How beneficial has competition been for the Australian equity marketplace?

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1 How beneficial has competition been for the Australian equity marketplace? Michael Aitken ᵵ, Haoming Chen ᵵ and Sean Foley 1 ᵵ Australian School of Business, University of NSW, Australia 1 Finance Discipline, Faculty of Business, University of Sydney, Sydney, 2006, Australia This Version: 24 th May 2013 Abstract This paper analyses the introduction of competition to the Australian equities market. The event of interest is the entry of the Chi-X marketplace and the impact it has on market quality. We define market quality by reference to the universal mandate of securities regulators which require that all market design changes, such as the authorisation of a new marketplace, must improve (or at least, not detract from) market efficiency and market integrity. We provide evidence that market efficiency, as proxied by transaction costs and price discovery, are improved in the wake of competition. We also argue that the market surveillance changes that accompanied the introduction of competition maintained market integrity, allowing us to conclude that the introduction of competition to the Australian equity market has enhanced market quality. We estimate the welfare affects to be between $36-220m to market participants in the first year alone. Our results confirm the theoretical findings of Foucault and Menkveld (2008) that reduced explicit fees alone are sufficient to reduce quoted spreads, as these savings are passed on by liquidity providers. We are also able to identify that the majority of spread reductions are caused by queue-jumping strategies due to the lack of time-priority between markets. We are able to show that such activity not only causes increased competition between liquidity suppliers, it also increases the extent to which markets become locked or crossed allowing traders to buy and sell at the same price. 1 Contact Author, Finance Discipline, School of Business, University of Sydney, 2006, Australia: Tel (+612) ; The authors would like to thank the CMCRC for funding assistance and thanks SIRCA for access to data.

2 1. Introduction The accessibility and affordability of technology combined with the will of regulators to inject competition into securities markets has led to fragmentation, with the proliferation of alternate trading venues, such as Chi-X, into markets that had historically lacked competition. Whilst this competition can put downward pressure on explicit trading fees, the network externalities of trading suggest consolidation is the optimal structure for liquidity (Di Noia, 2001). Additionally, the increased cost of regulating fragmented markets is more frequently being imposed on market participants, 2 leading many to question whether such fragmentation is in fact beneficial. This paper analyses the 2011 introduction of Chi-X into the Australian equities market. As part of identifying the impacts of fragmentation on market efficiency, we quantify the cost savings arising from reduced implicit and explicit costs of trading. We then compare these to the additional costs competition has imposed, including the increased costs of regulation and of broker connection to the new marketplace. Securities exchanges, market participants and regulators are interested in market quality, which Aitken and Siow (2003) argue must be evaluated in terms of the universal mandate of regulators to ensure that markets are both fair and efficient. In this paper we examine the efficiency of the Australian market, which can be further decomposed into transaction costs and price discovery (O Hara and Ye, 2011). 3 As a metric for transaction costs, we consider the impact Chi-X s introduction and proliferation has had on effective bid ask spreads in the consolidated market, allowing us to quantify the impact of the introduction of Chi-X on market participants. We also analyse the impact of the new exchange on volatility and autocorrelation metrics as part of understanding the impact of the new market on price discovery. Studies such as O Hara and Ye (2011) in the US and Foucault and Menkveld (2008) in Europe have found that competition has reduced both explicit and implicit transaction costs. As such, they have primarily assessed the impact of competition on market efficiency as proxied by transaction costs. We argue that these studies miss important aspects of the evaluation process which relate to the impact of competition on market integrity as well as additional aspects of market efficiency such as price discovery which are required by the universal mandate of regulators to ensure that all market design changes pass the dual test of fairness and efficiency. 2 See for example, the ASIC Market Supervision Cost Recovery scheme and the IIROC cost recovery regulations in Canada. 3 These metrics arise from a definition of market efficiency which requires that an efficient market be cheap to trade (the cheaper the better) and that the price at which one is trading reflects all available information.

