Abstract
This paper studies fragmentation of equity trading using a model of imperfect competition. The addition of an exchange has theoretically ambiguous consequences for market quality. Increased competition places downward pressure on transaction fees. However, increased adverse selection stems from additional arbitrage opportunities that arise in fragmented markets. To investigate this ambiguity empirically, we estimate key parameters of the model with order-level data from Australia. At the estimates, the benefits of increased competition are outweighed by the costs of multi-venue arbitrage. Compared to the prevailing duopoly, we predict that the counterfactual spread under a monopoly would be 23 percent lower.
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