Guest editorial

Citation

Westerholm, P.J. (2016), "Guest editorial", International Journal of Managerial Finance, Vol. 12 No. 4. https://doi.org/10.1108/IJMF-05-2016-0090

Guest editorial

Article Type: Guest editorial From: International Journal of Managerial Finance, Volume 12, Issue 4.

1. Editorial to the special issue of the International Journal of Managerial Finance – Fragmented Securities Markets

1.1. Introduction

Securities markets fragment to offer participants (investors, traders, brokers, liquidity providers and high frequency traders) market access that is closely tailored to their specific needs. There is, however, a process that naturally leads markets to consolidate, as the most liquid price leading trading venue will always attract most of the trading, and it is difficult for alternative trading platforms to attract participants from the incumbent exchanges (Harris, 1993). If markets, however, are organized so that every participant is guaranteed the best possible price and execution across all alternative trading venues (e.g. a National best bid and offer (NBBO)[1]), there is an optimal solution that allows many competing fragments of the market to co-exist. Such a market becomes a single virtual market with multiple points of entry (O’Hara and Ye, 2011).

The early literature shows that market fragmentation has been a concern of regulators ever since the US markets started seeing trading of the same (NYSE) security across two or more national and regional exchanges. Hamilton (1979) is an early paper that describes how the US Securities and Exchange Commission (SEC) reorganized markets into a national market system (NMS) in the early 1970s due to fragmentation[2]. Hamilton finds that the increased competition reduces spreads more than fragmentation increases them, and recommends a policy that promotes competition among trading venues. Baker (1984) discusses the social consequence of market fragmentation making communication and information flow more difficult. Cohen (1982) and Mendelson (1987) are among the first to consider the competing processes of fragmentation and consolidation and provide a theoretical framework for work in this area.

Harris (1993) outlines the impact on regulation as a result of the processes of securities market fragmentation and consolidation. He concludes that if externalities are not significant, competition will reveal the best market structure, but when exchanges try to provide public good services such as price continuity, insider trading restrictions and time precedence, externalities may keep sub-optimal market segment alive. Regulation may be required to solve such problems.

Hagerty and McDonald (1996) point out an interesting motivation for fragmentation: “To the extent that securities markets provide a central trading location serving to minimize the search cost of finding a counterparty, fragmentation is a puzzle. On the other hand, market participants often have private information, either about the ‘true value’ of the traded security, or about their trading motives. In markets with asymmetric information, informed traders earn a profit at the expense of the uninformed traders. Therefore there is clearly an incentive to create mechanisms that mitigate (for at least some subset of participants) costs created by the existence of private information. One obvious way for uninformed traders to minimize these costs is to trade in a non-anonymous market. Non-anonymous arrangements often have the appearance of a fragmented market” (p. 35, second paragraph).

In today’s high frequency trading world, market fragmentation brings about a new set of puzzles. The emergence of fragmentation and high frequency trading are in fact closely linked, as both are a consequence of technological improvement and globalization of financial markets. For example the regulation that requires every investor to be able to transact at the NBBO was intended to guarantee best execution across many alternative venues. It also had a side effect in that it promoted the emergence high frequency traders who anticipate and trade ahead of slow orders aiming for an execution at the NBBO in a more remote market center (that may take a few milliseconds longer to reach). There are several fragmentation related effects of technological progress. Zhu (2013) show theoretically that dark pools[3], another type of fragmentation of modern markets into a transparent and an anonymous trading platform, can provide an optimal solution. Zhu shows that under natural conditions the addition of a dark pool concentrates informed traders on the exchange through a self-selection mechanism, and improves price discovery. Wah and Wellman (2013) propose a theoretical model and simulate a market with participants conducing latency arbitrage trading[4]. They find that market fragmentation and the presence of a latency arbitrageur reduces total surplus and negatively impacts liquidity. By replacing continuous-time markets with periodic call markets, they are able to eliminate latency arbitrage opportunities and achieve further efficiency gains through the aggregation of orders over short time periods. Both Zhu (2013) and Wah and Wellman (2013) have the implication that markets have to be carefully designed for them to achieve the optimal level of fragmentation and to avoid a loss of welfare.

O’Hara and Ye (2011) investigate empirically the proliferation of trading venues in the US market. They observe that almost 30 percent of trading volume is executed in off-exchange venues. They also find that fragmented stock (shares that trade actively in multiple venues) have lower transaction costs and faster execution speeds. They find that compared to other firms, fragmented stocks have higher short-term volatility, while prices are more efficient close to following a random walk. As they do not investigate periods of instability and call for such future research.

