Trading Fees and Efficiency in Limit Order Markets

Abstract

Common wisdom has it that competition between trading platforms in securities markets benefits investors because it forces platforms to charge smaller fees. We challenge this view by showing that a decrease in trading fees can impair investors' expected welfare in limit order markets. Indeed, a decrease in trading fees can induce investors to strategically post limit orders with a smaller execution probability, in order to earn a greater surplus in case of execution. Hence, a decrease in trading fees yields larger gains from trade when a trade takes place but it can reduce the likelihood of a trade in the first place. The model has testable implications for the effects of a change in trading fees and their breakdown between investors submitting limit orders (makers) and market orders (takers) on limit order fill rates and various measures of bid-ask spreads.

Dark trading and price discovery

“…Fragmentation can also harm liquidity and price discovery by increasing search costs and thus decreasing competition between liquidity providers (e.g., Yin, 2005). Fragmentation can also benefit markets through increased competition between trading venues, which can lower trading costs (e.g., Foucault and Menkveld, 2008;Colliard and Foucault, 2012). The empirical evidence on the effects of fragmentation is mixed, mirroring the various opposing effects predicted by theory.…”

Optimal Make-Take Fees for Market Making Regulation

“…We would like to thank an anonymous referee for suggesting this interpretation 6. See indeedFigure 2by noting that u does not depend on the fee c.…”

“…From an academic viewpoint, studies of make-take fees structures and their impact on the welfare of the markets have been mostly empirical, or carried out in rather stylized models. An interesting theory, suggested in [2] and developed in [6] is that make-take fees have actually no impact on trading costs in the sense that the cum fee bid-ask spread should not depend on the make-take fees policy. This result is consistent with the empirical findings in [20,22].…”

Endogenous formation of security exchanges

“…Our model can deal with these issues using a club theory approach instead. Our work differs as well from the classic models of vertically differentiated duopolies; see Gabszewicz and Thisse (1979) for a leading work on vertically differentiated oligopolies, and Colliard and Foucault (2012) and Pagnotta and Philippon (2012) for models allowing investors to choose between two platforms that trade one security and exchanges compete à la Bertrand. In our model, every possible subset of traders can form a SX, and multiple SXs can form in equilibrium.…”

“…We leave this possibility for future research. 4 For simplicity, we do not model trading fees, which have become substantially less important since implementation of the Mifid regulation (seeColliard and Foucault 2012 for a survey of this literature and for an analysis of the effect of trading fees on the efficiency of the markets); nor do we consider transaction fees (e.g., stamp duty). We focus instead on the pure trading aspects of security markets.…”