Parlour And Seppi-Liquidity-Based Competition For Order Flow.pdf

Liquidity-Based Competition

for Order Flow

Christine A. Parlour

Carnegie Mellon University

Duane J. Seppi

Carnegie Mellon University

We present a microstructure model of competition for order ﬂow between exchanges

based on liquidity provision. We ﬁnd that neither a pure limit order market (PLM) nor

a hybrid specialist/limit order market (HM) structure is competition-proof. A PLM can

always be supported in equilibrium as the dominant market (i.e., where the hybrid limit

book is empty), but an HM can also be supported, for some market parameterizations,

as the dominant market. We also show the possible coexistence of competing markets.

Order preferencing—that is, decisions about where orders are routed when investors are

indifferent—is a key determinant of market viability. Welfare comparisons show that

competition between exchanges can increase as well as reduce the cost of liquidity.

Active competition between exchanges for order ﬂow in cross-listed securi-

ties is intense in the current ﬁnancial marketplace. Examples include rival-

ries between the New York Stock Exchange (NYSE), crossing networks,

and ECNs and between the London Stock Exchange, the Paris Bourse, and

other continental markets for equity trading and between Eurex and London

International Financial Futures and Options Exchange (LIFFE) for futures

volume. While exchanges compete along many dimensions (e.g., “payment

for order ﬂow,” transparency, execution speed), liquidity and “price improve-

ment” will, in our view, be the key variables driving competition in the future.

Over time, high-cost markets should be driven out of business as investors

switch to cheaper trading venues. Moreover, “market structure” is increas-

ingly singled out by regulators, exchanges, and other market participants as

a major determinant of liquidity. 1

We thank the editor, Larry Glosten, for many helpful insights and suggestions. We also beneﬁted from

comments from Shmuel Baruch, Utpal Bhattacharya, Bruno Biais, Wolfgang Bühler, David Goldreich, Rick

Green, Burton Holliﬁeld, Ronen Israel, Craig MacKinlay, Uday Rajan, Robert Schwartz, George Soﬁanos,

Tom Tallarini, Jr., Josef Zechner, as well as from seminar participants at the Catholic University of Louvain,

London Business School, Mannheim University, Stockholm School of Economics, Tilburg University, Uni-

versity of Utah, University of Vienna, Wharton School, and participants at the 1997 WFA and 1997 EFA

meetings and the 1999 RFS Price Formation conference in Toulouse. Financial support from the University of

Vienna during Seppi’s 1997 sabbatical is gratefully acknowledged. Address correspondence to: Duane Seppi,

Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, PA 15213-3890, or

e-mail: ds64@andrew.cmu.edu.

1 See Levitt (2000) and NYSE (2000) regarding the U.S. equity market and “One World, How Many Stock

Exchanges?” in the Wall Street Journal , May 15, 2000, Section C, page 1, for a summary of developments

in the global equity market. See also LIFFE (1998).

The Review of Financial Studies Summer 2003 Vol. 16, No. 2, pp. 301–343, DOI: 10.1093/rfs/hhg008

The Review of Financial Studies/v16n22003

The coexistence of competing markets raises a number of questions. Do

liquidity and trading naturally concentrate in a single market? Is the cur-

rent upheaval simply a transition to a new centralized trading arrangement?

Or will competing markets continue to coexist side by side in the future?

If multiple exchanges can coexist, is the resulting fragmentation of order

ﬂow desirable from a policy point of view? Do some market designs pro-

vide inherently greater liquidity than others on particular trade sizes? 2 If

so, which types of investors prefer which types of markets? If not, do the

observed differences in liquidity simply follow from locational cost advan-

tages (e.g., is the Frankfurt-based Eurex the natural “dominant” market for

Bundt futures)? Is there a constructive role for regulatory policy in enhancing

market liquidity?

To answer such questions the economics of both liquidity supply and

demand must be understood. In this article we study competition between

two common market structures. The ﬁrst is an “order driven” pure limit

order market in which investors post price-contingent orders to buy/sell at

preset limit prices. The Paris Bourse and ECNs such as Island are examples

of this structure. The second is a hybrid structure with both a specialist and a

limit book. The NYSE is the most prominent example of this type of market.

