The Impact of Fragmentation on Market Quality in Selected Markets

Implications for Competition in Australia

Authors: Agceli, Ulas (307145050) Clayton-Johnson, Lliam (308185137) Tate, Oscar (308185250) Zhao, Linton (307199487)

Abstract Chi-Xs impending introduction into Australian Equities Markets will see first competition for incumbent trading platform the Australian Securities Exchange (ASX). This raises questions over the impact of fragmentation on market quality, and potential implications for Australian securities. This report draws on theoretical relationships and real life case studies to assess the outlook for market quality in Australia, post Chi-Xs integration.

Table of Contents
Introduction3 Section 1: Market Quality..3 1.1 Liquidity...3 1.2 Transparency4 1.3 Price Discovery4 Section 2: Advantages and Disadvantages of Market Fragmentation...........................5 Section 3: Case Studies- Securities Markets in Europe and the U.S..8 3.1 Securities Markets in Europe...8 3.1.1 Market Structure8 3.1.2 Fragmentation Impact on Liquidity...9 3.1.3 Fragmentation Impact on Price Discovery..10 3.1.3 Fragmentation Impact on Transparancy..10 3.2 Securities Markets in the U.S.11 3.2.1 Market Structure..11 3.2.2 Fragmentation Impact on Liquidity.....12 3.2.3 Fragmentation Impact on Price Discovery..13 3.2.4 Fragmentation Impact on Transparency..13 Section 4: Conclusions.13 Section 5: Practical Implications for Australian Financial Markets ...14 References15

Introduction
The introduction of the alternative-trading venue Chi-X in Australian markets will have a significant impact on Australian financial markets. The appearance of similar alternative exchanges in the United States such as Archipelago and BATS, and in European markets Chi- X Europe has led to innovations in electronic trading that particularly favour algorithmic traders with lower transaction latencies and lower transaction costs. Such fragmentation of financial markets has also been criticised because of its effects on market quality. Fragmentation can impede information price discovery between market venues, divide liquidity and in doing so increase search costs and price inefficiencies. Market quality, primarily in terms of liquidity, transparency and pricing efficiency have shown to be effected when foreign market experienced fragmentation of this sort. We will analyse the responses of markets to new regulatory reforms in the United States and Europe. In doing so we hope to shed light on how Australian markets will respond to fragmentation given its current state and regulatory framework.

Section 1: Market Quality

The quality of a market is ultimately defined by the structure implemented and how well they accommodate current market participants in improving economic welfare (Harris 2003). OHara & Ye (2009) defines market quality to be markets ability to meet its dual goals of liquidity and price discovery. However, this does not succinctly describe the many facets that contribute to the quality of the market. This report proposes market quality to be an interconnecting web not limited to only liquidity and price discovery, but also spread of market participants and transparency. The following report will define the propose constituents of market quality and offer insight into the relationship.

1.1 Liquidity Theoretical review suggests there are various definitions and measures of liquidity. We propose that liquidity can be informally defined as the capability for traders to trade without the restraints of price impact, implicit and explicit costs and

search for counter-parties. More formally, liquidity can be separated into the following dimensions: immediacy, width, depth and resilience (Anand & Harris 1990). Depth and width, the number of shares that can be traded at a given spread (Heflin et. al, 2001), imply enough interest on the buy and sell side for traders to execute large trades with relative immediacy (Bernstein 1987). Moreover, Garbade (1982) describes resiliency as a large "countervailing order flow whenever transaction prices change because of temporary order imbalances", owing largely to diversity in stocks (Persaud 2003). Practically speaking, a suitable proxy for liquidity can be found in the ability to trade1 under current bid-ask quotes with little price impact. As such, tighter spreads are indicative of more liquid markets and help contribute to overall market quality (Grossman & Miller 1988; Kyle 1985).

1.2 Transparency Market transparency refers to the means by which of past trades and quote information are recorded and distributed to the public. What is not agreed upon by the academic community, is the effect of transparency for market quality, namely the change in price discovery and fairness (Bloomfield & OHara 1999). The two main conflicting arguments on market transparency are that market makers are offered insight into trade patterns such as imbalance between buyers and sellers. This in turn allows them to set prices more efficiently improving market quality (Pagano & Roell 1996). Market transparency however also decreases the incentive for market makers to compete for order flow through setting competitive spreads. This is because liquidity demanders are revealed to market makers in the order books and consequently charge higher prices for providing liquidity (Bloomfield & OHara 1999). This, in effect, decreases incentives for uninformed utilitarian traders to trade, to the detriment of market quality. Hence market transparency presents a conundrum for market structure designers and policy regulators in bettering the quality of the market.

