Working Paper: CEPR ID: DP8395
Authors: Jean-Edouard Colliard; Thierry Foucault
Abstract: We study competition between a dealer (OTC) market and a limit order market. In the limit order market, investors can choose to be "makers" (post limit orders) or "takers" (hit limit orders) whereas in the dealer market they must trade at dealers' quotes. Moreover, in the limit order market, investors pay a trading fee to the operator of this market ("the matchmaker"). We show that an increase in the matchmaker's trading fee can raise investors' ex-ante expected welfare. Actually, it induces makers to post more aggressive offers and thereby it raises the likelihood of a direct trade between investors. For this reason as well, a reduction in the matchmaker's trading fee can counter-intuitively raise the OTC market share. However, entry of a new matchmaker results in an improvement in investors' welfare, despite its negative effect on trading fees. The model has testable implications for the effects of a change in trading fees and their breakdown between makers and takers on various measures of market liquidity.
Keywords: intermarket competition; limit order markets; liquidity; maketake fees; otc markets; trading fees
JEL Codes: G00; G18; G20; L10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in matchmaker's trading fee (C78) | increase in investors' ex-ante expected welfare (D69) |
| increase in matchmaker's trading fee (C78) | more aggressive offers by makers (L14) |
| more aggressive offers by makers (L14) | increase in likelihood of direct trades between buyers and sellers (F69) |
| reduction in matchmaker's trading fee (C78) | increase in market share of OTC market (L19) |
| entry of a new matchmaker (C78) | improve investor welfare (G38) |
| changes in fee structures (D49) | affect execution probabilities (C69) |
| changes in fee structures (D49) | affect overall market activity (E44) |