Fragmentation of public equity markets

 Fragmentation of public equity markets
Traditionally, trading a specific stock in a single venue generated economies of scale
and network externalities that made stock exchanges considered as natural monopolies
sustained by regulatory advantages (Kay, 2006). However, technological advances have
come to challenge that; notably, communication technology that makes the geographical
location of a trading venue less important and information technologies that have
drastically decreased costs and time required for processing and disseminating large
amounts of information, such as orders and quotes.
Today, trading is fragmented in two dimensions: 1) between stock exchanges
(on-exchange) and a large number of other trading venues (off-exchange); and, 2) between
transactions where investors have access to pre-trade information about buying and
selling interests (lit or displayed trading) and transactions where pre-trade information is
not made available (non-displayed trading, often referred to as dark trading).

 In most advanced economies, trading in a company’s shares now takes place in many
different venues in addition to the stock exchange where the company’s shares are actually
listed. Most important among these “off-exchange” venues are alternative trading systems
(ATSs) in the United States and multilateral trading facilities (MTFs) in Europe, which
match buyers and sellers for a transaction. ATSs are not regulated like national securities
exchanges. They must register as broker-dealers and comply with Regulation ATS. Unlike
national securities exchanges, ATSs are not required to publicly disclose their trading
services, operations or fees. MTFs are regulated as investment services under the
EU regulatory framework.
In addition to exchanges and off-exchange trading venues such as ATSs and MTFs,
trading can also be executed in a firm’s internal trading system (e.g. broker, dealer or
Figure 4.2. Revenue structure of stock exchanges
Note: Aggregated revenue data from 18 stock exchanges.
Source: Thomson Reuters, stock exchanges’ websites and annual reports.
1 2
Cash and capital markets trading Derivatives and OTC markets trading
IT and market data services Post trade services
Listing and issuer services Financial income
2004 2014
investment bank). When a firm “internalises” a client’s order in this way, it generally
matches the order with its own inventory of securities. This means that the client’s order
is not routed to an exchange or an off-exchange trading venue. Instead, it is executed on a
bilateral basis within the internal trading system of the firm and against its own portfolio.
Taking advantage of advancements in information and communication technology
has been facilitated by regulatory changes. For example, the EU’s Markets in Financial
Instruments Directive (MiFID 1), which was adopted in 2007, abolished the “concentration
rule” that allowed EU member countries to require investment firms to route equity orders
only to stock exchanges, in particular to the company’s listing exchange. 

Together with the
recognition of the MTFs and systematic internalisers as trading venues, the abolition of the
concentration rule amplified competition between exchanges and off-exchange trading
venues in European equity markets.
Initiatives to the same effect have been taken in the United States. The US Regulation
National Market System (Regulation NMS) adopted in 2005 is a collection of existing and new
rules issued by the US Securities and Exchange Commission (US SEC). A new key rule was the
“Order Protection Rule” which requires trading centres to enforce policies and procedures that
prevent the execution of trades at prices inferior to protected quotations displayed by other
trading centres. The objective is to ensure that investors receive an execution price equivalent
to the best price available in all trading venues. 

A second change was the “Access Rule” which
was aimed at ensuring a level playing field among trading venues by improving access to
quotes in different trading venues. The third major change was to amend the market data
rules to further promote market data availability and to allocate market data revenues to
those Self-Regulatory Organisations1 that produce the most useful data for investors.
One of the key objectives of the US SEC’s new rules in Regulation NMS was to promote
competition among trading venues. First, Regulation NMS assured new or smaller trading
venues that if they displayed the best prices, they would attract order flows since larger,
dominant venues, according to the Order Protection Rule are not allowed to ignore their
quotations.2 Second, Regulation NMS provided new or smaller trading venues with access
to displayed quotations of dominant venues as required in the Access Rule (US SEC, 2005).
As mentioned above, the fragmentation of trading into multiple venues has been
accompanied by an increase in dark trading in the last decade. The difference between
dark and lit trading lies in the transparency of trade information.

 The information can be
transparent either pre-trade, which gives investors access to information about buying and
selling interest before trading, or post-trade, which means that trade information is
disseminated to the public after the execution of the trade. In both the United States and
Europe, post-trade disclosure is required for all trades, including trades that are executed
on off-exchange platforms and internal trading systems of firms. Therefore, the distinctive
character of dark trading is that there is no pre-trade transparency with respect to buyer
and seller interests.
While dark trading is often associated with off-exchange trading, the picture is not
that clear-cut. In fact, there are off-exchange venues that can carry out lit trading and there
are regulated exchanges that execute a significant amount of dark trading based on
so-called hidden orders. For example, one type of ATS, an Electronic Communication
Network (ECN) in the United States, is organised as a publicly displayed limit order book
that is fully electronic. An ECN automatically and anonymously matches and executes
orders, avoiding the need for a third party to be involved in the transaction.

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