Adverse selection, market access, and inter-market competition

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe study the role of informed trading in a fragmented financial market under the absence of inter-market price priority. Due to frictions in traders' market access, liquidity providers on alternative trading platforms may be exposed to an increased adverse selection risk. As a consequence, the main market dominates (offers better quotes) frequently albeit charging higher transaction fees. The empirical analysis of a dataset of trading in French and German stocks suggests that trades on Chi-X, a lowcost trading platform, carry significantly more private information than those executed in the Primary Markets. Consistent with our theory, we find a negative relationship between the competitiveness of Chi-X's quotes and this excess adverse selection risk faced by liquidity providers in the cross-section. Our results have some implications for the design of best-execution policies.Keywords: MiFID, Inter-market competition, Adverse selection, Transaction fees JEL Classification: G10, G14, G241 Non-technical summaryThis paper studies the role of adverse selection in competition among stock exchanges when price priority across markets is not enforced, i.e. the regulator does not explicitly prohibit trades to execute at prices that are inferior to the best available price across all relevant trading platforms. The analysis is motivated by the absence of a so-called "trade-through rule" under MiFID in the European Union, which stands in contrast to the Regulation National Market System (RegNMS) in the United States that protects the currently best quote by forcing exchanges to route incoming orders to other markets in case they offer better terms of trade.First, we present a two-market version of the Glosten and Milgrom (1985) sequential trade model, where one market (the "Primary Market") can be accessed by all agents while trading in the other market (the "Entrant Market") requires agents to have access to a multi-market trading technology. This is motivated by the fact that searching for the best price among multiple venues is costly and computer technology helps to facilitate this process. Additionally we assume that the Primary Market charges higher transaction fees, which is motivated by the lower transaction fees observed on newly created trading platforms across Europe post-MiFID. We show that under the absence of a trade-through prohibition, this market access friction gives rise to differences in the adverse...

Commonality in intraday liquidity and multilateral trading facilities: Evidence from Chi-X Europe

“…However, the benefits of MTFs stand against potential risks, associated with their entry. Hoffmann (2016) shows that trades, executed on alternative platforms, carry significantly more private information than those executed in the primary markets, increasing adverse selection risks for MTF liquidity suppliers. By enabling trading of all European equities on a single platform, MTFs might also facilitate the transmission of liquidity shocks across markets.…”

The paradoxical effects of market fragmentation on adverse selection risk and market efficiency

“…Informed (faster) traders, deploying smart order routing under the MiFID regime, could route their trades to venues with higher levels of uninformed traders and liquidity, increasing the adverse selection risk faced by uninformed traders. Thus, the lack of trade-through protection in Europe could lead to increased adverse selection risk (Hoffmann, 2016).…”