An intermediated exchange involves negotiated trading between two or more participants through a third-party, the intermediary. Specifically, in such an intermediated exchange, the participants do not communicate directly with each other, but rather through the third-party intermediary. Examples of items traded include intangibles, such as securities (stocks, bonds, and options) commodity futures, collateralized mortgage obligations, and pollution rights, as well as tangibles, such as copper or soy beans. All such items involved in an intermediated exchange are herein referred to as "commodities." In fact, any item that can be traded is a commodity.
In the case of stocks and options, there are several examples of intermediaries, which differ depending on the status of the securities as listed or as over-the-counter ("OTC") (i.e., unlisted). Listed stocks and options can be traded on securities exchanges, such as the New York Stock Exchange ("NYSE"), the American Stock Exchange ("AMEX"), and the Chicago Board of Options Exchange ("CBOE"). Specialists on the floors of these exchanges act as intermediaries for listed securities and, typically, have positions in the securities that they intermediate. Over-the-counter securities can be traded on a computer network, known as "NASDAQ," which links securities dealers who make markets and typically maintain positions in certain of these OTC securities. These networked dealers continually make available on NASDAQ the highest price at which they will buy a security ("bid price") and the lowest price at which they will sell a security ("offer price"). They then act as intermediaries between buyers and sellers of those securities for which they make markets. Also, they can trade with each other. Trading on this network is regulated by the National Association of Securities Dealers ("NASD").
Alternately, financial institutions can exchange both listed and OTC securities through intermediaries who form the "fourth" market. Fourth-market intermediaries do not maintain security positions; instead, they act only as agents for market participants, whether as buyers or sellers, maintaining the participant's anonymity and representing the participant's interests. Originally, the fourth market was largely a network of securities brokers communicating primarily by telephone (the "Rolodex" market). Later, Instinet (Reuters, New York, N.Y.) began offering partially automated intermediary services by providing a computer network through which participants can post their security trading interests and subsequently can negotiate trades using standardized messages made available by the network. More recently, POSIT (ITG, New York, N.Y.) and the Arizona Stock Exchange ("AZX") (Phoenix, Ariz.) began providing more fully automated fourth-market intermediary services. Instinet, POSIT, and AZX are referred to as "crossing networks" because they provide intermediary services with varying degrees of computer and communications technology.
In the simple form as currently practiced, a crossing-network intermediated exchange involves two participants who seek, through a computerized intermediary, to buy and/or sell a given amount of a given commodity at a given price. The amount of the commodity is determined by the network. In more complex forms, an intermediated exchange can be desirable where multiple participants who seek, through an intermediary, to buy and/or sell multiple commodities, each with a different price. For example, a portfolio manager may seek to execute an optimized series of commodity exchanges that are interdependent in the sense that, if some exchanges of the series cannot be executed, the portfolio manager would prefer to withdraw the previous series and submit for execution a new series of exchanges. In this more complex case of multiple commodities and optimized exchange strategies, the intermediary may provide for selecting the actual commodities to be exchanged from a list of possible commodities, as well as for determining the amounts and prices that satisfy the more-complex conditions of the participants. It is believed that no current network provides such more-complex exchanges. See, e.g., Orford, Trading on the Frontier, Plan Sponsor, October 1996, pp. 18-27.
Most market exchanges of financial commodities involve a specific, single instrument, e.g., "IBM stock," and two counter-parties, one the buyer and the other the seller. Even the most adaptable crossing networks require participants to supply a list of specific commodities they will exchange. But as the size and complexity of commerce and investment has grown, participants have become less interested in single commodities or lists of specific commodities and have become more interested in expressing their exchange goals as portfolios of commodities, which are drawn from a general universe of acceptable commodities and which achieve certain target-risk, return, and exposure profiles.
In this way, the composition of the associated intermediated exchange would be less dependent on any single investment or list and more dependent on the aggregate characteristics of all the commodities combined. The motivation for this approach is that it permits the participant the flexibility to dynamically adapt to market conditions that affect the price and availability of individual commodities. Currently, computer systems that support existing markets or crossing networks are not able to accommodate the evolving needs of participants, such as investment managers and others, who seek to trade multiple commodities to achieve general portfolio goals.
In addition, an intermediated exchange meeting those portfolio goals for multiple participants requires a computerized solution of what is known as a competitive equilibrium problem. See, e.g., Ellickson, 1993, Competitive Equilibrium--Theory and Applications, Cambridge University Press. Currently, no satisfactory solution exists for that problem as applied to the specific situations of intermediated exchanges.