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Trader Competition in Fragmented Markets: Liquidity Supply Versus Picking-Off Risk

Published online by Cambridge University Press:  16 January 2023

Alejandro Bernales ,
Nicolás Garrido ,
Satchit Sagade ,
Marcela Valenzuela Open the ORCID record for Marcela Valenzuela [Opens in a new window]  and
Christian Westheide
Alejandro Bernales
Affiliation:
Universidad de Chile - Facultad de Economía y Negocios - Departamento de Administración abernales@fen.uchile.cl
Nicolás Garrido
Affiliation:
London School of Economics N.garrido-sureda@lse.ac.uk
Satchit Sagade
Affiliation:
Nasdaq and Leibniz Institute for Financial Research SAFE satchit.sagade@nasdaq.com
Marcela Valenzuela*
Affiliation:
Pontificia Universidad Católica de Chile School of Management
Christian Westheide
Affiliation:
University of Vienna and Leibniz Institute for Financial Research SAFE christian.westheide@univie.ac.at
*
mavalenb@uc.cl (corresponding author)
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Abstract

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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 toward intermediaries. We empirically corroborate our model’s predictions about liquidity. Our model reconciles the mixed results in the empirical literature.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 1 , February 2024 , pp. 221 - 248
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

For helpful comments and discussions, we thank Markus Baldauf, Evangelos Benos, Jonathan Brogaard, Sabrina Buti, Jean-Edouard Colliard, Thierry Foucault, Peter Gomber, Thomas Johann, Jan-Pieter Krahnen, Raman Kumar, Jens Lausen, Katya Malinova, Albert Menkveld, Josua Mollner, Robert Neal, Andreas Park, Seongkyu Gilbert Park, Christine Parlour, Giovanni Petrella, Talis Putnins, Uday Rajan, Yves Rannou, Ioanid Rosu, Patrik Sandas, Andriy Shkilko, Erik Theissen, Vincent van Kervel, Clara Vega, Shixuan Wang, Marius Zoican, conference participants at the 2014 Market Microstructure: Confronting Many Viewpoints Conference, 2016 SAFE Market Microstructure Workshop, 2016 CMStatistics Conference, 2016 India Finance Conference, 2017 Securities Markets: Trends, Risks and Policies Conference, 2017 European Retail Investment Conference, 2017 Stern Microstructure Meeting, 2017 FIRS Conference, 2017 Spring International Conference of the French Finance Association, 2017 International Workshop in Financial Markets and Nonlinear Dynamics, 2017 FMA European Conference, BWL2017 Conference, 2017 AsianFA Conference (best paper award), 2017 Verein für Socialpolitik Jahrestagung, 2017 Northern Finance Association Conference, 2017 Annual Central Bank Conference on the Financial Microstructure of Financial Markets, 2017 Annual Meeting of the German Finance Association (DGF), 2018 SFS Cavalcade, and 2018 FMA Conference, and seminar participants at University of Birmingham, University of Mannheim, University of Manchester, University of Frankfurt, University of Chile, and Pontifical Catholic University of Chile. Sagade and Westheide gratefully acknowledge research support from the Research Center SAFE, funded by the State of Hessen initiative for research LOEWE. Sagade also gratefully acknowledges financial support from Deutsche Forschungsgemeinschaft (DFG, German Research Foundation) – Projektnummer 329107530. Bernales acknowledges the support of Fondecyt Project No. 1231660. Valenzuela acknowledges the support of Fondecyt Project No. 1231630, and the support of Instituto Milenio ICM IS130002. We are grateful to Rodrigo Orellana and Italo Riarte for their research assistance. The support of the Economic and Social Research Council (ESRC) in funding the SRC is gratefully acknowledged (grant number ES/R009724/1). We are grateful to EUROFIDAI for access to the BEDOFIH database (for more information, see http://www.eurofidai.org). The views expressed in the article are solely the authors’ and do not necessarily reflect those of Nasdaq.

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