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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, 2008. "Competition between Exchanges: Lessons from the Battle of the Bund," CEPR Discussion Papers 6923, C.E.P.R. Discussion Papers.
  2. Cantillon, Estelle & Yin, Pai-Ling, 2011. "Competition between exchanges: A research agenda," International Journal of Industrial Organization, Elsevier, vol. 29(3), pages 329-336, May.
  3. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2013. "Liquidity Cycles and Make/Take Fees in Electronic Markets," Journal of Finance, American Finance Association, vol. 68(1), pages 299-341, 02.
  4. Foucault, Thierry & Menkveld, Albert, 2006. "Competition for order flow and smart order routing systems," Les Cahiers de Recherche 831, HEC Paris.
  5. Gehrig, Thomas, 1993. "Intermediation in Search Markets," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 2(1), pages 97-120, Spring.
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Cited by:
  1. Degryse, Hans & Van Achter, Mark & Wuyts, Gunther, 2012. "Internalization, clearing and settlement, and liquidity," Open Access publications from Katholieke Universiteit Leuven urn:hdl:123456789/335865, Katholieke Universiteit Leuven.
  2. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.

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