In summary the literature shows that the first market to fragment, the US equity markets, has through a process of competition and regulation discovered a working model that relies on regulated best execution across all alternative trading venues. It appears that most markets first fragment and then as the need arises the local regulators address the situation. For example, in Australia a NBBO was introduced in 2011[5]. Going forward it would be helpful to learn from past experience as it is likely that more markets in the world will become increasingly fragmented, while they on the other hand are also likely to continue to consolidate in the global dimension.

2. Special issue

In this special issue we aim to contribute additional evidence to improve our understanding of the implications of the process of market fragmentation and consolidation. The following articles address their own areas, all relevant to the discussion on current developments in global market fragmentation and consolidation.

The articles in this issue investigate price discovery in fragmented markets, consolidation in cross-listed markets, the within market fragmentation between individual and institutional investors, and finally discuss how the fragmented US market operated during the instability of the financial crisis of 2007/2008.

2.1. Price discovery and fragmentation

Clapman and Zimmerman (2016) in their paper “Price discovery and convergence in fragmented securities markets” analyze price discovery in the fragmented European market environment using event study methodology to compare stocks across alternative venues during the call auction phase. They show that for German DAX index blue chip stock the Deutsche Börse Xetra platform is the price leading venue compared to BATS Chi-X Europe as Trading activity on Chi-X instantly declines during call auction phases on Xetra. Price discovery leadership is shown during intraday auctions as well as in the subsequent continuous trading period. Traders systematically quit trading at satellite markets during auctions and refrain from participating in price discovery. The relative absolute price difference between Xetra and Chi-X increases during intraday auctions due to high absolute returns on Xetra while prices on Chi-X remain unchanged. These findings indicate that, Chi-X is unable to provide price discovery when the leading market Xetra is closed. The results are comparable to the dominant-satellite market observation made by Garbade and Silber (1979) for the US market and the study by Lee (1993) of NYSE-listed stocks.

Hence market fragmentation appears dependent of one leading market, and regulators may be able to impact the whole system of trading venues through regulation of the main market(s). For example, if the lead market has requirement of execution at the NBBO, it is expected that all trades will be executed at the NBBO without monitoring the satellite markets.

2.2. Consolidation and fragmentation in cross-listed markets

In their paper “Short sales and price discovery of Chinese cross-listed firms”, Chen et al. (2016), examine the impact of the recently introduced short-selling and margin-trading regulation on the price discovery of Chinese cross-listed firms on the Hong Kong Stock Exchange. The paper aims to identify which of the two markets leads the process of price discovery when material new information arrives in the market. Chen et al. (2016) show that the home (A-share) market contributes more to price discovery over time, and that this pattern is mainly driven by those Chinese cross-listed firms that were not allowed to be sold short or bought on margin. In fact, there is no significant difference in the contribution of A-share and H-share markets to price discovery among firms with no short-selling or margin-trading restrictions in the Shanghai and Shenzhen markets[6].

This study hence shows that global consolidation has driven price discovery on the Chinese and Hong Kong markets to convergence, while the two markets have fragmented into those stocks that can be sold short and freely traded on margin, and those stocks that are restricted from short-selling and margin-trading.

2.3. Fragmentation within markets

Mudalige et al. (2016) highlight in their paper “Individual and institutional trading volume around firm-specific announcements” another aspect of fragmentation, the division within markets between individual and institutional investors. They investigate the immediate impact of firm-specific announcements on the trading volume of individual and institutional investors on the Australian Securities Exchange (ASX). Institutional investors exhibit abnormal trading volume before and after announcements. However, individual investors indicate abnormal trading volume only after announcements. Consistent with outcomes expected from a dividend washing strategy, abnormal trading volume around dividend announcements is statistically insignificant. Both individual and institutional investors’ buy volumes are higher than sell volumes before and after scheduled and unscheduled announcements. Our results add to the understanding of individual and institutional investors’ trading behavior around firm-specific announcements in a securities market with continuous disclosure.

One specific feature of the ASX makes it interesting for studies of information disclosure and dissemination. The continuous disclosure requirement on listed firms is stringent and company directors are required to instantly disclose any information that is expected to have an impact on price. This is different to most other developed markets, who rely on scheduled company announcements. Mudalige et al. show that the market segment institutional investors operate in is better informed. Indicated by their results that institutional investors increase trading both before and after announcements as opposed to individuals who only react to the announcement, institutions are in a position to benefit from their information advantage. This within market fragmentation disadvantages individual investors and the regulator may need to consider bridging the information gap between institutions and individuals so that they are both equally well informed about corporate events. This is the ultimate purpose of continuous disclosure regulation, but it appears that certain institutional investors are able to access this information earlier, possibly due to them spending more resources on research. A promotion of better public access to affordable research may solve this problem.

