A Tale of One Exchange and Two Order Books: Effects of Fragmentation in the Absence of Competition

File pdf 470KB

Exchanges nowadays routinely operate multiple limit order markets for the same security that are almost identically structured. We study the effects of such fragmentation on market performance using a dynamic model of fragmented markets where agents trade strategically across two identically-organized limit order books. We show that fragmented markets, in equilibrium, offer higher welfare to intermediaries at the expense of investors with intrinsic trading motives, and lower liquidity than consolidated markets. Consistent with our theory, we document improvements in liquidity and lower profits for liquidity providers when Euronext, in 2009, consolidated its order flow for stocks traded across multiple, country-specific, and identically-organized limit order books onto a single order book. Our results suggest that competition in market design, not fragmentation, drives previously documented improvements in market quality when new trading venues emerge; in the absence of such competition, market fragmentation is harmful.

Author(s):

Alejandro Bernales    
University of Chile
Chile

Italo Riarte    
University of Chile
Chile

Satchit Sagade    
Goethe University Frankfurt and Research Center SAFE
Germany

Marcela Valenzuela    
University of Chile
Chile

Christian Westheide    
University of Mannheim and Research Center SAFE
Germany