3 The two main findings of our study are that competition reduces transaction costs for a range of Australian equities, with effective spreads reducing more as fragmentation increases; and that the presence of interexchange competition is harmful neither to liquidity provision nor to the price discovery process. Foucault and Menkveld (2008) postulate that there are two mechanisms by which spreads may become lower in the presence of competition competition between market makers duplicating their limit order schedules across marektplaces and reductions in explicit costs generated as a result of competition reducing the order processing costs of the spread, allowing market makers to reduce their quoted spreads. We test the theories of Foucault and Menkveld (2008) and show that reductions in explicit transaction costs alone are sufficient to reduce spreads overall, observing lower quoted and effective spreads at the same time as reduced quoted volume at the national best bid and offer. We also identify an additional mechanism by which effective and quoted spreads may be reduced the ability of Australian markets to become locked with the best bid on one exchange equal to the best ask on another, or even crossed where the best bid on one exchange is higher than the best ask. The granularity of our data enable us to identify the portion of the day for which spreads are locked or crossed. We find that the introduction of Chi-X has significantly increased the portion of the day for which the market is constrained, locked or cossed. Finally we canvas some of the changes to the integrity of the marketplace that the introduction of Chi-X has sparked and conclude that these changes have at worst maintained the level of market quality, although these elements are not directly quantified. The paper is organised as follows. Section 2 outlines the institutional details of the Australian market that led to the entry of Chi-X. Section 3 reviews related literature. Section 4 discusses the data and research design employed. Section 5 presents summary statistics and results of our empirical analysis; Section 6 tests the robustness of our findings. Section 7 quantifies the total welfare implications for market participants and section 8 concludes. 2. Institutional Details 2.1 ASX and Chi-X Market Structures The Australian Securities Exchange (ASX) conducts the listing, trading, settlement and clearing of Australian equities and other financial securities. It was created from the merger of the Australian Stock Exchange with Sydney Futures Exchange in The Australian Stock Exchange had previously been formed through the amalgamation of six independent state-based exchanges in 1987, a process that was facilitated by the introduction

4 of the Stock Exchange Automated Trading System (SEATS), one of the first fully-automated trading systems globally. 4 The ASX held a virtual monopoly in the local trading of Australian equities since its formation until the 2011 introduction of Chi-X. As at December 2012, the ASX was the tenth largest equities market by market capitalisation, trading $1.336 trillion per year and providing a secondary market for 2056 listed companies. Average daily trading turnover on the electronic order book during 2012 was $3.57 billion. 5 The ASX has three minimum tick sizes for listed stocks, which form the lower bound on quoted bid ask spreads. These tick sizes vary depending on the security s price, being 0.1c for shares priced below 10c, 0.5c for shares priced from 10c to $2 and 1c for shares priced above $2. 6 Chi-X Australia (Chi-X) is an alternative trading venue for ASX listed securities. Chi-X s parent company, Chi-X Global Holdings, is owned by a syndicate of financial institutions led by Nomura. Trading occurs from 10:00 am to 4:12 pm in a continuous order driven market. No opening or closing auction occurs, with order entry only possible from 10:00am. This results in Chi-X beginning to trade selected securities prior to the ASX opening auction. The ASX conducts and maintains a monopoly on settlement and clearing functions. In the Australian market, Chi-X conducted a segmented rollout of tradeable securities. Six highly liquid stocks (BHP, CSL, LEI, ORG, QBE and WOW) and two ETFs (STW and ISO) began trading in a soft launch on the 31 st of October The remaining ASX200 constituent stocks and ASX listed ETFs became eligible to trade on Chi-X on the 9 th of November Trading in a further 47 ASX listed stocks was introduced incrementally from December 2011 to November On the 3 rd of May 2013 Chi-X expanded trading to encompass the entire universe of ASX listed securities. Table 1 summarises the key events in the introduction of competition to the Australian landscape. < Insert Table 1 here > Figure 1 documents the evolution of Chi-X s market share in Australia since its introduction. Similar to the evolution of Chi-X as a secondary exchange globally, market share in Australian equities began at a very low level, remaining below 2% of total daily turnover in its first 6 month of operation and not exceeding 5% until August Chi-X 4 For more information on the microstructure of the ASX, see Frino, Lecce and Segara (2011). 5 World Federation of Exchanges Monthly Reports, available at 6 ASX Pricing Information (Tick Sizes) is available at

