Imperfect Competition in Financial Markets: An Empirical Study of Island and Nasdaq

Abstract

The competition between Island and Nasdaq at the beginning of the century offers a natural laboratory to study competition between and within trading platforms and its consequences for liquidity supply. Our empirical strategy takes advantage of the difference between the pricing grids used on Island and Nasdaq, as well as of the decline in the Nasdaq tick. Using the finer grid prevailing on their market, Island limit order traders undercut Nasdaq quotes, much more than they undercut one another. The drop in the Nasdaq tick size triggered a drop in Island spreads, despite the Island tick already being very thin before Nasdaq decimalization. We also estimate a structural model of liquidity supply and find that Island limit order traders earned rents before Nasdaq decimalization. Our results suggest that perfect competition cannot be taken for granted, even on transparent open limit order books with a very thin pricing grid.competition in financial markets, liquidity supply, trading mechanisms, different tick sizes

One size fits all? High frequency trading, tick size changes and the implications for exchanges: market quality and market structure considerations

“…6 In addition, a smaller tick size encourages front-running in the limit order book (Ronen andWeaver 2001 andPortniaguina et al 2006). Finally, Biais et al (2010) show the effect of the tick size change on market structure through the change in competition between Island and Nasdaq. In particular, their study shows that Island traders undercut competition with Nasdaq traders by taking advantage of a finer tick size and spreads decreased further in Island after the reduction in the tick size for Nasdaq stocks.…”

Market Quality and Contagion in Fragmented Markets

“…While many papers compare liquidity metrics such as bid-ask spreads on an ECN with those on an exchange, with both being analyzed in isolation, fewer study the effects on liquidity of the interaction between ECNs and exchanges. In the latter camp are Hendershott and Mendelson (2000), Weston (2002), Foucault and Menkveld (2008) and Biais et al (2010), who find that in general the growth of electronic competitors has had a positive impact on bid-ask spreads in the underlying markets. None of these papers explicitly studies the effects of cross-venue trades, however, with the exception of Karolyi et al (2012) who argue that during periods of market stress, commonalities appear that are due to the crisis-induced trades by cross-market arbitrageurs, a theme that we also explore in this paper.…”

Adverse selection, market access, and inter-market competition

“…Pagano [1989] and Chowdry and Nanda [1991]) argue that markets display a natural tendency to consolidate as a consequence of liquidity externalities, there is a large empirical literature that empirically documents the existence of fragmented financial markets (e.g. Bessembinder [2003], Boehmer and Boehmer [2004], Goldstein et al [2007], Biais et al [2010]). …”