1.3 Price Discovery Price discovery, the process by which market prices incorporate new information, is one of the fundamental functions of financial markets (Yan, 2005). 4

The purpose of a financial market is to grapple with the resource allocation problem and inefficiency in price discovery fails to complete this market objective (Harris 2003). The implication is that high market quality requires efficient price discovery. One of the major concerns for market regulators and, to a large extent, welfare economists is the effect of fragmentation on price discovery and information dissemination (Hasbrouck 1995). Lockwood & Lin (1990) propose that efficiency of price discovery can be measured variably by volatility in stock prices. Volatility can be both reflective of market quality and market inefficiencies. Good volatility constitutes price movements that are attributable to new information in the market, and bad volatility reflects price changes resulting from transaction costs that arise from difficulty in discovering prices that are consistent with intrinsic values (Ozenbas, Schwartz & Wood 2002). It is to be concluded then, that the relationship between fragmentation and volatility is important in assessing the impact of competition on market quality.

Section 2: Advantages and Disadvantages of Market Fragmentation

Market fragmentation occurs because investors have heterogeneous demand (Harris 2003). High frequency traders prefer low latency network connections while average investors prefer pre or post trade services. Competition forces innovation through adopting newer technology, reduce explicit trading costs and enhance trading services (Riordan, Storkenmaier & Wagener 2010). The current literature discussing the impact of market fragmentation on market quality has not reached common consensus. The recurring argument is that the benefits of competition in fragmented markets are opposed to the adverse effects of inefficiency in price discovery (Harris 2003). Added to this problem, the effects of market fragmentation on liquidity, price volatility and transparency remain largely inconclusive. However, as Chowdhey & Nanda (1991) showed consolidation of order flow reduce search costs and enhance price discovery. Chowdhey & Nanda (1991) also argue consolidated markets reduce the avenue to which informed traders can exploit their private information. Consequently, the prevention of informed traders splitting trades across several markets increase the informativeness of prices. In addition,

Cream-skimming by informed trading within fragmented markets can have immense negative connotations to price discovery and efficiency (Easley, Kiefer & OHara 1996). By contrast, though fragmentation should theoretically decrease volatility (Harris, 2003), findings suggest otherwise. U.S markets are generally observed to have an increase in short-term volatility in a fragmented market (OHara & Ye 2011; Madhavan 1995). Lockwood and Lins (1990) proposal that short term volatility is a reflection of effective price dissemination, draws the implication from OHara and Yes (2011) findings that a fragmented market contributes to improvements in price discovery. Madhaven (1995) showed that in a fragmented market, the absence of trade disclosure can benefit large traders who place multiple trades, and that unless trade disclosure is compulsory then a single market system isnt necessarily required. Furthermore, Forde and Tang (2009) show that anonymous trading can benefit price competition and liquidity in fragmented markets, especially for large and liquid stocks. Conversely, Lee (2002) explains that more transparency means better informational efficiency and allows traders to choose which trading system delivers the best quoted price. This facilitates arbitrage between different systems, ensuring price priority, and enhancing the price discovery process. Lee (2002) also brings to light the possibility of too much transparency and that informed and uniformed traders have opposing preferences to the amount of pretrade transparency that exists. Gravelle (undated) reiterates this point by stating that in regard to transparency, there is no optimal market structure that would benefit all participants and simultaneously increase market efficiency and liquidity. As such, if fragmented markets implicitly decrease transparency, then it can be concluded that they have conflicting implications for market quality. Fragmented markets, and their insinuated lack of transparency, improve market quality through an increase in the liquidity of larger stocks (Forde and Tang, 2009). On the downside, if fragmented markets are not transparent then pricing efficiency is subsequently decreased. The literature found on market fragmentation and the effects on liquidity does not provide conclusive evidence on this matter. While there is consensual agreement on positive effects of liquidity externalities arising from gathering traders in space and 6

