Market fragmentation in Europe: Assessment and prospects for market quality

With the growth of computer trading and the implementation of MiFID, competition between trading venues and order flow fragmentation have considerably increased in Europe since 2007. Most of the rise in fragmentation took place from mid-2008 to 2009. The total market share of new entrants such as Chi-X, BATS Europe, and Turquoise exceeded 30% of on-exchange volumes at the end of 2011, and their contribution to price discovery is now substantial. Regulated dark pools, also known as crossing networks, execute less than 5% of the order flow and are not expected to grow much more. Regulated internalization has not emerged. In contrast, OTC trading is the second source of liquidity after incumbent and new exchanges with more than 35% of trading volumes. While MiFID served as a catalyst for the rise in fragmentation by allowing free competition, the actual drivers of fragmentation are investor clientele effects and technology. Clientele effects combined with a wider use of computer-based trading tools should sustain market fragmentation in the near future, yet liquidity aggregators should play a major role in consolidating the overall marketplace. The fragmentation of the visible order flow does not deteriorate price quality and does not harm liquidity. Crossing-network trading is not proved detrimental to liquidity either. On the contrary, competition contributes to reducing spreads and increasing market depth. Apart from those positive effects, significant trade-through rates are observed in European stock markets, and to date, fragmentation has been more beneficial to the liquidity of large stocks than to that of small stocks. These two observations are in contrast with U.S. stock markets where trade-throughs are prohibited and where market fragmentation benefits were found to be greater for small stocks than for large ones. Particular attention should be paid to the size of OTC trading as this type of internalization may have some adverse effects on liquidity. Last, as no regulatory body has been in charge of guaranteeing trade reporting consistency since MiFID1 and because price discovery is fragmented between several venues, there is a need for an official consolidated trade and quote tape in Europe.