5 Australia s share of daily turnover exceeded 10% in late 2012 and on the 31 st of January 2013 Chi-X held a 10.15% market share in the trading of Australian equities. < Insert Figure 1 here > 2.2 Explicit Trading Fee Comparison On the 1 st of July 2010, after the announcement of Chi-X s intention to establish a competing exchange in Australia, the ASX reduced fees for the trading services which would be subject to competition. 7 These changes are documented in Table 2. Services such as the opening and closing auctions (which did not face competition) experienced no reduction in fee. Chi-X s fee structure from market launch was 0.06bps for passive order execution and 0.12bps for active order execution. < Insert Table 2 Here > 2.3 ASIC Cost Recovery Scheme As part of the introduction of competition to Australia, it was considered necessary for the supervisory function of markets to be transferred from the ASX to the Australian Securities and Investments Commission (ASIC). The reason for this was straightforward. The introduction of a fragmented market left open the opportunity (as in Europe) for traders to split their trading across markets in order to hide potential incidences of insider trading and market manipulation. Setting up a centralised surveillance authority enabled the fragmented market to be reconsolidated for surveillance purposes, significantly reducing the incentives for traders to engage in such manipulative conduct. Compared to Europe, where we would expect market integrity to reduce in the presence of fragmentation, the centralisation of the regulatory functions in the Australian market do not result in the same incentives, leading to the conclusion that market integrity would remain unchanged in the wake of competition. As part of the move to a consolidated regulatory tape, ASIC implemented a market supervision and competition cost recovery scheme to recoup costs incurred in establishing the new regulatory framework and infrastructure. This framework allows provisions for the introduction of competition between exchanges in Australian equities, as well as a number of other operational upgrades. It seeks to recoup a total of $29.77 million between the 1 st of 7 ASX Market announcement on 3 June 2010, available at

6 January 2012 and the 30 th of June Table 3 documents the breakdown in the allocation of the funds ASIC is recovering from market participants. < Insert Table 3 Here > Of the costs in Table 3 accruing to market participants, non-it costs of $14.92 million and IT costs of $7.89 million will be allocated proportionally based on the number of transactions and the number of messages respectively, similar to the IIROC cost recovery program undertaken as a result of increased message traffic in Canada. 9 Of the $700,000 market operator specific costs allocated to establishing real-time surveillance and data connectivity, $434,558 is attributable to Chi-X and $265,862 to ASX PureMatch. Similar to the Canadian equities market, where inter-exchange competition has existed since 2007, but a cost recovery scheme has only been introduced recently, these expenses may not be entirely attributable to competition. Whilst explicit costs of less than $500,000 are allocated to the regulation of Chi-X, we err on the conservative side and attribute the entire increase in regulatory expenses as costs associated with the introduction of competition. Notwithstanding, the net results still suggest that competition has been beneficial for the total welfare of participants in the market. 3. Literature Review Three main areas of literature are relevant to identifying the impact of competition on market participants. The first deals with bid ask spreads (a proxy for market efficiency) as an element of implicit transaction costs and identifies variables which influence the level of spreads per stock. Whilst these variables allowed cross sectional comparison of bid ask spreads under consolidated and fragmented market structures, the optimal level of fragmentation was not directly addressed. The metrics developed in this early literature were then utilised in a second strand of literature to assess the impact of competition between brokers and separate listing venues. The recent introduction of regulation to foster competition and promote order flow fragmentation in the US and European equities markets has generated a third strand of literature dealing with the explicit impacts of inter-exchange competition on market quality. However, in nearly 8 ASIC Market Supervision Cost Recovery Impact Statement, available at 9 See Malinova, Park and Riordan (2012) for a description of this regulation.