Limit orders and specialists, we argue, play central roles in the supply of

liquidity. However, there is a timing difference which is key to modeling and

understanding these two types of liquidity provision. Limit orders, in either

a pure or a hybrid market, represent ex ante precommitments to provide liq-

uidity to market orders which may arrive sometime in the future. In contrast,

a specialist provides supplementary liquidity through ex post price improve-

ment after a market order has arrived. A pure limit order market has only

the ﬁrst type of liquidity provision, whereas a hybrid market has both. This

difference in the form of liquidity provision, in turn, plays an important role

in the outcome of competition between these two types of markets.

In this article we adapt the limit order model of Seppi (1997) to inves-

tigate interexchange competition for order ﬂow. 3 In particular, we jointly

model both liquidity demand (via market orders) and liquidity supply (via

limit orders, the specialist, etc.). Brieﬂy, this is a single-period model in

which limit orders are ﬁrst submitted by competitive value traders (who do

not need to trade per se) to the two rival markets. An active trader then arrives

2 Blume and Goldstein (1992), Lee (1993), Peterson and Fialkowski (1994), Lee and Myers (1995), and Barclay,

Hendershott, and McCormick (2001) ﬁnd signiﬁcant price impact differences of several cents across different

U.S. markets. For international evidence see de Jong, Nijman, and Röell (1995) and Frino and McCorry

(1995).

3 Other equilibrium models of limit orders, with and without specialists, are in Byrne (1993), Glosten (1994),

Kumar and Seppi (1994), Chakravarty and Holden (1995), Rock (1996), Parlour (1998), Foucault (1999),

Viswanathan and Wang (1999), and Biais, Martimort, and Rochet (2000). Cohen et al. (1981), Angel (1992),

and Harris (1994) describe optimal limit order strategies in partial equilibrium settings. In addition, Biais,

Hillion, and Spatt (1995), Greene (1996), Handa and Schwartz (1996), Harris and Hasbrouck (1996), and

Kavajecz (1999) describe the basic empirical properties of limit orders and Holliﬁeld, Miller, and Sandas

(2002) and Sandas (2001) carry out structural estimations.

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Liquidity-Based Competition for Order Flow

and submits market orders. In the pure market, the limit and market orders

are then mechanically crossed, while in the hybrid market, they are executed

with the intervention of a strategic specialist. As a way of minimizing her

total cost of trading, the active trader can split her orders between the two

competing exchanges. Limit order execution is governed by local price, pub-

lic order, and time priority rules on each exchange. Order submission costs

are symmetric across markets. This lets us assess the competitive viability of

different microstructures on a “level playing ﬁeld.” 4

Order splitting between markets appears in two guises in our article. The

ﬁrst is cost-minimizing splits which strictly reduce the active investor’s trad-

ing costs. These involve trade-offs between equalizing marginal prices across

competing limit order books and avoiding discontinuities in the specialist’s

pricing strategy. The second type of order splitting is a “tie-breaking” rule

used when the cost-minimizing split between the two markets is not unique.

This second type of splitting—which we call order preferencing —is contro-

versial. For example, the ability of brokers on the Nasdaq to direct order ﬂow

to the dealer of their choice so long as the best prevailing quote is matched

(i.e., to ignore time priority) has been criticized as potentially collusive.

Similarly the NYSE is critical of the ability of retail brokers to direct cus-

tomer orders to regional markets so long as the NYSE quotes are matched. 5

Our analysis below shows that concerns about order preferencing are well

founded since “tie-breaking” rules play a key role in equilibrium selection.

Our analysis follows the lead of Glosten (1994) in that we study the opti-

mal design of markets in terms of their competitive viability. In his article

Glosten speciﬁcally argues that a pure limit order market is competition-

proof in the sense that rival markets earn negative expected proﬁts when

competing against an equilibrium pure limit order book. We show, however,

that multiple equilibria exist if liquidity providers have heterogeneous costs.

In some of these equilibria the competing exchanges can coexist, while in

others the hybrid market may actually dominate the pure limit order market.

Our main results are

• Multiple equilibria can be supported by different preferencing rules.

Neither the pure limit order market nor the hybrid market is exclusively

competition-proof.

•

Competition between exchanges—as new markets open or as ﬁrms

cross-list their stock—can increase or decrease aggregate liquidity rel-

ative to a single market environment.

4 While actual order submission costs may still differ across exchanges, technological innovation and falling

regulatory barriers have dramatically reduced the scope of any natural (i.e., captive) investor clienteles.

5 Much of the controversy revolves around the possibility of forgone price improvement due to unposted

liquidity inside the NYSE spread. However, even when all unposted liquidity is optimally exploited, order

preferencing still has a signiﬁcant impact on intermarket competition in our model.

