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In the early 1980s and 1990s US regulators commenced promoting competition that fragmented trading on US exchanges in an effort to put competitive pressure on participants on those exchanges: specifically specialists and dealers.  The main rationale of US regulators was that these exchange participants enjoyed various forms of market power and they used this market power to extract economic rents from investors by quoting excessively wide bid-ask spreads.  The regulators reasoned that any upward pressure on bid-ask spreads resulting from fragmentation would be more than offset from the downward pressure on bid ask spreads through competition foisted on specialists and dealers, thereby reducing bid ask spreads and the cost of trading.  The measures advocated by the regulators included the promotion of competition between exchanges and regional exchanges as well as upstairs or off-market trading.  More recently, the opportunity to trade upstairs and technological innovation has spawned dark pools, which continue to fragment US markets.  The initial effects of the competition and fragmentation in US markets on bid-ask spreads (decades ago) has been documented in numerous academic studies.  These studies have confirmed that competing exchanges and upstairs trading historically reduced on-exchange bid-ask spreads and therefore reduced transaction costs thereby enhancing liquidity.

The business of financial intermediation – bringing capital to new endeavours, securing a well-regulated set of investment choices for savers, and enabling risks to be laid off or assumed – has been one of the world’s great growth industries. Regulated securities and futures’ exchanges have stood at the apex of the burgeoning business of financial intermediation. Were we not so used to it, we would be startled that a single type of business could be so prominent that its street address would serve as short-hand for the entire economy, and an index of its prices a key barometer of economic outlook. Wall Street, Threadneedle Street, Hang Sen, Sensex, CAC40: these and other such names have become accepted barometers for economic wellbeing or otherwise.

A recent article in Traders Magazine states that the amount of "internalization" in US markets has increased from 20% to 30% in the past year. As pointed out in the Traders Magazine article, the definition of internalization has expanded to include dark pool and upstairs trades and is also known as off-exchange reporting. In addition, a recent Wall Street Journal article reports that markets are becoming increasingly fragmented, with NYSE market share declining to 37% from 70% two years earlier. The question then is, given the increased fragmentation in US markets, what impact has the increase in off-exchange reporting had on market quality - if any? This study seeks to provide answers to that question.

PARIS (Reuters) - The 20-minute "flash crash" will reverberate for quite some time to come. For years, America's stock markets were the envy of the world, the model for modern trading -- fast, stable, efficient and for the most part transparent.

But after the Dow Jones industrial average plunged nearly 700 points on May 6 before sharply rebounding, that perception changed, possibly for good.

An exchange used to be a place – yes, a physical place -- where people would come together to buy or sell, hoping to achieve the best price for themselves. The more the exchange was able to attract all of the buy and sell interests in a product, the more the prices on the exchange would reflect the truestate of supply and demand.

Traditionally exchanges have been monopolies. They were owned by their members, blessed by governments, and acted like utilities. The cost of building a market center, developing a network, and gaining critical mass virtually ensured an exchange’s success. The more liquidity an exchange attracted, the more critical it was to trade there. This created a virtuous cycle where the big got bigger and the small became irrelevant. For decades this allowed larger exchanges to operate virtually unopposed, as they may as well have carved the adage “Where Liquidity Begets Liquidity” on their marble cornerstone.

Through the economic crisis, while credit markets failed, banks ceased lending and many financial institutions went hat in hand to governments for survival, organized, transparent stock and derivatives exchanges performed well. While the news wasn’t always good, buyers and sellers met in the market, trades were cleared and settled, and price discovery was orderly. May 6 changed that perception, and issuers and the public have lost some confidence in our markets.

Since May 6, 2010, CME Group has engaged in a detailed analysis regarding trading activity in its markets on that day. Our review indicates that our markets functioned properly. We have identified no trading activity that appeared to be erroneous or that caused the break in the cash equity markets during this period.

While many were relieved by the short duration of the flash crash on May 6 and the fact that it didn’t go nearly as far as the crashes of 1987 or 1929, in important respects, it was far worse than either of those. True, the Dow only dropped five and a half percent. But that drop took just five minutes, a speed of decline that exceeds anything in U.S. stock market history. Moreover, the decline in the averages sugarcoats the real carnage, which includes some stocks that went to zero for a few brief moments.

Around the world, financial markets are giving investors a bumpy ride. The sudden swoon of US stocks on May 6 - now referred to as the "flash crash" - was followed, 10 days later, by huge drops in Shanghai and Hong Kong. With continued nervousness about Europe's fiscal situation, civil unrest in Thailand, fears of conflict in Korea, and the unprecedented oil spill in the Gulf of Mexico, global markets have been hit with a string of bad news recently.

In March 2010, the WFE was invited to take part in a conference organized by the Australian market regulator, ASIC. The topic was the transparency: how had or transparent or ‘lit’ markets performed compared to the counter markets or ‘dark’ trading venues.

Dark Pools and Fragmented Markets: As far as I can recall, I have never come up with any title as foreboding as this one. The term “dark pools” conjures up some nasty images, like black holes and Darth Vader. Fragmented markets sounds terrible, like Humpty Dumpty after he took his big fall. Dark and fragmented, what kind of shape are our markets in? Let’s consider the dark pools first.

Volatility and risk are of central importance to those of us involved in finance. They lie at the center of virtually all of our work. Without volatility, without risk, finance would not exist as a subject in our business school curriculum, in our academic research. Finance, quite simply, would not be distinguishable from deterministic economics. Neither would finance departments in banks and industrial firms be endowed with anywhere near the importance that they currently have.


WFE Annual Meeting, Paris 2010 - Panel 1 Exchange Strategy

WFE Annual Meeting, Paris 2010 - Panel 1 Exchange Strategy

Short preview of the WFE 50th Anniversary


Executive Summary : The WFE especially welcomes this IOSCO public consultation given the importance of innovation for markets, and the need for its greater understanding. Exchanges believe that they can provide useful insight thanks to their front line role in monitoring, detecting and preventing market abuse, as well as in developing technology. The WFE appreciates the difficulty to deal properly with microstructure phenomena in isolation without considering the overall market structure. The absence of a level playing field in regulation among trade execution venues is one example. This level of fragmentation impairs the ability for listed companies to understand the market in their shares. It weakens the trust in capital markets; it diminishes the capacity of exchanges in raising capital to promote economic growth.