time to reduce search and trading costs, the inherent subjective nature of measuring liquidity, may provide a reasonable argument into the conflicting conclusions obtained by various academics (OHara & Ye 2009; Barclay & Hendershott 2004). We argue, supported by Heflin et. als (2001) conclusions, that the bid-ask spread is the main determinant of liquidity in a security. Fragmentation causes a reduction in monopoly power of liquidity suppliers forcing them to lower implicit costs (Riodana et al 2010). Not surprisingly, the prevalent view on fragmentation is it causes, on average, a reduction in bid-ask spread. Boehmer & Boehmer (2003), Battalio et al (2004), de Fontnouvelle et al (2003) and Hengelbrock & Theissen (2009) all present empirical evidence supporting the statement. Since tightening of spreads convey an increase in liquidity, fragmentation should inadvertently increase liquidity. A new innovation of trading is High Frequency Trading (HFT), specifically, algorithmic trading is said to amplify volatility. This particular form of trading is prevalent in fragmented markets due to increased opportunities for profit (Hendershott, Jones & Menkveld 2010). Chung & Kim (2005)s remark on the vulnerability of liquidity shock in fragmented market rang true in the 2010 Flash Crash. As liquidity dried up driven by series of algorithmic orders, security prices plunged creating widespread instability across the U.S market (Easley, de Prado & OHara 2011). While these studies all present empirical evidence and sound economic argument on the impact of market fragmentation to market quality, there are several key considerations that cannot be ignored. Heavily fragmented markets can be intrinsically consolidating. A prime example is the U.S equity market that may appear fragmented but is in fact virtually consolidated. Order routing technology, existence of a consolidation tape and the regulatory trade through policy are aspects that force consolidation (OHara & Ye 2006). Furthermore, fragmentation in various markets differ quantitatively as well as qualitatively, that is, empirical measures of fragmentation do not constitute accurate reflections of the various global markets. The European market may seem to be similarly fragmented to the U.S markets, but the reality is, non-uniform price on securities and the consequent inability to establish trade- through protection policy result in more severe market fragmentation (OHara & Ye 2006). As such, the 7

implication is that the market structure and subsequent regulations and protocols play a large part in aiding fragmentations contribution to market quality.

Section 3: Case Studies- Securities Markets in Europe and the US

Perhaps the best way to predict the impact of market fragmentation on Australian markets is to observe the impact of the phenomenon in other markets. Firstly we need to consider the state of the market place prior to the reforms, specifically the level of fragmentation in US and EU markets. Also important is the details of the trading protocols and the correspondence of rules which will be implemented in Australia with the inception of Chi-X. These will govern the degree to which the experience abroad will be relevant for Australian markets. Based on these findings we can form expectations on the effect of fragmentation on Australias market quality.

3.1 Securities Markets in Europe

3.1.1 Market Structure Up until the introduction of Chi-X Europe and other Multilateral Trading Facilities (MTFs), the European financial markets were showing a tendency to converge to a few centralised exchanges. Each European nation typically had one centralised exchange that local traders would consolidate in. The major exchanges included the Frankfurt Stock Exchange, BME Spanish Exchanges and the London Stock Exchange (LSE), while the smaller European markets banded together in the Euronext and OMX exchanges. There are two reasons why financial markets would concentrate in their respective countries. Firstly, as mentioned by Gresse (2010) a set of concentration rules was implemented by European nations to protect traditional exchanges and hinder competition from alternative trading venues. Furthermore the classical order flow externality was proposed to be a driving force that gravitated traders the same trading venues. According to Lannoo & Valiante (2010) the remaining fragmentation was mainly driven by geographical and behavioural factors. In November 2007 the European Union implemented Markets in Financial Instruments Directive (MiFID) with the primary objective of improving market

quality. The outlined objective is to encourage market competition, enforce transparency conditions and offer greater protection for retail investors. The law allowed exchanges based in a European member state to be regulated in that state and provide financial services to other member state investors. The key features of the MiFID directive are: The Best Execution rules under Article 21 states firms must seek the best execution available for their clients in terms of account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant Post-Trade Disclosure rules under article 28 states that venues that trade

outside of exchanges must disclose prices, volumes and trade conclusion times. Transparency rules under article 29 and 30 involve releasing pre-trade

data such as bid-offer price and depth information as well as post-trade data including prices, volumes and times of executions in as close to real time as possible. Stringent Europe wide disclosure, transparency and execution rules in MiFID have allowed a number of MTFs to compete in Europe. By offering brokers lower transaction fees, brokers are forced to deal off-exchange in response to best execution obligations. Some examples of MTF start-ups in response to the MiFID include Chi-X, Turquoise and BATS. The most successful of these has been Chi-X Europe which is the second largest European equity trading venue. In the first half of 2011 Chi-X Europe turned over in excess of 620% of all traded volume in FTSE 100, CAC 40, AEX 25, BEL 20 and DAX 30 equities (Chi-X Europe 2011). MTFs have served to create not only the competition intended by the introduction of the MiFID, but also fragmentation of all the major European markets. Chi- X captured 12.53% of the market in terms of total European equities turnover in the run up to December 2009. In aggregate, new entrants captured 20% of the entire European market in the one year period after the introduction of MiFID (Lannoo & Valiante 2010). Since 2009 markets have maintained this fragmentation with Chi-X Europe and BATS increasing their market share of total trades in European equities.

