Speed Competition and Segmentation in Illiquid Markets

Abstract

In this paper we present a general equilibrium model to analyze competition between multiple venues (dealers), endogenous market segmentation, transaction speeds and fees, trading volume, optimal regulator's choice for taxing traders, and welfare in illiquid asset markets. Differences in trading speed between different venues lead to endogenous market segmentation, which in- creases trading volume and thus overall liquidity. Specifically, we find that liquidity increases in trading speeds, while decreasing in transaction fees and regulatory taxes. With competition, the optimal choice of transaction fees are increasing (resp. decreasing) in the trading speed of the faster (resp. slower) venue. When venue entry is sequential, the entrant's optimal choice of trading speed increases with lower entry costs and regulatory taxes. We further consider different notions of welfare: surplus from trade, trading volume, and trading revenue. In each of these cases, we consider the optimal regulator's choice for taxing traders, and the resulting optimal choice of speed for the entrant. Depending on the regulator’s objective, the optimal trading tax choice can be zero or strictly positive. Finally, we investigate welfare loss due to competition and the speed choice of the entrant.