Organizational Design, Competition, and Financial Exchanges

We investigate the incentives for vertical and horizontal integration in the financial securities service industry. Our analysis shows that the incentives for vertical integration depend on industry characteristics revealing, for example, that incentives increase in the demand for liquidity. Decentralized decisions might lead to an industry equilibrium with lower aggregate profits for all participants. This problem can be overcome by horizontal integration. We link our results to recent regulatory and institutional developments, and argue that multilateral trading facilities and algorithmic trading lead to lower incentives for vertical integration whereas the regulatory push towards mandatory clearing of over-the-counter trades increases the profitability of vertical integration.