Anticompetitive Price Referencing

Abstract

Off-exchange trades are often executed by referencing on-exchange prices. In equilibrium, such price referencing softens market makers’ on-exchange competition and makes liquidity expensive for investors. Additionally, by equalizing on- and off-exchange prices, price referencing guarantees “best- execution” and makes investors indifferent where to trade. Market makers effectively obtain a license to fragment orders off exchange, raising their profits but reinforcing market-wide illiquidity. The inefficiencies remain tenacious under various proposed remedies: encouraging market maker entry, removing price referencing regulations, building firewalls inside market making firms, and forcing off-exchange competition for orders.

Keywords: order protection rule, market fragmentation, payment for order flow, order-by-order auctions

JEL Classification: D47, G11, G18