Competition for Order Flow and the Theory of Global Games: The impact of alternative trading systems on securities markets

295 Pages·2001·5.15 MB·German

by  Jutta A. Dönges (auth.)

Donges
Competition for Order Flow and the Theory of Global Games
GABLER EDITION WISSENSCHAFT
A.
Jutta Donges
Competition for
Order Flow and
the
Theory of Global Games
The impact of alternative
trading systems on securities markets
With a foreword
by Prof. Dr. Mark Wahrenburg
Springer Fachmedien Wiesbaden GmbH
Die Deutsche Bibliothek -CIP-Einheitsaufnahme
DOnges, JuHa A.:
Competitien fer order Aew and the theory of global games : the impact of alternative trading
systems on securities markets / Jutta A. Donges. With a foreword by Mark Wahrenburg.
-1. AuA .. -Wiesbaden : Dt. Univ.-Verl. ; Wiesbaden : Gabler, 2001
(Gabler Editien Wissenschaft)
Zugl.: Frankfurt/Main Univ., Diss., 2001
ISBN 978-3-8244-7426-4 ISBN 978-3-663-07734-3 (eBook)
DOI 10.1007/978-3-663-07734-3
1. AuAage September 2001
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ISBN 978-3-8244-7426-4
Meinen Eltern
VII
Foreword
Advances in information technology and the advent of alternative trading platforms
have increased the level of competition between securities exchanges tremendously
over the last years. However, the nature of competition between stock markets is
very different to that of other product markets due to network externalities such as
liquidity spillovers. It is therefore necessary to have a clear understanding of the
market outcome in order to evaluate the efficiency of unregulated competition and to
design adequate regulatory frameworks.
Economists have not yet provided a sound theory on the desirability of free competi
tion in the area of competing securities markets. The fundamental problem is that
theoretical models of securities market competition usually have multiple equilibria. It
is very hard to devise rules for regulators or strategies for exchanges from these
models, since it is a priori unclear which equilibrium will be realized.
Jutta Donges solves this basic problem by applying the recently developed theory of
global games onto the analysis of stock market competition. The theory of global
games introduces a small amount of heterogeneous information among investors
about the value of some relevant parameters of market choice and thus, derives a
unique equilibrium. The model produces a number of convincing results. Jutta
Donges shows as one example, that the migration of investors from the traditional
exchange to a newly opened crossing network is smaller than the efficient level of
migration. Regulatory support for new entrants can, therefore, be justified on the
ground of the analysis.
The application of the theory of global games by Jutta Donges onto the analysis of
stock market competition opens a broad field for future research. Not only has Jutta
Donges laid down an important theoretical foundation, she has also introduced an
approach that I am sure will be taken up by other researchers and will provide a fruit
ful basis for many future applications.
Mark Wahrenburg
Professor of Banking and Finance
Goethe-University of Frankfurt
IX
Acknowledgement
This work is a slightly revised version of my doctoral thesis which was submitted to
the Faculty of Economics and Business Administration at the Johann Wolfgang
Goethe-University of Frankfurt and would not have been possible without the
support, guidance and encouragement from many people. First and foremost, I
would like to express my sincere thanks to Professor Dr. Mark Wahrenburg who
agreed to supervise my thesis in the first place and who provided helpful comments
and suggestions throughout this study. I also thank Professor Dr. Gerhard lIIing for
agreeing without hesitation to be the second supervisor of my work.
I am deeply indebted to Privatdozent Dr. Frank Heinemann for his invaluable
academic support. The privilege to work together with Frank greatly deepened my
understanding of global game theory in particular and several economic theories in
general. It was the result of countless discussions with Frank that laid the
foundations of this work. Frank's enthusiasm encouraged me to continue in difficult
times and made my time at Goethe-University a most valuable experience.
I also would like to thank Professor Dr. Gisela Kubon-Gilke for awaking my interest in
micro economics and game theory early on and for encouraging me to start this
project and keep on going. She generously gave her time to read through and
discuss parts of my work for which I am most grateful.
My work benefited from the indispensable help I received from my colleagues and
friends at the faculty at Goethe-University who offered their insights and thoughts on
earlier drafts of this work during various stages throughout my study. Special thanks
also to my friends outside University who assisted me in researching and who read
through parts or the entire manuscript and provided detailed and helpful feedback.
lowe particular thanks to Jessica Stokes for her invaluable help in correcting my
English. All errors remain mine.
Most importantly, I would like to thank my parents, my sister, and the rest of my
family who made all this possible. I thank them for their strong encouragement and
caring support throughout the years.
Finally, I thank Christian, not only for the numerous helpful conversations,
constructive criticisms and for reading through and correcting the whole manuscript
again and again, but also for his patience, forbearance and unconditional support.
Jutta A. Di:inges
Table of Contents XI
Table of Contents
Figures .......................................................................................................................... XV
Tables ......................................................................................................................... XVII
Symbols ....................................................................................................................... XIX
Abbreviations ........................................................................................................... XXXIII
Introduction ............................................................................................................... 1
Motivation ................................................................................................................ 1
2 Objectives and Structure ........................................................................................ 5
II Alternative Trading Systems .................................................................................... 9
Impact of Technology on the Trading Industry ..................................................... 10
1 .1 Access to Financial Markets ......................................................................... 10
1.2 Automation of the Trading Process .............................................................. 11
2 Overview of Alternative Trading Systems ............................................................. 14
2.1 Definition of Alternative Trading Systems ..................................................... 14
2.2 Functioning of Alternative Trading Systems ................................................. 18
2.3 Benefits and Risks of Alternative Trading Systems ...................................... 20
2.3.1 Benefits .............................................................................................. 20
2.3.2 Risks .................................................................................................. 23
3 Alternative Trading Systems in the U.S ................................................................ 25
3.1 Major Players ................................................................................................ 25
3.2 Regulatory Initiatives ..................................................................................... 31
3.2.1 Regulatory Basis for the Emergence of Alternative Trading
Systems in the U.S ............................................................................ 32
3.2.1.1 Order Handling Rules ............................................................ 33
3.2.1.2 Tick Size Reduction ............................................................... 36
