Trading in Fragmented Markets

Note: This paper has been superceded by the November 2019 version: the SIEPR working paper 19-034. This paper applies an econometric model of imperfect competition to equity trading with competing exchanges. Stock of the same company is traded on multiple venues today. This development was driven by regulations, aimed at benefiting investors by fostering competition among exchanges. However, the welfare consequences of increased exchange competition are theoretically ambiguous. While competition does place down- ward pressure on the bid-ask spread, this force may be outweighed by increased adverse selection that stems from additional arbitrage opportunities. We investigate this ambiguity empirically by estimating key parameters of the model using detailed trading data from Australia. The benefits of increased competition are outweighed by the costs of multi-venue arbitrage. Compared to the prevailing duopoly, we predict that the counterfactual spread under a monopoly would be 23 percent lower. Further, market design variations on the continuous limit order book would eliminate profits from cross-venue arbitrage strategies and reduce the spread by 51 percent. Finally, eliminating off-exchange trades, so-called dark trading, would reduce the spread by 11 percent.