Why Do Large Orders Receive Discounts On The London Stock Exchange?

Abstract:     
On the NYSE and exchanges that feature open limit order books, larger orders receive worse prices. Accordingly, market microstructure theory has focused on developing consistent models. However, on exchanges such as the London Stock Exchange, NASDAQ and FX markets, larger orders receive better prices on average. In this paper, we argue that differences in market design can explain this finding. On the LSE and NASDAQ, in sharp contrast to the NYSE or exchanges that feature open limit order books, competition between dealers is largely intertemporal: a trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. We show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders.

Hence empirically, we predict that there should be a striking difference between the relationship between price impact and trade size on exchanges where all orders are immediately exposed to price competition, such as the NYSE, where price impact and trade size should be positively correlated, and exchanges where competition is largely intertemporal, such as London, where price impact and trade size should be negatively correlated. We derive the implications for inter-dealer trade, dealer profits, and find testable restrictions for pricing across different traders and order sizes. We test the predictions using data from the LSE. The results offer strong support for our hypothesis that on the LSE, broker-dealer relationships drive pricing.

JEL Classification: G12

working papers series