3.2.2 Incorporation into Nasdaq Market Structure ..................................... 37
3.2.3 Current Regulation of Alternative Trading Systems .......................... 39
3.2.3.1 Regulation ATS ..................................................................... 40
3.2.3.2 Current Developments .......................................................... 43
4 Alternative Trading Systems in Europe ................................................................ 44
4.1 Major Players ................................................................................................ 45
4.2 Regulatory Environment ............................................................................... 47
4.3 Market Potential of Alternative Trading Systems in Europe ......................... 49
XII Table of Contents
5 Impact of Alternative Trading Systems on Market Participants ............................ 52
5.1 Impact on Traditional Exchanges ........ :. ....................................................... 52
5.2 Impact on Intermediaries .............................................................................. 54
5.3 Impact on Investors ....................................................................................... 55
6 Future Perspectives and Open Questions ........................................................... 56
III Competition for Order Flow in Market Microstructure Theory ........................... 59
Introduction to Market Microstructure Theory ....................................................... 59
2 Fragmentation versus Consolidation of Liquidity .................................................. 65
2.1 Liquidity ......................................................................................................... 66
2.1.1 Definition of Liquidity ......................................................................... 66
2.1.2 Overview of Research on Liquidity .................................................... 67
2.2 Fragmentation versus Consolidation ............................................................ 69
2.2.1 Fragmentation versus Consolidation Controversy ............................ 70
2.2.2 Overview of Research on Fragmentation versus Consolidation ....... 73
3 Models of Competition for Order Flow .................................................................. 74
3.1 Overview of Theoretical Research on Intermarket Competition ................... 75
3.2 Model of Competition between Identical and Different Markets ................... 77
3.2.1 Model ................................................................................................. 78
3.2.2 Summary of Results .......................................................................... 83
3.3 Model of Competition between Search and Trading with an
Intermediary .................................................................................................. 84
3.a1 M~~ ................................................................................................. M
3.3.2 Summary of Results .......................................................................... 89
3.4 Model of Competition between a Crossing Network and a Dealer
Market ........................................................................................................... 90
3.4.1 Model ................................................................................................. 90
3.4.2 Summary of Results .......................................................................... 96
3.5 Other Models of Intermarket Competition .................................................... 97
4 Summary of Results ............................................................................................. 99
IV Theory of Global Games ....................................................................................... 103
Introduction to Game Theory .............................................................................. 104
2 Information and Knowledge ................................................................................ 109
2.1 Information and Information Structure ........................................................ 109
2.2 Concept of Common Knowledge ................................................................ 111
2.3 Higher Order Beliefs ................................................................................... 114
3 Introduction to the Theory of Global Games ...................................................... 116
3.1 Coordination Games ................................................................................... 117
3.1.1 Characterization of Coordination Games ........................................ 117
Table of Contents XIII
3.1.2 Approaches to Equilibrium Selection .............................................. 120
3.2 Global Games ............................................................................................. 122
3.2.1 Symmetric Two Person Binary Action Game .................................. 123
3.2.2 Symmetric N-Person Binary Action Game ...................................... 126
3.2.3 Summary of Results ........................................................................ 129
3.3 Further Developments ................................................................................ 131
4 Applications of the Theory of Global Games ...................................................... 133
4.1 Leading Example ........................................................................................ 134
4.1.1 Basic Model ..................................................................................... 134
4.1.2 Incomplete Information Model ......................................................... 136
4.2 Uniqueness of Equilibrium .......................................................................... 140
4.2.1 Uniqueness with Uniform Distribution ............................................. 140
4.2.2 Uniqueness with General Distributions ........................................... 143
4.2.3 Limit Uniqueness and Noise Independent Selection ...................... 146
5 Summary of Results ........................................................................................... 147
V Competition for Order Flow as a Global Game .................................................. 149
Equilibrium Selection in Games of Competition for Order Flow ......................... 150
1.1 Framework .................................................................................................. 150
1.2 Game with Common Knowledge of the Value of Trade ............................. 153
1.3 Global Game with Incomplete Information of the Value of Trade .............. 159
1.3.1 Existence of Dominated Strategies ................................................. 160
1.3.2 Iterated Elimination of Dominated Strategies .................................. 162
1.4 Game with Individual Values of Trade ........................................................ 170
1.5 Discussion of Results .................................................................................. 174
2 Global Game with Endogenous Dealer Pricing .................................................. 178
2.1 Competition from a Crossing Network in Different Market Structures ........ 178
2.1.1 Dealers' Pricing Behavior ................................................................ 179
2.1.1.1 Monopolistic Dealer ............................................................. 180
2.1.1.2 Competitive Dealers ............................................................ 189
2.1.2 Comparison of Different Market Structures ..................................... 192
2.2 Impact of the Introduction of a Crossing Network ...................................... 195
2.2.1 Dealers' Pricing Behavior without a Crossing Network ................... 195
2.2.1.1 Monopolistic Dealer ............................................................ 197
2.2.1.2 Competitive Dealers ............................................................ 198
2.2.2 Comparison of Markets with and without a Crossing Network ........ 199
2.3 Discussion of Results .................................................................................. 204
VI Summary of Results and Further Research ....................................................... 207