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Trading fees and efficiency in limit order markets

Author

Listed:
  • Thierry Foucault

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

  • Jean-Edouard Colliard

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.

Suggested Citation

  • Thierry Foucault & Jean-Edouard Colliard, 2012. "Trading fees and efficiency in limit order markets," Working Papers hal-00722602, HAL.
    • Handle: RePEc:hal:wpaper:hal-00722602
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    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • L10 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - General

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