Transparency and Bypass in Electronic Financial Markets
23 Pages Posted: 15 Oct 2008
Date Written: June 1993
Electronic markets use information technology to disseminate information onprices, quantities, and buyer and supplier identities. In spite of the recognizedbenefits of electronic markets, increased visibility and transparency may introduceimperfections, and create profitable opportunities to bypass markets that generatesthe information. In the U.S. securities markets, dissemination of market data hasequipped several firms to develop competing, off-exchange trading mechanismsthat rely on market price data, but whose transactions bypass the establishedmarket. Concern is rising that the growing volume of trading occurring awayfrom the main market may reduce liquidity, and increase transactions costs. Asimulation model of securities trading in a continuous auction market (similar tothe market structure of the New York Stock Exchange) is used to examine themarket quality effects of increasing levels of trading activity through an off-exchangedealer. Market characteristics, such as transactions costs, are measuredas off-exchange trading increases from zero percent to 20 percent of the totaltrading volume. The results indicate that competition from an alternative tradingvenue reduces some trading costs borne by investors. Contrary to regulatorygoals, however, off-market trading expands the role of profit-seeking dealers, andlowers the probability that some investors' orders will execute.
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