7 all of these cases market quality has been restricted to look at market efficiency only and within market efficiency, primarily transactions costs. As previously indicated this does not accord with the view of market quality as outlined in the universal mandate of regulators Accordingly, we extend this literature to analyse the impacts of competition not only on transaction costs but also on price discovery (the two essential elements of market efficiency) as well as market integrity to provide an appreciation of the impact of competition on the total welfare for market participants. 3.1 Determinants of Bid Ask Spreads In the market for transacting financial securities, costs include both explicit fees (such as brokerage, clearing costs and the cost of connecting to marketplaces) and the implicit cost of crossing the spread. Bid-ask spreads were first modelled as a cost of transferring title to securities, both theoretically and empirically, in Demsetz (1968). For a cross section of NYSE stocks, spreads in dollar terms were found to be positively related to price per share and negatively related to the number of shareholders and transactions per day. As these two variables are proxies for trading volume, Demsetz (1968) argues that economies of scale exist in share trading, implying that natural monopolies may exist in securities exchanges. Demsetz (1968) also finds competition through listing in outside markets does not have a significant impact on quoted spreads. Benston and Hagerman (1974) modelled bid ask spreads as the price of immediacy. They applied economic demand theory from the dealer s perspective to decompose spreads into costs associated with inventory holding, order processing and adverse selection. They test this theory empirically for a randomly drawn sample of OTC stocks, finding that spreads are positively related to unsystematic risk, adverse selection and inventory holding costs. Additionally, spreads are found to be negatively related to the number of dealers and transaction volume, implying that competition reduces spreads and dealers are not natural monopolists. Benston and Hagerman (1974) do however allow for the possibility of economies of scale at the market level. Stoll (1978) extends this work by providing an explicit theory of dealer costs and their determinants, focussing on bid ask spreads for NASDAQ stocks in basis points, rather than in absolute dollar terms. Stoll (1978) links proportional spreads to price, volume, competition, turnover percentage and both systematic and unsystematic risk. These factors are found to account for 82% of the variation in spreads. The empirical literature on the determinants of bid ask spreads as a transaction cost was extended to the market for Australian equities by Aitken and Frino (1996). They find relative spreads are reduced with increased stock prices, as higher prices with constrained minimum tick sizes leads to lower proportional spreads. Spreads are also negatively related to volume, as competition for order flow with price-time priority forces bid ask spreads to

8 narrow. A positive relationship was found between spreads and volatility, indicating that greater price uncertainty leads market participants to demand more compensation for potential adverse selection or increased inventory holding costs in the form of wider spreads. Although Australian equities are traded in an automated order driven market, rather than a dealer quote driven market, Aitken and Frino (1996) find the determinants of spreads are similar to studies in US quote-driven or hybrid markets. Competition between venues is identified as a possible spread determinant, and with the introduction of Chi-X into Australia this is examined explicitly in the present paper. 3.2 Comparison of Bid Ask Spreads under Consolidated and Fragmented Markets Whilst the prior literature developed a number of stock-specific factors that constitute the determinants of the spread, a body of literature has developed that examines the potential impact on transaction cost of the competition for order flow, primarily between dealers and competing listing venues. Hamilton (1979) finds that market structure can have two competing impacts on transaction costs, with economies of scale reducing costs when markets are consolidated and competition between market centres reducing costs in fragmented markets. Securities exchanges may be natural monopolies, with significant economies of scale in clearing, settling and infrastructure provision due to the high fixed and low marginal costs of matching trades. Pagano (1989) finds that liquidity begets liquidity due to these network externalities, with order flow gravitating towards one single, dominant exchange. In contrast, Economides (1996) argues competitive forces are necessary to promote operating efficiency and ensure that exchanges do not behave monopolistically to earn excessive profits. This tension has led to the waves of fragmentation and consolidation seen since the 1960 s, typified in the US experience. A number of studies have attempted to quantify the impacts of competition on market quality but it is noteworthy that most of these studies constrain market quality to market efficiency and within market efficiency to transaction costs. Since the introduction of competition is rarely a clean experiment, many alternative situations have been analysed. However, no definitive consensus exists on whether fragmentation is beneficial for transaction costs. A number of situations have provided support for competition as beneficial for transactions costs. For example, Cohen and Conroy (1990) find that the introduction of regulation allowing exchange members to make off-board markets in NYSE stocks resulted in narrower relative bid-ask spreads. Battalio (1997) shows that the entry of Madoff Securities, a third-market broker dealer, results in a reduction of bid ask spreads for NYSE listed securities. Domowitz et al. (1998) finds that international cross listing and competition for

