The immediacy implications of exchange organization

The paper introduces a connection between the needs of exchanges to respond to the immediacy needs of their clientele and the need to manage the credit risks faced by exchange members. Queueing theory is used to represent the opportunity loss suffered by brokers engaging in multiple activities: order-flow origination and its intermediation. The role of market-making locals is depicted as enabling specialization. Brokers focus on originating order flow and locals on fulfilling intermediation needs. The capacity to specialize is constrained by the availability of creditworthy members acting as locals. This results in a tension between pursuit of immediacy and managing inter-member credit exposure. Two exchange rules, tick size and price limits, are evaluated for their effects in resolving this tension. This research benefits from the comments of Ray DeGennaro, Mark Flannery, Steve Kane, Tom Lindley, Jay Marchand, Pat Parkinson, Asani Sarkar, Lester Telser, Rich Tsuhara and participants of the Brookings-Wharton Financial Services Conference (January, 2002). Errors remaining in this draft are mine. The views of the paper do not reflect the official positions of the Federal Reserve.