Internalization, Clearing and Settlement, and Liquidity
CentER Discussion Paper Series No. 2012-002
46 Pages Posted: 12 Jan 2012
Date Written: January 11, 2012
We study the relation between liquidity in financial markets and post-trading fees (i.e. clearing and settlement fees). The clearing and settlement agent (CSD) faces different marginal costs for different types of transactions. Costs are lower for an internalized transaction, i.e. when buyer and seller originate from the same broker. We study two fee structures that the CSD applies to cover its costs. The first is a uniform fee on all trades (internalized and non-internalized) such that the CSD breaks even on average. Traders then maximize trading rates and higher post-trading fees increase observed liquidity in the market. The second fee structure features a CSD breaking even by charging the internalized and non-internalized trades their respective marginal cost. In this case, traders face the following trade-off address all possible counter-parties at the expense of considerable post-trading fees, or enjoy lower post-trading fees by targeting own-broker counter-parties only. This difference in post-trading fees drives traders' strategies and thus liquidity. Furthermore, across the two fee structures, we find that observed liquidity may differ from cum-fee liquidity (which encompasses the post-trading fees). With trade-specific fees, the cum-fee spread depends on the interacting counter-parties. Next, regulators can improve welfare by imposing a particular fee structure. The optimal fee structure hinges on the magnitude of the post-trading costs. Noteworthy, a fee structure yielding higher social welfare may in fact reduce observed liquidity. Finally, we consider a number of extensions including market power for the CSD, anonymous trading and differences in broker size.
Keywords: transaction fees, internalization, clearing and settlement, liquidity, anonymity
JEL Classification: G10, G15
Suggested Citation: Suggested Citation