Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE). He also maintains the economics blog Worthwhile Canadian Initiative.
Economists spend a lot of time thinking about markets, but most of our attention is usually focused on things like prices, quantities and the factors that determine them. Most of us – at least, most of us who don’t specialise in the field of industrial organisation – don’t spend much time thinking about the mechanics of how buyers and sellers meet in the first place. It turns out that the economics behind the proposed merger of the TMX and the LSE stock exchanges are non-standard and interesting.
The actual business of stock markets is costly: organizing the matches between buyers and sellers and making sure that everyone has access to the information necessary to make informed decisions requires specialised skills and infrastructure. Stock markets cover these costs from the fees it charges firms that list their shares and from brokers who buy and sell them on behalf of their clients.
This structure – soliciting business from both firms and traders – makes stock markets an example of a two-sided market in which network effects play a crucial role. A stock market with many listed firms will attract brokers, and one with many brokers will attract firms willing to list their shares.
Before the development of modern communications technology, there were physical limits to how big a stock market could be: too many traders and/or too many listed firms led to chaos [insert wry comment here]. These days, brokers have access to a large number of prices bid and asked in real time, and they don’t have to be on the premises to make a trade. As a result, stock markets face increasing returns to scale: the bigger you are, the more attractive you are to both firms and brokers.
Those increasing returns are behind the TSX-LSE merger proposal as well as that of Deutsche Boerse and NYSE Euronext. Nationalist sentiment aside, it’s hard to see the downside of a TMX-LSE merger. Canadian firms seeking capital will benefit from a deeper pool of investors, and Canadian investors seeking returns will benefit from the broader choice offered by the merged stock exchange.
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