A Theory of Stock Exchange Competition and Innovation: Will the Market Fix the Market?

Eric Budish, Robin S. Lee, John J. Shim

NBER Working Paper No. 25855
Issued in May 2019, Revised in July 2020
NBER Program(s):Asset Pricing, Corporate Finance, Industrial Organization, Law and Economics

This paper builds a new model of financial exchange competition, tailored to the institutional details of the modern US stock market. In equilibrium, exchange trading fees are competitive but exchanges are able to earn economic profits from the sale of speed technology. We document stylized facts consistent with these results. We then use the model to analyze incentives for market design innovation. The novel tension between private and social innovation incentives is incumbents’ rents from speed technology in the status quo. This creates a disincentive to adopt new market designs that eliminate latency arbitrage and the high-frequency trading arms race.

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Supplementary materials for this paper:

• Data Appendix

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w25855