DP11591 Strategic Fragmented Markets
We study the determinants of asset market fragmentation. We develop a model of market formation in which investors with heterogeneous valuations for an asset trade strategically. When choosing a dealer with whom to trade, investors trade off the lower price impact and the steeper competition for the dealer's liquidity offered by a larger market. When the correlation among investor valuations is high, the increase in competition dominates the decrease in price impact and investors prefer to trade in a smaller market, which makes market fragmentation an equilibrium outcome. Fragmented market structures can Pareto dominate centralized ones and can exhibit higher trading volumes.