Working Paper: CEPR ID: DP5523
Authors: Thierry Foucault; Albert J. Menkveld
Abstract: We study changes in liquidity following the introduction of a new electronic limit order market when, prior to its introduction, trading is centralized in a single limit order market. We also study how automation of routing decisions and trading fees affect the relative liquidity of rival markets. The theoretical analysis yields three main predictions: (i) consolidated depth is larger in the multiple limit order markets environment, (ii) consolidated bid-ask spread is smaller in the multiple limit order markets environment and (iii) the liquidity of the entrant market relative to that of the incumbent market increases with the level of automation for routing decisions (the proportion of 'smart routers'). We test these predictions by studying the rivalry between the London Stock Exchange (entrant) and Euronext (incumbent) in the Dutch stock market. The main predictions of the model are supported.
Keywords: centralized limit order book; market fragmentation; smart routers; tradethroughs; trading fees
JEL Codes: G10; G18; G24; L13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Introduction of a new electronic limit order market (C69) | Greater consolidated depth (F12) |
| Multiple limit order markets (C69) | Decrease in bid-ask spread (G19) |
| Increase in automation in routing decisions (L23) | Increase in liquidity of the new entrant market relative to the incumbent market (G19) |