Trading Rules, Competition for Order Flow and Market Fragmentation

89 Pages Posted: 11 Dec 2013 Last revised: 29 Apr 2014

See all articles by Amy Kwan

Amy Kwan

University of Sydney Business School

Ronald W. Masulis

University of New South Wales, Sydney; European Corporate Governance Institute (ECGI); Financial Research Network (FIRN); National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER)

Thomas H. McInish

University of Memphis - Fogelman College of Business and Economics

Date Written: April 23, 2014

Abstract

We investigate competition between traditional stock exchanges and new ‘dark’ trading venues using an important difference in regulatory treatment. SEC required minimum pricing increments constrain some stock spreads, causing large limit order queues. Dark pools allow some traders to by-pass existing limit order queues with minimal price improvement. Using a regression discontinuity design, we find spread constraints significantly weaken exchanges’ competitiveness. As more orders migrate to dark pools, the probability of subsequent order execution there increases, raising liquidity. The ability to circumvent time priority of displayed limit orders is one cause of the rapid rise in U.S. equity market fragmentation.

Keywords: Market Fragmentation; Regression Discontinuity; Dark Pools; Trade Reporting Facility

JEL Classification: G24, G28, G12

Suggested Citation

Kwan, Amy and Masulis, Ronald W. and McInish, Thomas H., Trading Rules, Competition for Order Flow and Market Fragmentation (April 23, 2014). Forthcoming, Journal of Financial Economics (JFE); European Corporate Governance Institute (ECGI) - Law Working Paper No. 256/2014. Available at SSRN: https://ssrn.com/abstract=2365603 or http://dx.doi.org/10.2139/ssrn.2365603

Amy Kwan (Contact Author)

University of Sydney Business School ( email )

Cnr. of Codrington and Rose Streets
Sydney, NSW 2006
Australia

Ronald W. Masulis

University of New South Wales, Sydney ( email )

UNSW Business School
High St
Sydney, NSW 2052
Australia
612-9385-5860 (Phone)
612-9385-6347 (Fax)

European Corporate Governance Institute (ECGI) ( email )

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Belgium

Financial Research Network (FIRN)

C/- University of Queensland Business School
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Queensland
Australia

HOME PAGE: http://www.firn.org.au

National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER) ( email )

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1 Business Link
Singapore, 117592
Singapore

Thomas H. McInish

University of Memphis - Fogelman College of Business and Economics ( email )

Memphis, TN 38152
United States
901-678-4662 (Phone)
901-678-3006 (Fax)

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