Fragmentation and Strategic Market-Making
67 Pages Posted: 20 Sep 2014 Last revised: 19 Apr 2018
Date Written: April 2018
Information technology, infrastructure enhancement, and arbitrage strategies all contribute to link trading venues in fragmented markets. Our paper highlights a new cross-market linking channel: the interdependence of liquidity providers' inventory costs. We use a two-venue duopoly model involving strategic risk-averse market-makers. Costs to provide immediacy depend on market-makers' inventory aggregated across venues, implying that absorbing a shock in one venue simultaneously changes marginal costs in all other venues. Moreover, market-makers strategically choose which shock(s) to absorb. These two forces may lead to competitive prices and enhanced liquidity. Using Euronext proprietary data, we uncover evidence for these cross-market inventory cost linkages.
Keywords: Market fragmentation, strategic price competition, cross-market inventory cost linkage
JEL Classification: 360
Suggested Citation: Suggested Citation