2.4. Financial instability and fragmentation

In his paper “The financial crisis and market quality: the impact of institutional trading and short sale bans on liquidity and volatility” Mostafa (2016) investigates the total impact on market quality and efficiency of the short sale ban in the US market following the financial crisis of 2008 and 2009. Analyzing the changes between the pre-crisis, the crisis period, and the recovery period, January 1, 2007-December 31, 2010, the S&P 500 stocks exhibit a negative association between breadth of institutional ownership and returns, realized volatility and spreads, and a positive association between breadth of institutional ownership and range-based volatility and volume. For small quantile stocks, breadth of institutional ownership is negatively related to return, volatility and volume, while positively related to spreads (realized quoted and effective). In summary the market quality effects of the crisis is complex, but the evidence indicate that the withdrawal of institutional investors from the market increases the negative impact of the crisis. The difference between the large and the small quintile stocks indicates that institutional ownership benefits the market quality of large stocks, but not necessarily the market quality of small stocks. This paper shows a significant improvement in market efficiency (variance ratios) after the crisis period for small and non-financial stocks, while the price efficiency lost during the crisis period is more persistent for large and financial stocks. Hence the fraction of the market with greater institutional holding is more severely affected by the financial crisis.

This paper investigates how the fragmented US equities market fair in crisis and what characteristics are important for resilience. The paper concludes that institutional ownership is very important for resilience during periods of financial instability. The literature shows that institutional investors typically follow a positive feedback trading (often called momentum) strategy Yan and Zhang (2009). This in combination with evidence of institutional herding in the recent literature, see Sias (2004), may lead to a destabilizing effect of institutional ownership during periods of instability. Mostafa (2016) shows that actions by institutions further exuberates the deterioration in market quality during the financial crisis of 2007 and 2008. While it is hard to think of a way to incentivize large institutional traders to buy when everyone else is selling it would greatly stabilize markets and improve the performance of today’s fragmented markets if institutions acted like the long term value investors they make themselves out to be. For example additional liquidity facilities similar to what currently is discussed for banks, could also be extended by the Federal Reserve and central banks to major institutions, so that they can take a more long term view during crisis. If institutions were able to act as the liquidity providers of last resort, they and their investors may also greatly benefit, as they would purchase securities below their fundamental values.

3. Summary and conclusion

In summary the articles in this special issue find that price discovery typically is concentrated to one lead market; that in cross-listed markets price discovery consolidates provided that at least one market allows the cross-listed stock to trade freely with no restrictions on short-selling and marking lending; the institutional investor segment of the market benefits from an informational advantage and institutional exit from the market in crisis is a significant driver of instability. Policy recommendations can be deducted from this work. For example, the conclusions in these papers emphasize the findings in the previous literature that fragmentation can lead to benefits from competition, but also highlight two new results; the need to incentivize institutional investors to stabilize fragmented markets and the need to improve the information individual investors have access to, particularly regarding alternative trading routes to achieve best execution.

The relatively scarce availability of research on topics related to fragmentation that emerged in the compilation of this special issue highlights the need for more work in this area. For example the body of work in high frequency trading is growing rapidly, we have in this issue shown that HFT is directly connected to fragmentation of securities markets.

P. Joakim Westerholm
University of Sydney Business School, Sydney, Australia

Notes

1. The National Best Bid and Offer (NBBO), refers to the SEC requirement that the best bid and ask prices available across all market venues are displayed to customers of securities firms.

2. The current version of the SEC Regulation NMS was passed in 2005 and is comprised of four main components: The Order Protection Rule aims to ensure that investors receive the best price when their order is executed by removing the ability to have orders traded through (executed at a worse price). The Access Rule, aims to improve access to quotations from trading centers in the National Market System by requiring greater linking and lower access fees. The Sub-Penny Rule, which sets the lowers quotation increment of all stocks over $1.00 per share to at least $0.01. Market Data Rules, which allocate revenue to self-regulated organizations that promote and improve market data access (Blume, 2007; Securities and Exchange Commission, 2005)

3. A dark pool is a trading venue without pre-trade transparency intended for liquidity driven traders can post their orders anonymously and gain execution at the mid-point price against other anonymous traders with trading needs in the opposite direction.

