forthcoming in Journal of Financial and Quantitative Analysis

Trader Competition in Fragmented Markets: Liquidity Supply versus Picking-off Risk

By employing a dynamic model with two limit order books, we show that

fragmentation is associated with reduced competition among liquidity

suppliers and lower picking-off risk of limit orders. Due to these

countervailing channels, the impact of fragmentation on liquidity and welfare

differs with asset volatility: when volatility is high (low), liquidity and

aggregate welfare in a fragmented market are higher (lower) than in a single

market. However, fragmentation always shifts welfare away from agents with

exogenous trading motives and towards intermediaries. We empirically

corroborate our modelā€™s predictions about liquidity. Our model reconciles the

mixed results in the empirical literature.