Competition and the Industrial Organization
of Securities Markets

A conference on Competition and the Industrial Organization of Securities Markets took place in Cambridge on December 1. Tarun Chordia of Emory University, Gideon Saar of Cornell University, and Faculty Research Fellow Mao Ye of the University of Illinois at Urbana-Champaign organized the meeting. These researchers' papers were presented and discussed:

Mariana Khapko, the University of Toronto, and Marius A. Zoican, Université Paris-Dauphine

Smart Settlement

Blockchain technology is poised to streamline trade settlement. Khapko and Zoican build a model of intermediated trading with flexible time-to-settlement, search frictions, and counterparty risk. Longer trade-to-settlement time increases counterparty risk exposure. However, since intermediaries have more time to match buyers and sellers, liquidity improves. With imperfect competition, intermediaries specialize in either high- or low-default risk contracts. In equilibrium, they are able to relax price competition. Intermediaries' rents increase in the market-wide default rate due to larger scope for specialization. Further, intermediary specialization leads to excess supply of immediate settlement. Setting a unique time-to-settlement for trades in a given security improves welfare.

Markus Baldauf, the University of British Columbia, and Joshua J. Mollner, Northwestern University

Trading in Fragmented Markets

Baldauf and Mollner study fragmentation of equity trading using a model of imperfect competition among exchanges. The addition of an exchange has theoretically ambiguous consequences for market quality. Increased competition places downward pressure on trading fees. However, additional arbitrage opportunities arise in fragmented markets, which intensify adverse selection. To investigate this ambiguity empirically, the researchers estimate key parameters of the model with order-level data from Australia. At the estimates, the benefits of increased competition are outweighed by the costs of multi-venue arbitrage. Compared to the prevailing duopoly, Baldauf and Mollner predict that the counterfactual monopoly spread monopoly would be 23 percent lower.

John W. Hatfield, the University of Texas at Austin; Scott Duke Kominers, Harvard University; Richard Lowery, the University of Texas at Austin; and Jordan M. Barry, the University of San Diego School of Law

Collusion in Markets with Syndication

Many markets, including the markets for IPOs and debt issuances, are syndicated, in that a bidder who wins a contract will often invite competitors to join a syndicate that will fulfill the contract. Hatfield, Kominers, Lowery, and Barry model syndicated markets as a repeated extensive form game and show that standard intuitions from industrial organization can be reversed: Collusion may become easier as market concentration falls, and market entry may in fact facilitate collusion. In particular, price collusion can be sustained by a strategy in which firms refuse to join the syndicate of any firm that deviates from the collusive price, thereby raising total production costs. The researchers results can thus rationalize the apparently contradictory empirical facts that the market for IPO underwriting exhibits seemingly collusive pricing despite its low level of market concentration.

Lin William Cong, the University of Chicago, and Zhiguo He, the University of Chicago and NBER

Blockchain Disruption and Smart Contracts

Distributed ledger technology embodied in blockchains feature decentralized consensus as well as low-cost, tamper-proof, and algorithmic executions, and consequently enlarge the contracting space through smart contracts. Meanwhile, the process of generating decentralized consensus which involves information distribution necessarily alters the informational environment. Cong and He analyze how decentralization improves consensus effectiveness, and how the quintessential features of blockchain reshape industrial organization and the landscape of competition. Smart contracts can mitigate information asymmetry and deliver higher social welfare and consumer surplus through enhanced entry and competition, yet blockchains may also encourage collusion due to the irreducible distribution of information. In general, blockchains can sustain market equilibria with a larger range of economic outcomes. The researchers further discuss anti-trust policy implications targeted to blockchain applications such as separating consensus record-keepers from users.

Peter H. Haslag, Vanderbilt University, and Matthew Ringgenberg, the University of Utah

The Demise of the NYSE and NASDAQ: Market Quality in the Age of Market Fragmentation

Haslag and Ringgenberg estimate the causal impact of market fragmentation. Theoretically, more exchange competition should reduce trading costs, however it may also generate negative network externalities which reduce market quality. The researchers document evidence of both effects, however their results show differential impacts for large and small stocks. For large stocks, the former effect dominates and market quality is better. For small stocks, negative network externalities dominate and market quality is relatively worse. In response, Haslag and Ringgenberg find that traders use inter-market sweep orders to avoid negative network externalities. The researchers results reconcile conflicting findings in the literature and show that fragmentation has dramatically changed U.S. markets.

James Brugler, the University of Melbourne; Carole Comerton-Forde, the University of New South Wales; and Terrence Hendershott, the University of California at Berkeley

Does Financial Market Structure Impact the Cost of Capital?

Brugler, Comerton-Forde, and Hendershott examine the impact of secondary market structure and liquidity on the cost of capital. In the 1990s trading on Nasdaq transformed from a dealer-oriented over-the-counter market to a market where investors could directly interact with each other. The Order Handling Rules (OHR) reforms that accomplished this were phased in across Nasdaq stocks over time allowing for identification of their impact on firms' cost of capital. The researchers find that OHR significantly reduced the underpricing of seasoned equity offerings by one to two percentage points from a pre-OHR average of 3.6 percent. Using the staggered introduction of the OHR as an instrument shows improved secondary market liquidity drives the reduction in underpricing. Finally, consistent with liquidity impacting asset prices, Nasdaq stocks outperformed NYSE stocks by 11% over the OHR introduction period.

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