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Title: Competition for Order Flow and Smart Order Routing Systems

Author(s): Thierry Foucault and Albert J. Menkveld

Publication Date: March 2006

Keyword(s): centralized limit order book, market fragmentation, smart routers, trade-throughs and trading fees

Programme Area(s): Financial Economics

Abstract: We study changes in liquidity following the introduction of a new electronic limit order market when, prior to its introduction, trading is centralized in a single limit order market. We also study how automation of routing decisions and trading fees affect the relative liquidity of rival markets. The theoretical analysis yields three main predictions: (i) consolidated depth is larger in the multiple limit order markets environment, (ii) consolidated bid-ask spread is smaller in the multiple limit order markets environment and (iii) the liquidity of the entrant market relative to that of the incumbent market increases with the level of automation for routing decisions (the proportion of 'smart routers'). We test these predictions by studying the rivalry between the London Stock Exchange (entrant) and Euronext (incumbent) in the Dutch stock market. The main predictions of the model are supported.

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Bibliographic Reference

Foucault, T and Menkveld, A. 2006. 'Competition for Order Flow and Smart Order Routing Systems'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5523