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Questions On Exchanges

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Creating an exchange is extremely difficult.  But, once you get them going they can create a lot of value for customers.  The exchange model can lend itself to lots of different business verticals.  However, there are some questions that need to be figured out before you start an exchange.  Here are some pertinent questions.

  • Are there natural buyers and sellers that are looking for a better solution?  For example, in the wheat market, wheat farmers are natural sellers and will hedge their crops.  Bread makers are natural buyers and are interested in hedging so they can smooth the costs of raw material inputs.
  • How are you going to settle the market every day?  The settlement gives a reference price and the corresponding payments and collections that revolve around that settlement.
  • How are you going to clear your trades?  Matching trades on the front end is simple.  You can download a matching engine off the internet. It’s the guts of the back office where clearing happens that is the backbone of the business.  If you haven’t contemplated clearing, you don’t have an exchange.  You can build it yourself, or contract with a third-party provider.
  • Is their significant price movement and risk that will attract speculators and provide a reason for your market to exist?
  • Is the customer base ready for an exchange model? What educational hurdles will you have to overcome to get it going?  Are your customers sophisticated enough?
  • Do you have an easy interface for customers to use so they can enter and exit the market at the touch of a button?
  • Who’s going to do your banking and custody if you have physical products?
  • Are you going to settle the market in cash, or in physical goods?  If physical, how will you deliver and manage delivery?
  • Is the industry fragmented enough to see value in an exchange?  For example, the poultry industry is vertical and not fragmented.  You don’t see futures contracts in poultry products.

Exchanges are great when they are transparent and provide really good price information.  Entire industries can grow up and innovate around that reference price.  Exchanges can smooth costs, defray a lot of costs, and make the entire industry a lot more efficient.

Usually, in the exchange model, the winner takes the most.  Other exchanges will have trouble competing with an established exchange purely because of network effects.  The reasons contracts leave one exchange for another are due to technical things or political things.

The ground has to be fertile for an exchange to work.  Just building an exchange isn’t the answer to everything.

The post Questions On Exchanges first appeared on Points and Figures.


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