4. Wah and Wellman (2013) illustrate the process for latency arbitrage as follows. “Given order information from exchanges, the Security Information Processor (SIP) (the system that disseminates the NBBO to the market) takes some finite time, say δ milliseconds, to compute and disseminate the NBBO. A computationally advantaged trader who can process the order stream in less than δ milliseconds can simply out-compute the SIP to derive NBBO*, a projection of the future NBBO that will be seen by the public. By anticipating future NBBO, an HFT algorithm can capitalize on cross-market disparities before they are reflected in the public price quote, in effect jumping ahead of incoming orders to pocket a small but sure profit” (p. 2, third paragraph).

5. The Australian securities market regulator ASIC introduced Regulatory Guide 223, first issued April 2011, and last updated May 2015, which provides guidance on ASIC market integrity rules for competition in exchange markets. Section C contains guidelines for best execution that require market participants (licensed securities brokerage firms) to execute their client orders at the best available price across ASX Trade Match and Chi-X after a transition period ending March 1, 2013. There is also regulation for how a participant can fulfill their best execution obligation using both licensed markets and dark pools: “In most circumstances, a market participant can discharge its best execution obligation by trading only on a pre-trade transparent order book of a licensed market. There may be circumstances where it is appropriate to consider non-pre-trade transparent liquidity” p. 24 first paragraph, ASIC Regulatory Guide 223 (2015).

6. Since April 2010, a number of firms listed on the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchanges (SZSE) have been allowed to be sold short or bought on margin; some of these firms are cross-listed on the Stock Exchange of Hong Kong (SEHK) which will be the subject of our investigation.

References

Baker, W.E. (1984), “The social structure of a national securities market”, American Journal of Sociology, Vol. 89 No. 4, pp. 775-811

Blume, M.E. (2007), Competition and Fragmentation in the Equity Markets: The Effects of Regulation NMS, The Rodney L. White Center for Financial Research, The Wharton School, Philadelphia, PA

Cohen, K.J. (1982), “An analysis of the economic justification for consolidation in a secondary security market”, Journal of Banking & Finance, Vol. 6 No. 1, pp. 117-136

Garbade, K.D. and Silber, W.L. (1979), “Dominant and satellite markets: a study of dually-traded securities”, The Review of Economics and Statistics, pp. 455-460

Hagerty, K. and McDonald, R.L. (1996), “Brokerage, market fragmentation, and securities market regulation”, in Lo, A.W. (Ed.), The Industrial Organization and Regulation of the Securities Industry, University of Chicago Press, Chicago, IL, pp. 35-62

Harris, L.E. (1993), “Consolidation, fragmentation, segmentation, and regulation”, Journal of Finance, Vol. 48 No. 3, pp. 1092-1093

O’Hara, M. and Ye, M. (2011), “Is market fragmentation harming market quality?”, Journal of Financial Economics, Vol. 100 No. 3, pp. 459-474

Hamilton, J.L. (1979), “Market fragmentation, competition and efficiency of the stock exchange”, Journal of Finance, Vol. 34 No. 1, pp. 171-187

Lee, C.M.C. (1993), “Market integration and price execution for NYSE-Listed securities”, The Journal of Finance, Vol. 48 No. 3, pp. 1009-1038, doi: 10.1111/j.1540-6261.1993.tb04028.x, available at: http://dx.doi.org/10.1111/j.1540-6261.1993.tb04028.x

Mendelson, H. (1987), “Consolidation, fragmentation, and market performance”, Journal of Financial and Quantitative Analysis, Vol. 22 No. 2, pp. 189-207

Securities and Exchange Commission (2005), “Regulation NMS 17 CFR Parts 200, 201, 230, 240, 242, 249, 270”, Release No. 34-51808 File No. S7-10-04, June 9, available at: www.sec.gov/rules/final/34-51808.pdf

Sias, R. (2004), “Institutional herding”, Review of Financial Studies, Vol. 17 No. 1, pp. 165-206

Wah, E. and Wellman, M.P. (2013), “Latency arbitrage, market fragmentation, and efficiency: a two-market model”, working paper, University of Michigan, New York, NY

Yan, X.S. and Zhang, Z. (2009), “Institutional investors and equity returns: are short-term institutions better informed?”, Review of Financial Studies, Vol. 22 No. 2, pp. 893-924

Zhu, H. (2013), “Do dark pools harm price discovery?”, Review of Financial Studies, Vol. 27 No. 3, pp. 747-789

Further reading

Australian Securities and Investments Commission (2015), “RG 223 guidance on ASIC market integrity rules for competition in exchange markets”, Australian Securities and Investments Commission, May 4, available at: http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-223-guidance-on-asic-market-integrity-rules-for-competition-in-exchange-markets/ (accessed May 10, 2016)

Marshall, E.B. (2007), “Competition and fragmentation in the equity markets: the effect of regulation NMS”, SSRN Electronic Journal, pp. 1-18