Liquidity and the Simple Io of Stock Exchanges

Instituto de Economia PUC Working Paper No. 211; CEA Working Paper No. 123

46 Pages Posted: 17 Apr 2002

See all articles by Alexander Galetovic

Alexander Galetovic

Universidad Adolfo Ibáñez; Stanford University - The Hoover Institution on War, Revolution and Peace; University of Padua - CRIEP

Felipe Zurita

Pontificia Universidad Católica de Chile

Date Written: March 2002

Abstract

It is usually thought that network externalities, which are inherent to liquidity, make it desirable to concentrate transactions in one stock exchange. This paper shows that when the value of liquidity stems from the ability to potentially reach as many traders as possible, the market is integrated when every broker meets every other broker in at least one exchange. Thus, fragmentation is not about trades being executed in different exchanges but of connectedness among brokers.

An implication of this distinction is that in an integrated market the network externality created by liquidity becomes pecuniary and the optimal number of exchanges depends only on the shape of the (physical) technology to execute trades - whether it exhibits increasing, constant or decreasing returns to scale - as in any standard industry.

We characterize the planner's allocation and compare it with that reached by a monopoly. It is shown that when exchanges are natural monopolies a particular ownership structure of the exchange and allocation of voting rights over the exchange fee achieve the planner's optimum.

With decreasing returns to scale the Walrasian allocation is efficient, provided that the market is integrated. Nevertheless, with few exchanges the price-taking assumption is suspect. If exchanges are not price takers, there are many other equilibria, all of them inefficient. Moreover, there are reasons to doubt that the market will become integrated. Fragmentation softens price competition between exchanges and may help a monopolist exchange to erect a barrier to entry even when he has no cost advantage.

Keywords: brokerage, exchange fee, fragmentation, liquidity, network externality

JEL Classification: G24, L1

Suggested Citation

Galetovic, Alexander and Zurita, Felipe, Liquidity and the Simple Io of Stock Exchanges (March 2002). Instituto de Economia PUC Working Paper No. 211; CEA Working Paper No. 123. Available at SSRN: https://ssrn.com/abstract=305483 or http://dx.doi.org/10.2139/ssrn.305483

Alexander Galetovic (Contact Author)

Universidad Adolfo Ibáñez ( email )

Peñalolén
Santiago
Chile

Stanford University - The Hoover Institution on War, Revolution and Peace ( email )

Stanford, CA 94305-6010
United States

University of Padua - CRIEP ( email )

Padua
Italy

Felipe Zurita

Pontificia Universidad Católica de Chile ( email )

Av Libertador General Bernardo O'Higgins 340
Santiago, Región Metropolitana 8331150
Chile
+56-2-2354 4318 (Phone)

HOME PAGE: http://www.uc.cl

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