3.1.2 Fragmentation Impact on Liquidity Hengelbrock & Theissen (2009) studied the extent to which such fragmentations in the European market impact on overall market quality. 9

Concentrating on the introduction of Turquoise, they find bid-ask spreads tighten and liquidity measures increase. The primary effect is a reduction in rent liquidity suppliers can charge in the primary market. The liquidity aspect of market quality and how its effected by fragmentation is also studied by Foucault & Menkveld (2008). By observing the EuroSETS alternative trading venue in Netherlands, they found the fee reductions resulting from competition could lead to an increase in market depth in the primary exchange. Surprisingly, the increase in demand for trades exceeded the loss of liquidity resulting from the migration of order flow to the alternative venue. Thus many authors agree that market fragmentation has benefited market quality in relation to the amount of available liquidity.

3.1.3 Fragmentation Impact on Price Discovery Riordan et al (2010) similarly make observations on changes in market quality as a result of the introduction of MiFID. Contrary to traditional views, they showed fragmentation had no detrimental effect on efficiency of the price discovery process. Riordan et al (2010) conclude competition and MiFID have a positive effect on market quality and price efficiency. Ozenbas, Schwartz & Wood (2002) reinforce these findings through their own empirical research. Their results show that European securities are volatile in the short term, which is consistent with Lockwood and Lins (1990) proposal that price efficiency is reflected in volatility post the release of new information.

3.1.4 Fragmentation Impact on Transparency Since the creation and implementation of the Markets in Financial Instruments Directive (MiFID), which aimed at increasing competition in Europe, there have been mixed impacts on market quality. Due to the existence of pre-trade transparency waivers, the European market and the newly introduced MTFs have increased the prevalence of dark pool trading of anonymously matched (usually large) trades (Gresse, 2010). This reduces the integrity of electronic order routing systems which require transparency to be effective and give the full picture of the market and prices. Europe basically operates a similar concept to the US market however it allows market forces to determine certain aspects of microstructure (CFA Institute 2009). To minimise the negative impacts of fragmentation, a system which does not include 10

waivers-to-transparency mandates would be desirable (Gresse, 2010).

3.2 Securities Markets in the US

3.2.1 Market Structure The US Securities and Exchange Commission (SEC) have a mandate to build a national market system with best price and execution while fostering innovation (Oesterle 2005). These goals are often in conflict with each other as best execution and prices are obtained in centralised markets, while innovation in financial markets is typically a result of strong competition (Langevoort 2008). The introduction of the Regulation National Market System (Reg NMS) in 2005 seeks to strengthen the NMS by sustaining competition between trading venues. The US counterpart to the European MiFID, the Reg NMS enforced similar rules to the MiFID that forced brokers to seek best executions and rules that governing transparency. The key features of the regulations are as follows: Order Protection Rule: Rule 611 in Reg NMS establishes intermarket protection against trade-throughs for all NMS stocks. A trade-through occurs when a market venue executes a trade at an inferior price to that available elsewhere. Access Rule: Under rule 610, among other things, no trading center can charge a fee for the execution of a trade against any best bid/offer quote price Sub-Penny Rule: Under rule 612, Reg NMS prohibits venues from

displaying, ranking or accepting quotations in increments of less than $0.01 The order protection rule is the most important of these for the encouragement of Alternative Trading Systems (ATSs). It forces exchanges to move orders to external markets so that they are executed at the best available price and not necessarily on the basis of best execution as in Europe. The rules that govern transparency however are more relaxed than in the MiFID. The result of these measures by the SEC has lead to significant market fragmentation more so than that seen in Europe post-MiFID. According to OHara and Ye (2011), Reg NMS has resulted in more than 40 trading platforms in 2008 with 20 or more ATSs, and 5 Electronic Communication Networks (ECNs). Data cited in Lannoo and Valiante (2010) shows the market share of the ECNs, ATSs and

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traditional exchanges as of September 2009 in terms of percentage of total volume traded. Most notable amongst these are BATS, Direct Edge and NYSE ARCA all new upstart ECNs together controlling 30% of all volume in the US. This combined with the internalisation of 17.5% of total volume by broker-dealers, and the 7.9% of volume accounted for by institutional trades in Dark Pools, leaves little space for traditional exchanges such as NYSE and NASDAQ.