9 order flow in Mexican stocks decreases bid ask spreads in the domestic market. DeFontnouvelle et al (2003) analyse changes in US options markets which allowed exchanges to directly compete for order flow in options which previously held exclusivity in trading. They find that quoted and effective spreads decrease 30 40% immediately after multiple listing, though the declines revert marginally after one year. However, a large body of literature exists that finds the benefits of competition are outweighed by the costs. Bessembinder and Kaufman (1997) provide evidence showing that fragmentation allows cream skimming of uninformed traders on non-nyse markets, resulting in increased realised and effective spreads. Bennett and Wei (2006) demonstrate that after stocks voluntarily transferred listing from the NASDAQ dealer market to the more consolidated NYSE venue, average quoted, effective and realised spreads decreased significantly, providing evidence for the benefits of consolidation. They find liquidity improves most for stocks with the greatest increases in the level of consolidation in trading. A study of European stocks by Gajewski and Gresse (2007) find that spreads are lower under a centralised, consolidated electronic order-driven market than under a hybrid market, where orders are fragmented between an order book and competing dealers. It is possible the varying conclusions of these studies is due to the lack of an optimal natural experiment exposing the impacts of competition, such as exists with the introduction of competition into Australia, generating explicit competition between two trading venues. 3.3 Impact of Inter-Exchange Competition for Order Flow on Bid Ask Spreads Beginning with the implementation of Regulation National Market System (Reg NMS) in the United States in 2005; and the Markets in Financial Instruments Directive (MiFID) in Europe in 2007, a competitive environment for securities transaction services was established, facilitating the rapid fragmentation of global securities markets. With the increasing prevalence of smart order routing systems enforcing price priority between multiple markets, academic research has begun examining inter-exchange competition, order flow fragmentation and its impact on market quality, proxied primarily by transaction costs US Market Studies Reg NMS introduced significant changes to the structure of US equities markets, including an order protection rule enforcing inter-market price priority, ensuring orders are sent to the market with the best price. O Hara and Ye (2011) conduct the first empirical analysis of the impact of Reg NMS on transaction costs in US equities. 36% of NASDAQ and 23% of NYSE trading volume is found to occur through off-exchange trade reporting facilities (TRFs). Order flow fragmentation is found to reduce effective spreads as well as reducing the time from order receipt to execution. These results differ substantially from

10 Bennett and Wei (2006) although both studies analyse the US market. One potential reason for these differences is the way in which fragmentation is measured, with Bennett and Wei (2006) using trading venue as a proxy for market fragmentation, whilst O Hara and Ye (2011) use the more explicit percentage of order flow executed through TRFs. O Hara and Ye (2011) argue that although trading in US equities is fragmented across multiple venues, it benefits from virtual consolidation, as a single market with multiple points of entry due to smart order routing and the trade-through prohibition. They find that competition reduces transaction costs and enhances price discovery, with the benefits of competition outweighing any loss of consolidated trading s positive network effects European Market Studies Foucault and Menkveld (2008) analyse the liquidity impact on Amsterdam Exchange Index constituent stocks of switching from a centralised limit order market to a fragmented environment, with competition between two pure limit order markets occurring as a result of the introduction of LSE EuroSETS in Foucault and Menkveld (2008) provide a theoretical framework in which they show two mechanisms by which competition for secondary market order flow can reduce trading cots. The first involves the competitior exchange needing to charge lower explicit fees than the incumbent in order to attract order flow. This reduction in explicit fees is shown to reduce the order processing costs of market makers, allowing them to quote tighter spreads. The second mechanism involves the lack of time priority between venues. This allows market makers to queue jump by submitting orders to the competitor exchange. Such a mechanism provides an additional source of competition between the market makers, increasing national best bid and offer (NBBO) depth and potentially quoted spreads. Foucault and Menkveld jointly test these hypotheses in the Dutch market, finding consolidated depths significantly increase, with relative inside quoted spreads either narrowed or unchanged in the post entry period. They find that the more prevalent are smart order routers, which are able to obtain the best available prices regardless of venue, the greater is overall liquidity supply. Foucault and Menkveld (2008) argue that fragmentation may be beneficial only if trade-throughs are prohibited a feature that is not currently present in Australia. We provide evidence that the reduction in spreads observed by Foucault and Menkveld (2008) can occur without the necessity of increased competition due to the lack of time priority between venues. We show that the 2010 reduction in ASX fees ahead of the Chi- X introduction in 2011 was associated with a significant reduction in spreads, with spreads further declining with the introduction of Chi-X s lower fee schedule, notwithstanding the observed reduction in overall market depth.

