Electronic Markets

Electronic Markets

Markets are a fundamental feature of modern capitalism and have a long history behind them. During the Middle Ages in England, for example, fairs and markets were organized by individuals under a franchise from the king. Organizers of these markets not only provided the physical facilities for the markets, but were also responsible for security and settlement of disputes in the trading. Throughout history, some traditional markets have diminished in importance while new ones have gained in importance. For example, stock and commodities markets, previously not significant, now play a vital role in the world economy. Regardless of changes, the fundamental functions of markets remain the same: to match buyers and sellers, enforce contracts, and provide a price mechanism to guide the trade.

Electronic markets are markets connected through modern communications networks and powered by high-speed computers. In an electronic marketplace, buyers and sellers do not have to be in the same physical location in order to interact. A classic example of electronic markets is the Nasdaq stock market. Nasdaq was launched in the 1970s, long before the widespread use of the Internet, and it does not have an exchange floor. Essentially, Nasdaq is a huge electronic network connecting investors, brokers, and dealers, allowing various parties to exchange information and buy and sell securities. With the explosive development of the Internet, electronic markets will play a more important role in people's everyday lives. The World Wide Web has become the universal interface for electronic markets. People can use the web to access various electronic markets virtually from anywhere at any time. Ordinary investors can use the Internet to conduct online trading through online brokerage firms, and customers can bid for various products at online auction houses such as eBay.

Consider the development of electronic markets in the financial world. In just a few years, online trading has fundamentally changed the dynamics of investment. Before the advent of web-based technologies, an investor who wanted to place an order with a broker had to either walk to the local office of the broker or call by phone. Then, some time later, a second call was necessary to get a confirmation of the transaction. As of 2002, a growing number of brokerage firms offer Internet-based services that contrast sharply with the traditional scenario. Online investors can log onto the web site of the brokerage firm using a web browser. The following are some of the typical functions of the online trading application offered by most online brokers to investors:

• Place buy and sell orders and receive electronic confirmations as soon as the order is executed;
• Check account balances;
• Receive real-time price updates;
• View historic account activities;
• Track the portfolio performance on a real-time basis.

Online trading is not only flexible and easy to use, it also incurs lower costs. Online brokerage firms are able to charge customers lower commission fees since they no longer have to employ a large staff to field phone calls from customers. The savings in overhead costs from replacing human brokers with Internet-based communication systems are passed on to investors in the form of lower fees.

The popularity of online trading has resulted in a new category of traders known as day traders. Some individual investors use online brokers to make dozens of trades per day, many times on the same security. Even though day trading can be profitable, it involves high risks and has significant tax issues to day traders. While all the trading gains are subject to federal income tax, investors can only claim a loss of a maximum of $3,000 per year.

New Avenues

Electronic markets have had an impact that reaches far beyond the financial world. Entrepreneurs have created new markets to better match buyers and sellers, and they have also introduced innovative products for trading. Two examples, eBay and the catastrophe insurance market, illustrate such recent developments.

eBay.

eBay is the world's leading online person-to-person auction market. Individual buyers and sellers can register at eBay and exchange products and services. Founded in 1995, eBay had more than 29 million registered users in 2001, and many businesses use eBay to sell their products as well. eBay has created a worldwide central marketplace that lists millions of items such as computers, antiques, coins, and furniture. Such a large-scale market has never existed before, and without the Internet, it would have been impossible to create such a market.

Although there are several other auction sites on the Internet, eBay is by far the most successful. Since the beginning, eBay tried to be the dominant player in the online market environment. It has taken full advantage of the network effect in electronic markets. Without geographical barriers in the Internet, buyers and sellers would like to visit the dominant market because it is the place where sellers will find the most buyers and buyers will find the most sellers. The network effect is simple: more buyers and sellers will attract even more buyers and sellers to the same market. By providing a central marketplace, eBay has lowered the costs of trading for millions of buyers and sellers.

Catastrophe Insurance.

Another successful online offering is the catastrophe insurance market, showing how electronic markets can bring innovative products for trading and fundamentally change the way existing companies do businesses. Risk and insurance are integral parts of modern-day life. Insurance companies provide protection against loss in value of human capital, physical property, and financial assets. However, almost any insurance company is limited in the amount of insurance it can write on any one risk. The law of averages makes it safer to insure a large number of small risks than to insure a few large risks. For example, a catastrophe as big as Hurricane Andrew, which devastated Florida in 1992, can easily bankrupt an insurance company. Therefore, insurance companies have to seek ways to reduce large risks.

A catastrophe insurance market tries to share risks between insurance companies and other institutions. Risk is the product that is traded in a catastrophe market. The process to convert risks to tradable products is called securitization, which transforms illiquid assets into liquid financial securities in a financial market. Securitizing insurance risk enables institutions and individuals who are not in the insurance business to participate in the insurance market. Currently, the products that are openly traded include Cat (catastrophe) bonds and Cat options.

The Catastrophe Risk Exchange (CATEX) is a New Jersey-based electronic market that allows property and casualty insurers, reinsurers, and brokers to swap or trade risk exposure to natural disasters. Developed in reaction to events such as Hurricane Andrew and the Northridge Earthquake, the exchange is designed to allow insurers to protect themselves against severe losses by geographically distributing risk and diversifying across different perils through an electronic marketplace. Trading operations on CATEX started in 1996. In 1998 CATEX was launched over the Internet. Meanwhile, CATEX began evolving from the initial swap exchange to a more complete insurance market, which supported the reinsurance transactions of marine, energy, and political risk.

Growth of Electronic Banking

Rapid growth in electronic market applications requires a secure and efficient electronic banking and payment services. If one buys shares of a company listed on a stock exchange, she has to send in her payment within three days of the date of purchase. She can either send a check by express mail or make a bank transfer. Both options are relatively expensive. Many brokers require that she maintain sufficient funds with them to cover the cost of any such purchase, but there can be situations when she would prefer not to leave money sitting idle in her brokerage account. Payment systems that allow the investor to make payments directly out of her bank account would be far superior in a number of ways.

Individuals can have better control over the movement of cash in and out of their accounts. Today's check-based systems are also considerably more expensive than most electronic payment systems under development. Though many banks do not directly charge customers for use of checks, they do recover it in other ways, typically by paying low interest rates on checking accounts. Safer and more efficient payment systems such as digital check, digital wallets, or electronic money are still in the experimental stage. The bottom line is that the trend is toward electronic payment and real-time settlement of transactions. Electronic payment systems being designed for electronic markets will allow transactions to be settled on a real-time basis as soon as the transaction is executed, or at least on the same day. Faster settlement will lower the risks of default by the counter-party in the transaction.

see also E-banking; Internet: Applications; World Wide Web.

Ming Fan

Bibliography

Fan, Ming, et al. Electronic Commerce and the Revolution in Financial Markets. Stamford, CT: Thomson Learning, 2002.

Fan, Ming, Jan Stallaert, and Andrew B. Whinston. "The Internet and the Future of Financial Markets." Communications of the ACM 43, no. 11 (2000): 83-88.

North, Douglass C. Institutions, Institutional Change, and Economic Performance. Cambridge: Cambridge University Press, 1990.