3.2.2 Fragmentation Impact on Liquidity OHara and Ye (2011) is the cornerstone paper that discusses the empirical effect of market fragmentation in the United States and its effect on the quality of the market. Foremost amongst their findings are the observed reductions in bid-ask spread sizes and increase in execution speeds. Bennett & Wei (2006) exploited the differential market structure between the dealer driven NASDAQ and order driven NYSE to examine the effects of fragmentation on liquidity. Moreover, Bennett & Wei (2006) proposed that order flow consolidates when a security switch listing from NASDAQ to NYSE. It is found liquidity significantly improved for generally illiquid securities moving to a more consolidated market (i.e. NYSE). Mendelson (1987), Madhavan (1995) and Barclay & Hendershott (2004), among others all documented increase in liquidity with consolidation in markets. Boehmer & Boehmers (2003) analysis on the effects of market fragmentation on liquidity is motivated with NYSEs introduction of three Exchange Traded Funds (ETFs) that are also listed on the American Stock Exchange. The multiexchange traded ETFs had a substantial decrease spreads and increase in depth subsequently improving liquidity. Hengelbrock & Theissen (2009)s event study provided evidence on liquidity improvements in the European market with the launch of Turquoise in 14 European countries. Battalio, Hatch & Jennings (2004) and de Fontnouvelle, Fishe & Harris (2003) confirmed reduction in spreads for multiple listed single equity option contracts in the U.S derivatives markets. The fragmentation can also have some serious unforeseen effects. As Easley et al (2011) concludes, the 2010 Flash Crash was a liquidity crisis arising from the impact of high frequency traders on short term price movements. The encouragement of fragmented markets allow for the development of trading venues that specifically cater for algorithmic traders. The proliferation of such trading 12

methods can increase the severity of market failures leading to a deterioration of market quality when the whole business cycle is considered.

3.2.3 Fragmentation Impact on Price Discovery Short-term volatility was also observed in US markets and found to increase in a manner that made price movements closer to a random walk. The higher price efficiency reflected in short term volatility suggests a significant improvement in market quality (OHara and Ye, 2011). Ozenbas, Schwartz & Wood (2002) achieved similar results to those seen in European markets. They found that fragmented markets were typically defined by short-term volatility, particularly at the open of trading. This serves to support the findings of OHara and Ye (2011), that fragmentation increases pricing efficiency, reflected through the immediate dissemination of information into stock prices. No conclusive evidence was found about long-term volatility, implying that fragmentation does not necessarily increase transaction costs associated with ineffective price discovery.

3.2.4 Fragmentation Impact on Transparency More consistent transparency rules that apply to traditional exchanges and ATSs alike also help to create a level playing field and improve market quality further (Gresse, 2010). The major recent developments in US market regulations were finalised in 2005 as the National Market System, which ensures best execution through enforcement of both pre and post-trade transparency. Since the fragmentation of the US market, the National Best Bid and Offer is formed by electronic order routing systems which match trades from all instruments, of which prices and volumes must be known (CFA Institute 2009).

Section 4: Case Study Conclusions

The impacts of fragmentation on market quality have proved to be largely consistent across European and American equities markets. That is, competition governed by coherent regulatory bodies has served to improve liquidity, price discovery and transparency. With the exception of the Flash Crash, market quality

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has improved on the basis that alternate trading platforms compete to accommodate all market participants.

Section 5: Practical Implications for Australian Financial Markets

All proposals for competition structure have been sourced from Chi-X Australia (2011).

1. Best Execution: Australian securities markets will seek to provide market orders, FOK orders and IOC orders with the best available price. Implication: Much like the order protection rule in the US and best execution rule in Europe, this will create competition in the market to offer best price. Therefore, Australian securities markets can expect improved liquidity through the tightening of bid-ask spreads and as such, an improvement in market quality. Though it was not realised in the case studies, literature suggests that the dispersion of stocks across two platforms may harm liquidity. This is highly unlikely, as orders on Chi-X will clear through the ASX. 2. Pre-trade transparency and Price Formation: Details will be provided on all orders, order amendments, order cancellations and trades that occur. 3. Post-trade transparency: The establishment of a consolidated tape to effectively provide a national best bid, best offer and last traded price as a key reference tool. Implications: Highly comparable to the MiFID rule of pre trade transparency, pre-trade transparency and price formation increases the chance of dark pools of anonymously matched large trades. This will reduce the integrity of electronic order routing systems that require transparency to reflect best price. Furthermore, pricing inefficiency will deter utilitarian traders from the market and subsequently decrease liquidity. If dark pools do not form, pre-trade and post-trade transparency will likely encourage information symmetry and limited long-term volatility in stock prices. As such, price efficiency and market quality will be readily improved. All in all, fragmentation is likely to impact market quality favourably.

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