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• “Best execution” regulations limiting intermarket price differences to

one tick greatly improve the competitive viability of a hybrid market

relative to a pure limit order market.

A few other articles also look at competition between exchanges. The

work most closely related to ours is Glosten (1998), which looks at compe-

tition with multiple pure limit order markets and different precedence rules.

Hendershott and Mendelson (2000) model competition between call mar-

kets and dealer markets. Santos and Scheinkman (2001) study competition

in margin requirements and Foucault and Parlour (2000) look at competi-

tion in listing fees. Otherwise, market research has largely taken a regulatory

approach in which the pros and cons of different possible structures for a

single market are contrasted. Glosten (1989) shows that monopolistic market

making is more robust than competitive markets to extreme adverse selec-

tion. Madhavan (1992) ﬁnds that periodic batch markets are viable when

continuous markets would close. Biais (1993) shows that spreads are more

volatile in centralized markets (i.e., exchanges) than in fragmented markets

(e.g., over-the-counter [OTC] telephone markets). Seppi (1997) ﬁnds that

large institutional and small retail investors get better execution on hybrid

markets, while investors trading intermediate-size orders may prefer a pure

limit order market. His result suggests that competing exchanges may cater

to speciﬁc order size clienteles. Viswanathan and Wang (2002) contrast pure

and hybrid market equilibria with risk-averse market makers.

This article is organized as follows. Section 1 describes the basic model of

competition between a pure limit order market and a hybrid specialist/limit

order market, and Section 2 presents our results. Section 3 compares trading

and liquidity across other institutional arrangements. Section 4 summarizes

our ﬁndings. All proofs are in the appendix.

1. Competition Between Pure and Hybrid Markets

We consider a liquidity provision game along the lines of Seppi (1997) in

which two exchanges—a pure limit order market (PLM) and a hybrid market

(HM) with both a specialist and a limit order book—compete for order ﬂow.

In the model, both the supply and demand for liquidity in each market are

endogenous. A timeline of events is shown in Figure 1.

Liquidity is demanded by an active trader who arrives at time 2 and sub-

mits market orders to the two exchanges. The total number of shares x which

she trades is random and exogenous. With probability she wants to buy

and with probability 1

−

she must sell. The distribution over the random

is a continuous strictly increasing function F . Since

the model is symmetric, we focus expositionally on trading when she must

buy x> 0 shares. As in Bernhardt and Hughson (1997), the active trader

minimizes her total trading cost by splitting her order across the two mar-

kets. In particular, let B h denote the number of shares she sends as a market

304

(unsigned) volume

Liquidity-Based Competition for Order Flow

Figure 1

Timeline for sequence of events

buy to the hybrid market and let B p

−

B h be the market buy sent to the

pure market.

Liquidity is supplied by three types of investors. At time 1, competitive

risk-neutral value traders post limit orders in the pure and hybrid markets’

respective limit order books. At time 3, additional liquidity is provided by

trading crowds —competitive groups of dealers who stand ready to trade

whenever the proﬁt in either market exceeds a hurdle level r . In addition, a

single strategic specialist with a cost advantage over both the value traders

and the crowd provides further liquidity on the hybrid market. All of the

liquidity providers have a common valuation v for the traded stock. Thus the

main issue is how much of a premium over v the active trader must pay for

immediacy so as to execute her trades.

Collectively the actions of the various liquidity providers—described in

greater detail below—lead to competing liquidity supply schedules, T h and

T p , in the two exchanges. In particular, T h B h is the cost of liquidity in

the hybrid market when buying B h shares (i.e., the premium in excess of

the shares’ underlying value vB h ) and T p B p is the corresponding price

of liquidity in the pure limit order market. Given the two liquidity supply

schedules and the total number of shares x to be bought, the active trader

chooses market orders, B h and B p , to minimize her trading costs:

min

B h B p s t B h

T h B h

T p B p

(1)

B p

Solving the active trader’s optimization [Problem (1)] for each possible

volume x> 0 lets us construct order submission policy functions, B p x

and B h x . These two policy functions, together with the distribution F over

x , induce endogenous probability distributions F p and F h over the arriv-

ing market orders B p and B h in the pure and hybrid markets and, hence,

over the random payoffs to liquidity providers. In equilibrium, the demand

for liquidity in the two markets, as given by F p and F h , and the liquid-

ity supply schedules, T p and T h , must be consistent with each other. One

goal of this article is to describe the equilibrium relation between the market

order arrival distributions and the liquidity supply schedules. What types of

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