Research Highlights
Trading Speed Matters
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Fragmentation benefits buy side investors by lowering the cost of trading.
By Thomas Philippon, Associate Professor of Finance, and Emiliano Pagnotta, Assistant Professor of Finance
Not all investors are equally concerned with trading speeds. For some, like high-frequency traders, index arbitrageurs, and option hedgers, microseconds count. The exchange that delivers transactions the fastest wins their attention and can charge a premium for its services. Others, like retail investors and pension funds, are not very concerned with speed and aim at finding the lowest trading costs. According to new research from NYU Stern Professors Thomas Philippon and Emiliano Pagnotta, exchanges welcome the ability that new and faster technologies give them to differentiate their services.
“Fragmentation benefits buy side investors by lowering the cost of trading,” says Pagnotta. “Exchanges are of course better off being monopolists; their profits decrease with competition. However, speed is welcomed by them since two exchanges competing with each other would make zero profits if they competed on market access cost basis only.”
In their paper, “Competing on Speed,” the authors point out that an investment in new technology stimulated the entry of new, faster exchanges in the US, such as Direct Edge and BATS. Chi X Global, which came on line in 2008 offering the quickest transactions in Europe, has already attracted substantial trading business, becoming the most important exchange on that continent.
Having multiple exchanges can be socially beneficial. First, competition will reduce access fees, increasing household market participation. Second, it is likely to lead to more innovation in trading technologies, benefiting those investors that value speed highly. There is the risk of inefficient cost duplication, though, due to excessive entry. The researchers also found that competition between exchanges reduces asset prices, which may affect the cost of funding for corporations.
Additionally, the professors point out that policy makers should also be concerned about the best way of regulating the interaction between these markets. They find that price protection, such as that ensured by Regulation National Market System (Reg NMS), introduced by the Securities & Exchange Commission about five years ago, further reduces asset prices and has ambiguous effects on social welfare.
“Fragmentation benefits buy side investors by lowering the cost of trading,” says Pagnotta. “Exchanges are of course better off being monopolists; their profits decrease with competition. However, speed is welcomed by them since two exchanges competing with each other would make zero profits if they competed on market access cost basis only.”
In their paper, “Competing on Speed,” the authors point out that an investment in new technology stimulated the entry of new, faster exchanges in the US, such as Direct Edge and BATS. Chi X Global, which came on line in 2008 offering the quickest transactions in Europe, has already attracted substantial trading business, becoming the most important exchange on that continent.
Having multiple exchanges can be socially beneficial. First, competition will reduce access fees, increasing household market participation. Second, it is likely to lead to more innovation in trading technologies, benefiting those investors that value speed highly. There is the risk of inefficient cost duplication, though, due to excessive entry. The researchers also found that competition between exchanges reduces asset prices, which may affect the cost of funding for corporations.
Additionally, the professors point out that policy makers should also be concerned about the best way of regulating the interaction between these markets. They find that price protection, such as that ensured by Regulation National Market System (Reg NMS), introduced by the Securities & Exchange Commission about five years ago, further reduces asset prices and has ambiguous effects on social welfare.