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 January 2020
NBER Program(s):Asset Pricing, Corporate Finance, Industrial Organization, Law and Economics

This paper builds a model of stock exchange competition tailored to the institutional and regulatory details of the modern U.S. stock market. The model shows that under the status quo market design: (i) trading behavior across the seemingly fragmented exchanges is as if there is just a single synthesized exchange; (ii) as a result, trading fees are perfectly competitive; (iii) however, exchanges are able to capture and maintain economic rents from the sale of speed technology such as proprietary data feeds and co-location — arms for the high-frequency trading arms race. We document stylized empirical facts consistent with each of the three main results of the theory. We then use the model to examine the private and social incentives for exchanges to adopt new market designs, such as frequent batch auctions, that address the negative aspects of high-frequency trading. The robust conclusion is that private innovation incentives are much smaller than the social incentives, especially for incumbents who face the loss of speed technology rents. A policy insight that emerges from the analysis is that a regulatory “push,” as opposed to a market design mandate, may be sufficient to tip the balance of incentives and encourage “the market to fix the market.”

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Document Object Identifier (DOI): 10.3386/w25855