Plato Partnership released a new piece of independent academic research into how the market quality effects of fragmentation depend on the type of exchange competition. The research was conducted by Michał Dzieliński and Björn Hagströmer from Stockholm Business School, Stockholm University, and Chengcheng Qu from the College of International Management, Ritsumeikan Asia Pacific University as part of Plato Partnership’s MI3 Academic initiative.
Market fragmentation impact:
- Only 40% of European stock trading now takes place at listing exchanges, marking a dramatic shift in market structure over the past two decades
- The study identifies three key areas of exchange competition: liquidity, speed, and compliance
- Research shows that centralization leads to declined liquidity, with bid-ask spreads widening and market depth falling
Surprising findings:
- Low correlation between liquidity competition and market fragmentation suggests exchanges attract trades for reasons beyond improved liquidity
- Stocks with high liquidity competition showed a 23% increase in effective bid-ask spread after centralization, compared to just 5% for other stocks
- Market depth dropped 33% for stocks with high liquidity competition, versus 17% for other Swiss stocks
Swiss market case study:
- Natural experiment following Switzerland’s loss of EU regulatory equivalence in July 2019
- Swiss equity market shifted from 30% MTF trading to zero
- German stocks used as control group showed significantly smaller liquidity impacts
This paper focuses on liquidity competition, measured by how much the multi-lateral trading facilities (MTFs) improve the bid-ask spread, or by the fraction of market depth provided by the MTFs. An interesting finding is that the correlation between liquidity competition and the degree of market fragmentation (measured as the MTF share of trading volume) is low. This suggests that exchanges attract trades not only due to improved liquidity, but also for other reasons, such as speed and compliance.
To identify the effects of exchange competition, this paper studies the sudden centralization of trading in Swiss stocks in July 2019. At that time, the Swiss financial market’s status of regulatory “equivalence” with the EU was revoked. The Swiss equity market went from having around 30% of the trading activity at the MTFs, on average, to zero.
The results show that after the centralization of trading, the liquidity in Swiss stocks declines. The bid-ask spreads widen and the market depth falls. This is consistent with prior studies showing that fragmentation benefits market liquidity. Surprisingly, however, the effects are not stronger for the stocks with higher fragmentation before the event. Instead, it is the stocks with the greatest liquidity competition, which display the largest drops in liquidity.
Specifically, the effective bid-ask spread in stocks with high liquidity competition increase by 23% after the centralization. For other Swiss stocks, the increase is merely 5% – on par with a set of German stocks that are used as a control group. Similar results hold for the quoted bid-ask spread. Furthermore, the depth posted in the order book drops by 33% for Swiss stocks with high liquidity competition, and only by 17% for other Swiss stocks. For the German control group, depth falls by 7% over the same time period.
The findings hold for liquidity measured on aggregate across exchanges, as well as for the Swiss exchange in isolation. The latter is relevant to investors who do all their trading at the listing venue, which is common for, e.g., retail investors.
The study concludes that different types of exchange competition have different impact on market liquidity. Market fragmentation is associated with liquidity benefits, but that boost hinges on the exchanges competing on liquidity provision. Thus, if the goal of policymakers is to reduce overall transaction costs, they should prioritize competition on liquidity among the fragmented marketplaces.