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The Handbook of Market Design. 2013. Nir Vulkan, Alvin E. Roth, and Zvika Neeman.
Reviewed by Mark S. Rzepczynski
This handbook provides an insightful set of articles on the impact of economics and game theory on the development of structures to solve market design problems. Bringing together the latest research in this growing field, the editors provide a detailed overview on how market mechanisms can be used to solve problems of matching and exchange. By describing unique market designs not looked at by financial professionals, it offers a different perspective on solutions to exchange-trading problems.
The broad topic of design, in disciplines ranging from marketing to finance, is currently a “hot” area of interest in business schools. It has also become a critical issue in microeconomics. The microstructure through which buyers and sellers can meet and agree on a price or a match to clear a market has drawn increasing interest as a means of solving real-world problems. Auction mechanics and trading structures have been studied in a host of applications that include running eBay sales, matching kidney donors with those in need, selling bandwidth, and selling distressed assets. The controversies surrounding high-frequency trading in equities are in essence one more subject for research on and discussion of market design.
Market design will be an even more critical issue for finance in the coming years. Trading is being pushed onto exchanges and away from the over-the-counter matching of buyers and sellers through brokers and dealers. At the same time, market liquidity is being fragmented through different pooling mechanisms that increase market complexity. Immediate liquidity may simply not exist for all these markets, nor will there necessarily be simple mechanisms for getting trades done in all cases. An exchange structure may not be the solution for all trading problems in finance.
There are also a number of problems involving the determination of prices at the close, for fixes, and through auctions. Think of the current controversies with LIBOR pricing, foreign exchange closes, and even the gold fix as just the tip of the iceberg of challenges in setting or determining a fair market price. All the current issues of market manipulation and clearing involve market design.
How access is achieved and markets are cleared cannot be taken for granted by either exchange participants or regulators. The rules of any trading game matter and create winners and losers. Nir Vulkan of Saïd Business School at the University of Oxford, Alvin E. Roth of Stanford University, and Zvika Neeman, visiting professor at Yale University, set out to address this vital subject from a broad perspective.
Their efforts have resulted in a handbook on the topic with contributions from some of the leading minds in the field. It highlights the plethora of research outside of finance that should prove insightful for those who focus on the mechanics of the capital markets industry. The book is exceedingly relevant for the future of trading structures and should stimulate readers to think beyond the current norms of finance.
The Handbook of Market Design consists of a series of articles that cover a number of real-world market design problems. Through detailed explanations and modeling, the authors demonstrate how certain design problems can be solved by careful rule making.
The book begins by recounting what economists have learned about market design over the last decade. During that period, the topic has exploded with new work and insights. The editors also provide a short review of auction theory, which is the foundation for all market design. Alvin E. Roth, the author of this introduction, identifies three principles or characteristics that all good market designs should exhibit — thickness, congestion, and safety. Internalizing these three concepts is the key to thinking about sound market design.
Thickness is the ability to attract a significant portion of potential participants to transact in a market. It is associated with the network economies that are often discussed in connection with a trading exchange. As more buyers and sellers come to the designed market, prices better reflect true market levels. Conversely, the current fragmentation of exchanges, trading pools, and matching engines reduces the thickness of the markets.
Once a market becomes thick, the design must overcome congestion. Market participants need sufficient time, yet have transactions occur fast enough, in order to consider their alternatives and arrive at satisfactory decisions. Design has to find the “goldilocks” of time management. Trading should be fast — but not so fast as to prevent participants from making the right choice. An excellent example of a financial market design feature geared to solving congestion is the circuit breaker used in the stock market. On extreme down days, the market stops to allow investors an opportunity to consider their alternatives.
Finally, an effective market design must provide a safe environment that makes it better to trade within than outside the structure and in which players cannot engage in strategic behavior that reduces welfare. The current high-frequency trading controversies represent a clear case of market design having real effects. Aspects of market design that help some participants profit may also work against market thickness and reduce welfare.
Using the three-concept framework for good design, the handbook provides detailed studies of market design problems and shows how the introduction of institutional details is critical to understanding certain microeconomic problems. Economists’ desire to be more scientific has resulted in an overreliance on mathematical modeling and too little attention to how markets operate. The Handbook of Market Design is a refreshing change that shows the importance of knowing the details of market structure.
An example of effective design is presented in the section on the matching of medical school graduates with residency appointments. Markets have to clear quickly and efficiently to make this complex problem manageable. The book also includes sections on school choice, e-commerce, the job market for economists, and microcredit allocation decisions. Trading design now touches on a seemingly endless list of activities, so applying what has been learned to asset trading is a natural extension.
Vulkan, Roth, and Neeman’s handbook provides a useful entrée into a key knowledge area for anyone actively engaged in trading. The advantage and, at the same time, the glaring problem with the book is its wide scope, with a focus mainly on issues outside of financial markets. The Handbook of Market Design is also an imperfect fit for the CFA charterholder who is fascinated by the topic but lacks the time or energy to work through 700 pages of technical articles. The hope remains that someone will produce a handbook concentrating on the critical issues and significant welfare implications of market design for those who trade financial assets.
Nonetheless, for any reader seeking a broader vision of how markets could operate, this is a compelling work. The breadth of innovative research on market designs should open the reader’s imagination to the vast possibilities in this exciting subject area. Certainly, the regulation of financial markets is too important to be left entirely to the lawyers. Free-ranging thinkers are needed to enhance market efficiency. The pathways for innovation in financial market design are abundant once we move beyond the conventional.
More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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