Execution in an aggregator

An aggregator is a technology that consolidates liquidity—in the form of bid and ask prices and amounts—from multiple sources into a single unified order book to facilitate ‘best-price’ execution. It is widely used by traders in financial markets, particularly those in the globally fragmented spot currency market. In this paper, I study the properties of execution in an aggregator where multiple liquidity providers (LPs) compete for a trader’s uninformed flow. There are two main contributions. Firstly, I formulate a model for the liquidity dynamics and contract formation process, and use this to characterize key trading metrics such as the observed inside spread in the aggregator, the reject rate due to the so-called ‘last-look’ trade acceptance process, the effective spread that the trader pays, as well as the market share and gross revenues of the LPs. An important observation here is that aggregation induces adverse selection where the LP that receives the trader’s deal request will suffer from the ‘Winner’s curse’, and this effect grows stronger when the trader increases the number of participants in the aggregator. To defend against this, the model allows LPs to adjust the nominal spread they charge or alter the trade acceptance criteria. This interplay is a key determinant of transaction costs. Secondly, I analyse the properties of different execution styles. I show that when the trader splits her order across multiple LPs, a single provider that has quick market access and for whom it is relatively expensive to internalize risk can effectively force all other providers to join her in externalizing the trader’s flow thereby maximizing the market impact and aggregate hedging costs. It is therefore not only the number, but also the type of LP and execution style adopted by the trader that determines transaction costs.