The Causal Impact of Market Fragmentation on Liquidity
52 Pages Posted: 10 Apr 2015 Last revised: 21 Jan 2017
Date Written: November 14, 2016
We estimate the causal impact of market fragmentation. Theoretically, more exchange competition should reduce trading costs, however it may also generate negative network externalities which reduce market quality. We document evidence of both effects, however our results show differential impacts for large and small stocks. For large stocks, the former effect dominates and market quality is better. For small stocks, negative network externalities dominate and market quality is relatively worse. In response, we find that traders use inter-market sweep orders to avoid negative network externalities. Our results reconcile conflicting findings in the literature and show that fragmentation has dramatically changed U.S. markets.
Keywords: Exchange competition, fragmentation, liquidity, market microstructure
JEL Classification: G12, G14
Suggested Citation: Suggested Citation