11 The implementation of MiFID in Europe abolished the concentration rule and promoted competition between trading platforms. Chlistalla and Lutat (2011) analyse the impact of MiFID on French equities, where order flow has fragmented substantially as a result of Chi-X s market entry. For actively traded stocks, competition is found to increase market liquidity, as measured through lower quoted spreads, increased depth at best bid and offer and reduced synthetic round trip execution costs. 10 Gresse (2012) examines the impact of competition and order flow fragmentation on French CAC40, SBF120 and UK FTSE100 constituent equities among regulated markets, multilateral trading facilities and systematic internalisers. Both consolidated and local spreads are found to have narrowed after the implementation of MiFID, with the reduction most prominent for large capitalisation equities, increasing in magnitude as the level of fragmentation increased through time. This study builds on the findings of Gresse (2012, identifying the source of spread reductions observed contemporaneously with competition, whilst also analysing the impact competition has on explicit transaction costs, price discovery and market integrity. All empirical studies to date have found an improvement in consolidated market liquidity (i.e. lower transaction costs) from interexchange competition and associated order flow fragmentation. Noteworthy is that few of these studies consider market quality in the sense referred to in the mandate of regulators, which universally requires that all market design changes (of which the introduction of competition is one) pass the dual tests of fairness and efficiency. Fairness is typically ignored altogether while efficiency is generally only proxied by transaction costs. This suggests that previous works have at best given a flavor for the possible effects of competition on market quality. For markets where fragmentation has not been accompanied by regulatory consolidation, such as in Europe, we hypothesise that market integrity is likely to have deteriorated, notwithstanding reported enhancements in market efficiency, leading to the need to consider the tradeoff between fairness and efficiency. This is left to a subsequent paper. This paper makes several contributions to the empirical literature. First, we extend the analysis of interexchange competition s impacts on implicit transaction costs to a unique natural experimental setting the introduction of Chi-X trading in ASX listed securities in a small, centralised market consisting of a limit order exchange which did not previously experience substantial competitive forces. Second, we identify which of the two mechanisms theorised by Foucault and Menkveld (2008) lead competition to reduce spreads namely the reduction in the order processing costs of market makers generated by lower explicit fees. 10 These synthetic round trip costs measure the ability to trade 100,000 worth of stock at any point in time.

12 Third, our granular data enable us to identify an additional mechanism by which fragmentation can lower NBBO quoted spreads in the absence of trade-through prohibitions, namely the ability of stock prices to become locked or crossed. Importantly, we extend the concept of market quality to explicitly encompass the mandate of regulators around the world that require all market design changes to pass the dual tests of fairness and efficiency. To this end we extend the concept of efficiency to encompass price discovery and we address the issue of market fairness/integrity. Finally, we quantify the welfare impacts of competition for market participants. 4. Data and Research Design Data on trades and quotes is obtained from the Securities Industry Research Centre of Asia-Pacific (SIRCA) Thomson Reuters Tick History database, time-stamped to the millisecond. This data includes information on price, volume and qualifiers indicating whether a trade is executed off-market, against hidden liquidity or in the open or closing auctions. Quotes prior to 10:15am and after 3:45pm are removed from our continuous market variables in order to avoid the opening and closing auction process. Our primary observation period encompasses the 1 st of May 2012 (six months after the introduction of Chi-X) to the 31 st of January For robustness we have constructed all metrics from the 1 st of July 2011 to the 31 st of January Our sample of securities includes all constituents of the ASX200 on the 1 st of November, We remove from this list 11 securities that are removed from the ASX200 by the 1 st of January, We additionally remove 3 securities that trade below 10c within our sample period (due to issues surrounding tick size changes) and 12 securities that delist due to bankruptcy or takeover in the same period. This leaves a total sample of 174 ASX200 securities. We analyse the impact of the introduction of Chi-X in two ways. The first method compares liquidity metrics across one pre- and two post-event observation periods. The second method uses the percentage of trading in Chi-X as an indicator of the level of fragmentation in each stock-day. This allows us to identify the relationship between order flow fragmentation and changes in transaction costs and price discovery Cross Sectional Analysis of Transaction Cost 6 and 12 Months after Competition This specification examines three slices of time, one prior to the introduction of competition (October, 2011), the second six months after the introduction of competition (May, 2012) and the third one year after competition (November, 2012). This allows us to compare the impact of competition through time, utilising a dummy variable for each postcompetition period, similar to the method used in Foucault and Menkveld (2008). The

