We recently discussed how fragmentation undoubtedly adds to competition for places.
Of course, it also adds fixed and opportunity costs for traders.
However, some of our recent studies suggest that it can reduce competition for quotes.
Today, we look at business economics from the point of view of the merchant who established the National Best Boli and Offer (NBBO). Our analysis suggests that they are probably the greatest loser by increasing fragmentation, which, in turn, throw light on how the economics of price settings and data use in the current market is quite inappropriate.
Wants to capture a price setter spread
If we see how the stock markets worked in the 1990s, and how the futures markets still work, the trading was integrated at a site. In those single marketplaces, if you want to capture the spread, you will either have to wait until you reach the top of the queue or improve NBBO prices.
Trading and routing in that context are also very simple: everyone knows what and where the best prices are – and all traders have the same access to those prices at those prices.
An important player in the ecosystem is the merchant who determines the prices of NBBOs, market manufacturer. Because market maker wants to capture the spread, they usually:
- Advertise a bid and a proposal at the same time,
- Which helps set NBBO
- And, in a competitive market, the harassment spreads.
We show it in Chart 1 below.
The action of the market maker creates significant savings for traders and investors.
Chart 1: Price setters tighten the spread and set NBBOs (for the benefit of other traders)
Because a market manufacturer is “two -sided”, when the stock price goes up or down (which they call adverse selection), they do not benefit. Instead, they take advantage of capturing the spread only, which requires both a buyer and a seller to trade on the same spread.
Ideally, it works as we show in Chart 2 below, where:
- A market manufacturer improves bid and proposal.
- The first “market purchase” enters the market and trades with the offering of market makers (Note: For now, the market manufacturer has a small position and risk).
- The next order is a “market cell”, which trades the market manufacturers with bids (market manufacturers’ status is closed and they capture a spread).
Importantly, this advantage makes the market make more likely to re -connect the proposal to try to capture the dissemination.
Chart 2: Want to spread the price setter
