Asset Pricing Frictions in Fragmented Markets

Abstract

We study the consequences of trading fragmentation and speed on liquidity and asset prices. Exchanges invest in speed-enhancing technologies and price trading services to attract investors. Investors trade due to idiosyncratic preference shocks. We show how the resulting market organization affects asset liquidity and the composition of participating investors. In a consolidated market, speed investments raise liquidity and prices. When markets fragment, liquidity and asset prices can move in opposite directions. We also show how mechanisms that protect execution prices, such as the SEC’s trade-through rule, can decrease price levels and trading volume relative to unregulated markets. Our results suggest that recent regulatory reforms in secondary markets may have unintended negative consequences for public corporations.