Why Do Different Stocks Fragment Differently?

One of the biggest successes of the Markets in Financial Instruments Directive (MiFID) has been the emergence of a truly competitive trading landscape in the European equities market. However, this fragmentation has not been uniform across the entire European stock universe. There are differences across different European indices as well as across stocks within a single index. In the first study, we examine the cross-sectional and time-series determinants of differences in the levels of fragmentation. Determinants considered include stock characteristics, venues’ trading protocols, and possible cherry-picking by trading venues concerning the stocks admitted for trading.

Regulatory changes in the US and EU have brought forth a wealth of research on the trade-off between innovation and cost reduction arising from the existence of competition, and potentially detrimental effects on liquidity due to network externalities. We examine the isolated effects of competition and fragmentation by studying changes in liquidity and price efficiency around specific changes in market structure (technological integration following the merger and change in fee levels) after two venues merge.

• The data for this project come from multiple sources. The first paper on “Why do different stocks fragment differently?” uses Thomson Reuters Tick History. We find fragmentation to be larger for stocks of high market capitalization and high trading volume. These are stocks for which market operators are expected to find competition for market share to be worthwhile, and for which voluntary market makers find their activity across multiple trading venues to be sufficiently profitable. We also find that the tick size has some relevance. We interpret this as liquidity providing market participants avoiding improvement of the best price if the price increment is large and instead of providing liquidity on alternative trading venues.
• In the second paper, we study the effects of such fragmentation on market performance using a dynamic model 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 two country-specific and identically organized order books into 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.
• We have enhanced this project by an additional paper, “Dark Trading under MiFID II”. This paper is concerned with the effects of upcoming changes to the rules for non-transparent trading brought about by the revised regulation “MiFID II”, and thus with the fragmentation of trading volume across transparent and non-transparent trading venues. The chapter discusses institutional details and the anticipated changes expected to result from the revised rules.