Stock Exchange Competition in a High Frequency World

Abstract

This dissertation examines the impacts of competition among stock exchanges in a high frequency equities trading environment on liquidity provision, gains from trade for different trader types and externalities on other exchange venues. New securities regulation has facilitated the entry of stock exchanges that compete to provide alternative secondary market trading venues. Concurrently, major advancements in technology, including algorithmic trading, co-located market access and low latency communication networks, have dramatically increased the speed of trading. As a result, modern equities trading is both fast and fragmented.

This dissertation presents three empirical studies. The first study assesses the entry of a new trading venue into a monopolistic trading environment. Competition improves liquidity as the entrant reduces the incumbent's market power, which lowers trading fees that liquidity suppliers pass on via narrower bid-ask spreads. Market efficiency improves following the entrant exchange's launch, especially for participants with smart order routing technology to access both exchanges.

The second study investigates the introduction of a speed bump on an existing stock exchange, which provides some fast liquidity suppliers with guaranteed millisecond-level latency advantages to avoid order flow driven adverse selection. Profits from liquidity provision increase immensely for these beneficiaries. Slower liquidity suppliers, and those on other exchanges, face higher adverse selection, which is partially absorbed into lower profits and partially passed on via wider bid-ask spreads, increasing implicit transaction costs.

The third study examines a trading platform speed upgrade to the microsecond-level on the main stock exchange in a competitive trading environment. The upgrade allows faster liquidity replenishment by high frequency traders and increases the venue's market share. However, quicker trade completion also enables fast liquidity suppliers on other venues to fade their quotes after observing trades on the upgraded venue, reducing the accessibility of liquidity across venues.

The dissertation's findings demonstrate that competition among stock exchanges in a high frequency world can have both intended consequences of attracting order flow and reducing market frictions, as well as unintended consequences that affect liquidity on other trading venues and the gains from trade for different trader types.