Title: The effects of artificial fragmentation of trading in equity markets
Authors: Alejandro Bernales - Universidad de Chile (Chile)
Italo Riarte - Universidad de Chile (Chile)
Satchit Sagade - Goethe University Frankfurt (Germany) [presenting]
Marcela Valenzuela - Universidad de Chile (Chile)
Christian Westheide - University of Mannheim and Research Center SAFE (Germany)
Abstract: Equity markets in the US, EU and elsewhere have moved from monopolist/dominant exchanges to a competitive environment where multiple trading venues coexist. Studies - while highlighting the trade-off between competition-induced innovation and/or cost reduction, and the detrimental effects of fragmentation due to network externalities - have provided conflicting results. We argue that this can be attributed to the difficulty in disentangling the effects of fragmentation and competition. We develop a dynamic model of limit order markets, where heterogeneous agents make endogenously sequential optimal decisions in continuous time to maximize expected payoffs, taking into account markets conditions, potential future trading decisions, and other agents strategies. We compare two scenarios: a market organized as a single limit order book versus one where multiple books coexist. We find that fragmented markets benefit arbitrageurs and market-makers at the expense of liquidity-motivated traders. Consolidated markets, on the other hand, result in positive network externalities leading to improvements in market quality and welfare. We confirm the models predictions by examining a unique event at NYSE Euronext which led to a reduction in market fragmentation without affecting overall competition. Our results suggest market competition, not market fragmentation, in market design drives market quality improvements when new trading venues emerge.