Liquidity-Based Competition for Order Flow
Posted: 22 Sep 1998
Date Written: August 1998
We present a microstructure model of competition between exchanges for order flow based on liquidity provision. Different pairings of pure limit order markets (PLM) and hybrid specialist/limit order markets (HM) are considered. We find that neither a pure nor a hybrid market structure is competition-proof. A PLM can always be supported in equilibrium as the dominant market (i.e., where the hybrid limit book is empty), but a HM can also be supported for some market parameterizations, as the dominant market. We also have examples of co-existence of competing markets. Order preferencing --- i.e., decisions about where orders are routed when investors are indifferent --- is a key determinant of market viability. Welfare comparisons show that competition between exchanges often, but not always, reduces the cost of liquidity.
JEL Classification: D4, G2, L1
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