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Trading Fees and Efficiency in Limit Order Markets

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  • Colliard, Jean-Edouard
  • Foucault, Thierry

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8395.

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Date of creation: May 2011
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Handle: RePEc:cpr:ceprdp:8395

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Keywords: inter-market competition; Limit order markets; liquidity; make/take fees; OTC markets; trading fees;

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References

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  1. Cantillon, Estelle & Yin, Pai-Ling, 2011. "Competition between exchanges: A research agenda," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 29(3), pages 329-336, May.
  2. Thomas Gehrig, 1993. "Intermediation in Search Markets," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 1058, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Thierry Foucault & Albert J. Menkveld, 2008. "Competition for Order Flow and Smart Order Routing Systems," Journal of Finance, American Finance Association, American Finance Association, vol. 63(1), pages 119-158, 02.
  4. Foucault, Thierry & Kadan, Ohad & Kandel, Eugene, 2009. "Liquidity cycles and make/take fees in electronic markets," Les Cahiers de Recherche 920, HEC Paris.
  5. Cantillon, Estelle & Yin, Pai-Ling, 2008. "Competition between Exchanges: Lessons from the Battle of the Bund," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6923, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. Degryse, H.A. & Achter, M. van & Wuyts, G., 2012. "Internalization, Clearing and Settlement, and Liquidity," Discussion Paper, Tilburg University, Center for Economic Research 2012-002, Tilburg University, Center for Economic Research.
  2. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 44621, University Library of Munich, Germany, revised Jan 2013.
  3. Hoffmann, Peter, 2013. "A dynamic limit order market with fast and slow traders," Working Paper Series, European Central Bank 1526, European Central Bank.
  4. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.
  5. Gomber, Peter & Sagade, Satchit & Theissen, Erik & Weber, Moritz Christian & Westheide, Christian, 2013. "Competition/fragmentation in equities markets: A literature survey," SAFE Working Paper Series 35, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
  6. Hoffmann, Peter, 2014. "A dynamic limit order market with fast and slow traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 113(1), pages 156-169.
  7. Brogaard, Jonathan & Hendershott, Terrence & Riordan, Ryan, 2013. "High frequency trading and price discovery," Working Paper Series, European Central Bank 1602, European Central Bank.

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