Working Paper: NBER ID: w25855
Authors: Eric Budish; Robin S. Lee; John J. Shim
Abstract: Will stock exchanges innovate to address latency arbitrage and the arms race for speed? This paper models how exchanges compete in the modern electronic era and how this shapes incentives for market design innovation. In the status quo, exchange trading fees are competitive while exchanges earn economic rents from selling speed. These rents create a wedge between private and social incentives to innovate, and support the persistence of an inefficient market design in equilibrium of a market design adoption game. We discuss implications for policy and insights for the literatures on market design, innovation, and platforms.
Keywords: market design; latency arbitrage; financial exchanges; innovation incentives
JEL Codes: D02; D44; D47; D53; D82; G1; G2; G23; L1; L13; L5; L89
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market design reform (D47) | solve latency arbitrage issues (F16) |
| market structure (D49) | innovation incentives (O31) |
| regulatory frameworks (G38) | incentives for market design innovation (D47) |
| latency arbitrage issues (F16) | divergence between private and social incentives to innovate (O35) |
| market design choices (D49) | trading fees (D49) |
| market design choices (D49) | market share (L17) |
| incumbent exchanges (F33) | maintain status quo (C62) |
| one exchange adopts market design (D47) | gain market share (L17) |
| one exchange adopts market design (D47) | charge higher trading fees (D49) |
| multiple exchanges adopt design (D47) | competitive pressures drive fees down (D49) |
| individual exchanges deviate to discrete design (D47) | higher profits (D33) |
| all exchanges shift to new design (F33) | worse off collectively (A39) |
| lack of economic incentive (P19) | barrier to market design reform (D47) |