Brown Hruska And Ellig Market Fragmentation Final Present To Sta 2000

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Brown Hruska And Ellig Market Fragmentation Final Present To Sta 2000

  1. 1. Market Fragmentation: What the Research Shows Sharon Brown-Hruska and Jerry Ellig Mercatus Center George Mason University http://www.mercatus.org/
  2. 2. Fragmentation or Competition? <ul><li>Multiple stock exchanges </li></ul><ul><li>Multiple dealers </li></ul><ul><li>Alternative Trading Systems </li></ul><ul><li>Internalization </li></ul>
  3. 3. Does fragmentation impair quote competition? <ul><li>The Evidence: </li></ul><ul><li>NYSE gains volume when a specialist price improves </li></ul><ul><li>Competing exchanges gain volume when they price improve </li></ul><ul><li>Nasdaq broker-dealers gain volume when they price improve </li></ul><ul><li>Entry of third market firm order flow narrows spreads </li></ul>
  4. 4. Benefits of competition (a.k.a. “fragmentation”) <ul><li>Cost reduction </li></ul><ul><li>Increased competition lowers costs. </li></ul><ul><li>Differentiation </li></ul><ul><li>No one market center dominates on all measures of execution quality. </li></ul>
  5. 5. SEC’s 1997 Preferencing Study <ul><li>Market orders traded on preferencing regional exchanges tend to trade more favorably than market orders placed on non-preferencing regional exchanges. </li></ul><ul><li>Limit orders have a greater probability of executing on regional exchanges than on the NYSE. </li></ul><ul><li>Data do not indicate that preferencing has harmed the market quality of the preferencing exchanges. </li></ul>
  6. 6. Suspicions… <ul><li>Payment for order flow “ may ultimately harm the process of public price discovery, increase price volatility, and detract from the depth and liquidity of the markets.” (SEC, August) </li></ul><ul><li>Investor comments in Market Fragmentation inquiry (Spring 2000) opposed payment for order flow </li></ul><ul><li>STA member survey: 44% believe all types and 65% believe some types of payment for order flow should be banned </li></ul>
  7. 7. SEC proposals, August 2000 <ul><li>Market centers must disclose monthly a 20 x 20 matrix of selected execution quality statistics </li></ul><ul><li>Brokers must report quarterly to customers on order-routing practices and quality of executions </li></ul><ul><li>Implicit strategy: curtail/eliminate payment for order flow through moral suasion and threat of class action lawsuits </li></ul>
  8. 8. Payment for order flow: <ul><li>Who wins, who loses? </li></ul>
  9. 9. Does payment for order flow impair market efficiency? <ul><li>No evidence that it harms price discovery </li></ul><ul><li>No evidence that it reduces liquidity </li></ul><ul><li>No evidence that it increases volatility </li></ul>
  10. 10. “ Best execution” is multi-faceted <ul><li>Spread </li></ul><ul><li>Commission </li></ul><ul><li>Price certainty </li></ul><ul><li>Other transaction costs </li></ul><ul><li>Speed of execution </li></ul>
  11. 11. Payment for order flow and execution quality Faster Speed of execution Lower Other transaction costs Greater (NBBO) Price certainty Lower (Likely offsets spread) Commissions Higher Spread
  12. 12. Payment for order flow segments the market <ul><li>Well-informed traders are riskier (higher cost) to trade with </li></ul><ul><li>Less-informed traders are less risky (lower cost) </li></ul><ul><li>Pricing structure segments orders </li></ul><ul><ul><li>Smaller, less informed: Higher spreads + low fixed costs </li></ul></ul><ul><ul><li>Larger, well-informed: Low spreads + higher fixed costs </li></ul></ul>
  13. 13. Different effects on different traders <ul><li>Less-informed traders better off on net </li></ul><ul><li>Wider spreads </li></ul><ul><li>Lower commissions </li></ul><ul><li>Other benefits </li></ul><ul><li>Well-informed traders may be better or worse off </li></ul><ul><li>Spreads may fall due to competition </li></ul><ul><li>Spreads may rise due to loss of cross-subsidy </li></ul>
  14. 14. Conclusions <ul><li>Competition (a.k.a. “market fragmentation”) does not impair market efficiency. </li></ul><ul><li>Competition produces benefits in the form of cost competition and differentiation. </li></ul><ul><li>Payment for order flow most likely benefits the traders whose orders are sold. </li></ul><ul><li>Payment for order flow improves market efficiency by segmenting the market into groups with different costs and charging them accordingly. </li></ul>
  15. 15. For more information… <ul><li>See the Public Interest Comments filed by the Mercatus Center’s Regulatory Studies Program </li></ul><ul><li>Disclosure of Order Routing and Execution Practices </li></ul><ul><li>Issues Related to Market Fragmentation </li></ul><ul><li>Regulation of Market Information Fees and Revenues </li></ul><ul><li>At www.mercatus.org </li></ul>

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