for each transaction the investors perform. This simplified analysis shows how the most basic network models with intermediaries are still very useful when trying to analyze real-life transactions involving buyers, sellers and traders.