Market Fragmentation: A Cushion Against Exchange Outages?
(with Hans Degryse and Niklas Landsberg)
SSRN
Abstract: When disruptions are costly, engineers use redundancies to enhance resiliency. In financial markets where many exchanges compete for order flow in the same security, such redundancies may emerge as a positive side effect. We test this conjecture in a large sample of primary exchange outages in European equity markets. Although trading remains technically possible on other venues, the overall market in treated stocks turns illiquid during outages. The effective spread increases by 110% and turnover drops by 96%. We find that the degree of ex-ante fragmentation does not mitigate the illiquidity during outages. Overall, our findings imply a missed opportunity for European financial regulation.
The European Liquidity Gap
(with Jonathan Brogaard and Abalfazl Zareei)
SSRN
Abstract: The perception that European stocks are less liquid than those in the United States (US) is only partially true. Controlling for firm size, we find that large European stocks have caught up and now have liquidity on par with their US peers. European small-caps, however, remain 70% more expensive to trade than similar stocks in the US. This “liquidity gap” is wider for stocks with lower exchange competition, lower free float, listed at smaller exchange groups, in countries with lower retail ownership. The evidence highlights liquidity as a defining constraint of Europe’s capital market competitiveness.
Exchange Competition, Fragmentation, and Market Quality
(with Michał Dzieliński and Chengcheng Qu)
SSRN
Abstract: Fragmented trading of the same security across multiple venues is prevalent in modern stock markets. This paper investigates how the market quality effects associated with such fragmentation depend on the type of exchange competition. Using a natural experiment where trading goes from fragmented to centralized overnight, we show that market liquidity falls, but surprisingly, the effect is unrelated to the degree of fragmentation. Instead, the liquidity reduction is concentrated among stocks that before the event had the most intense exchange competition on liquidity supply. The results imply that competition in other dimensions, e.g., speed and compliance, does not benefit liquidity.
Trades, Quotes, and (Unbiased) Information Shares
(with Albert Menkveld)
SSRN | blog
Abstract: Information arrives at securities markets through price quotes and trades. Informed traders impose adverse-selection costs on quote suppliers. This creates incentives for the latter to identify relatively uninformed groups and trade with them off-exchange. The marketplace turns hybrid, at the cost of thinner, highly informed (toxic) volume at the center. This pattern has largely eluded econometricians, because the conventional approach to measuring information shares is biased against finding it. We show why this is the case, and propose a fix. The novel approach shows that, indeed, the conjectured pattern is strongly present in the data.
Market Fragmentation in Europe
SSRN
Abstract: The European equity trading landscape of 2022 is a complex mix of exchanges, dark pools, dealers, and auctions. The once dominant national stock exchanges are now part of global exchange groups that compete with investment banks and high-frequency trading (HFT) firms to match the orders of retail and institutional investors. Is this diverse trading environment in the best interests of investors? Academic research has taken on this question from many angles, both theoretically and empirically. This paper surveys the findings of the market fragmentation literature, with a special focus on European equity market quality. I discuss why markets fragment, what the potential market quality effects are, and what this implies for the European context. The objective is to provide a concise review that captures the implications for current policy in Europe.
Resting working papers
Mid-Day Call Auctions
(with Jonathan Brogaard and Caihong Xu)
SSRN
Abstract: In illiquid and fragmented limit order book markets, asynchronously arriving buyers and sellers have a coordination problem. This problem is particularly strong mid-day, when trading is generally thin. We evaluate a market structure reform at Nasdaq Nordic, where the continuous trading session is replaced mid-day by a five-minute call auction. We find that the mid-day call auction works as a coordination device, reducing transitory price impact. The call auction attracts end investors rather than intermediaries. Stocks with greater end investor flows show stronger benefits of the call auction. The results indicate that mid-day auctions can improve continuous markets.
Does Commonality in Illiquidity Matter to Investors?
(with Richard Anderson, Jane Binner, and Birger Nilsson)
Published 2013 as a Federal Reserve Bank of St Louis Working Paper
SSRN
Abstract: This paper investigates whether investors are compensated for taking on commonality risk in equity portfolios. A large literature documents the existence and the causes of commonality in illiquidity, but the implications for investors are less understood. In a more than fifty year long sample of NYSE stocks, we find that commonality risk carries a return premium of at least 2.0 per cent annually. The commonality risk premium is statistically and economically significant, and substantially higher than what is found in previous studies. It is robust when controlling for illiquidity level effects, transaction costs, as well as variations in illiquidity measurement.
Best Execution: Can Institutional and Retail Investors Benefit from Fast and Fragmented Trading?
(with Michał Dzieliński and Lars Nordén)
Asian Finance Association Best Paper Award 2016
SSRN
Abstract: Fast trading and fragmentation of volume make equity markets complex, leading retail and institutional investors to demand sophisticated brokerage services. In a sample of stock transactions in Swedish large-cap firms, we find that brokers who show high trading sophistication when trading their own book do not deliver comparable execution quality when trading on behalf of clients. Best execution legislation states that brokers should take all reasonable steps to maximize the execution quality when trading on behalf of clients. For institutional clients, the shortcoming in execution quality is primarily driven by brokers’ inability to route the transactions to the trading venue with the best price. For retail clients, in contrast, the shortcoming is due to poor liquidity timing and a strong reliance on active executions. Only institutional block trades benefit from execution by sophisticated brokers.
Björn Hagströmer 