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Stock markets fragmentation, volatility and final investors

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Abstract

The 2000s in equity markets are marked by two major regulatory shocks: RegNMS in the United States, and MiFID in the European Union. Simultaneously, there is a massive increase in the proportion of high-frequency trading, and market orders volume. However, trading volumes do not significantly increase. We propose a theoretical model describing the effects of stock markets fragmentation on two types of investors optimization problems: “intermediary” high-frequency and “final” investors. Volatility has a permanent and a transitory component, whose weights depend on market fragmentation via the share of non-marketable orders of intermediary investors. The trading volume of final investors depends on market fragmentation both directly via transaction costs, and indirectly via total volatility. Finally a shock in fragmentation may lead to a decrease in trading volume, enhanced in the case of an equity markets crisis by a rise in the components of volatility.

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Notes

  1. It should be noted, moreover, that these indicators may underestimate fragmentation. First, they take into account trading, and not the whole orders volume (Madhavan 2012). Secondly, they do not include “dark pools” and off-book transactions. Alternative calculation methods exist (Harris and Mayhew 2005), but the corresponding indicators are not available.

  2. The extremely low level of the trades/quotes ratio for the CAC40 might be explained by the fact that France tends to replace The Netherlands as the main hub of network representations of continental Europe securities markets. This process is highlighted, in particular, by topological representations derived from the common component of assets prices dynamics (Sandoval 2012). This atypically high degree of integration of French equity markets is likely to cause specific high-frequency investors strategies.

  3. The National Best Bid and Offer (NBBO) system identifies at any moment the lowest ask and highest bid price for a given security among all venues. “Cohesion was supposedly ensured in the U.S. through a mechanism for the consolidation of individual orders processed via multiple venues [...] Reg NMS accomplished its goal of creating a single virtual market with many points of entry” (Easley et al. 2012).

  4. This result on the effect of information asymmetries is specific to a context of fragmentation, generating price differentials between different venues and thus an increased profitability of high-frequency transactions. When this is not the case, even if market operators make (small) errors in their assessment of the strategies of other agents, the market equilibrium is not necessarily affected (Boulatov and Bernhardt 2015). Short-term trades by informed speculators are even likely to exert a favorable externality on the amount of long-term transactions (Gümbel 2005).

  5. For a theoretical basis see Foucault et al. (2013). The speed of reaction to trading opportunities is endogenous since traders face a trade-off between the benefit generated by being the first to seize an opportunity and the cost required to achieve this result.

  6. In addition, there may be a reciprocal relationship between volatility and liquidity (Francotte et al. 2011).

  7. We ignore for the sake of simplicity the horizontal (lower bound) part of Eq. (13). For the values of \(\gamma _{1}\), \(\gamma _{2}\), \(\sigma _{t_{0}}\) and \(\sigma _{t_{2}}\) used in the example of Fig. 4, this horizontal part corresponds to a market fragmentation which is several times greater than that of the United States equity markets, currently by far the highest.

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Acknowledgements

The author wishes to thank Gunther Capelle Blancard, Thierry Foucault, Ali Kutan, Delphine Lahet, Charles Albert Lehalle, Catherine Lubochinsky, Nadine Marchand, Simon Neaime, Catherine Refait-Alexandre, Maya Shaton, Dominique Torre, Anne-Gael Vaubourg and Laurent Weill for their remarks and suggestions. I also thank for their comments on earlier versions of this paper the participants to the 31th International Symposium on Money, Banking and Finance (Lyon, 19–20 June 2014), the 32nd International Symposium on Money, Banking and Finance (Nice, 11–12 June 2015), the 3rd Bordeaux Workshop in International Economics and Finance (Bordeaux, 11 December 2015), and the 2015 Paris Financial Management Conference (Paris, 14–15 December 2015). Finally I am grateful to the Editor and the referee for their careful reading of the paper and their suggestions.

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  1. Cécile Bastidon

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  1. LEAD, Université de Toulon, Toulon, France

    Cécile Bastidon

  2. CAC IXXI, ENS Lyon, Lyon, France

    Cécile Bastidon

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Bastidon, C. Stock markets fragmentation, volatility and final investors. Ann Finance 13, 435–451 (2017). https://doi.org/10.1007/s10436-017-0305-0

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