Will the Market Fix the Market? A Theory of Stock Exchange Competition and Innovation

87 Pages Posted: 5 Jun 2019

See all articles by Eric B. Budish

Eric B. Budish

University of Chicago - Booth School of Business

Robin S. Lee

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

John J. Shim

University of Notre Dame - Mendoza College of Business

Multiple version iconThere are 2 versions of this paper

Date Written: May 1, 2019

Abstract

Will the market adopt new market designs that address the negative aspects of high-frequency trading? This paper builds a theoretical model of stock exchange competition, shaped by institutional and regulatory details of the U.S. equities market. We show that under the status quo market design: (i) trading behavior across the many distinct exchanges is as if there is just a single “synthesized” exchange; (ii) as a result, trading fees are perfectly competitive; but (iii) exchanges capture and maintain significant economic rents from the sale of “speed technology” (i.e., proprietary data feeds and co-location)—arms for the high-frequency trading arms race. Using a variety of data, we document seven stylized empirical facts that suggest that the model captures the essential economics of how U.S. stock exchanges compete and make money in the modern era. We then use the model to examine the private and social incentives for market design innovation. We find that while the social returns to market design innovation are large, the private returns are much smaller and may be negative, especially for incumbents that derive rents in the status quo from selling speed technology.

JEL Classification: D02, D44, D47, D53, D82, G1,G2, G23, L1, L13, L5, L89

Suggested Citation

Budish, Eric B. and Lee, Robin S. and Shim, John J., Will the Market Fix the Market? A Theory of Stock Exchange Competition and Innovation (May 1, 2019). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2019-72. Available at SSRN: https://ssrn.com/abstract=3391461 or http://dx.doi.org/10.2139/ssrn.3391461

Eric B. Budish (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-8453 (Phone)

Robin S. Lee

Harvard University - Department of Economics ( email )

1805 Cambridge St.
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

John J. Shim

University of Notre Dame - Mendoza College of Business ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States

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