13 liquidity metrics analysed are quoted, effective and realised spreads, as well as the depth at NBBO. Equation 1 below specifies the regression estimated: (1) where is the transaction cost or informational efficiency metric under consideration, and are indicator variables equal to one for stock-day observations in May 2012 and November 2012 respectively, and zero otherwise, with the nocompetition period of October 2011 constituting our base case. is 1 divided by the daily time-weighted midpoint price of the security. is the natural logarithm of the security s daily trading turnover in dollars across both markets. We use the natural logarithm of volume to minimise skewing of results from the variance of large magnitude observations, as in Benston and Hagerman (1974). Volatility is calculated as per stock-day. This variable is not taken in logarithmic form since it is scaled by the share price and represented as a percentage. takes a value of 1 if the average price of stock i is less than $2 on day d, implying it had a tick size of ½c, and 0 otherwise (implying a tick size of 1c). represents stock-specific fixed effects which control for symbol-specific differences in Chi-X market share Continuous analysis of Transaction Costs and Informational Efficiency Metrics Our second specification uses Chi-X s percentage of Australian market turnover as a proxy for the level of fragmentation, analogous to the two-firm Herfindhal index utilised in Gresse (2012), to analyse changes in transaction costs and price discovery metrics. Market share is calculated as the percentage of dollar volume traded in each venue on a daily basis to capture differences in market share through time. We avoid issues of potential endogeneity between Chi-X participation and market quality variables by using the 1-day lagged 10-day moving average of same security Chi-X trading, as exposed in equation 2 below, where is the percentage of stock i dollar volume traded on Chi-X in day t: (2) We analyse data for all trading days from the 1 st of May st of January 2013, during which Chi-X market share increased to over 10%. The regression specification employed is documented in Equation 3 below.

14 (3) The variables used in Equation 3 have the same meaning as in Equation 1.In Equations 1 and 3, represents the dependent variable of interest. In our study, we employ quoted, effective and realised spreads, depth at the best bid and offer and Amihud illiquidity as our measures of liquidity. Measures of informational efficiency include the absolute value of mid-quote autocorrelation and the standard deviation of mid-quote returns. Similar to McInish and Wood (1992), our analysis utilises relative time-weighted bidask spreads. Quoted spreads are constructed from the best bid and offer quotes across both markets each time a new limit order is entered. For each stock and each day, these spreads are then weighted by the proportion of the day for which the prevailing quote is active. This provides an additional layer of continuous granularity that is not present in the method of Foucault and Menkveld (2008), where discrete order book snapshots are taken every five minutes during the trading day. This granularity allows us capture the increased complexity of modern capital markets, with high frequency traders operating in the millisecond range creating the possibility of locked or crossed markets in multi-venue trading. As per Chordia, Roll and Subrahmanyam (2001), outlier spreads are computed as those that exceed 25% of the time-weighted midpoint. If the proportion of outlier spreads in a stock-day observation exceeds 1%, it is removed from our sample. Similarly, if a stock s NBBO is crossed for more than 1% of the day, this stock-day observation is also removed, since a large proportion of crossed spreads typically indicates a trading halt. This process results in the deletion of 2535 stock day observations, out of a full sample size of for 174 stocks from July 2011 to January According to the findings of Foucault and Menkveld (2008) we expect the reduction in order processing costs attributable to reduced explicit trading costs on Chi-X to reduce quoted spreads. If the addition of Chi-X produces additional competition between brokers we would expect to see market makers duplicating their limit order schedules to maximise the probability of execution, as documented in Van Kervel (2012). This would result in increased quoted depth and potentially tighter quoted and effective spreads Impact of ASX fee reduction Our final specification seeks to identify whether a fee reduction on its own can generate the observed reduction in spreads. Whilst Foucault and Menkveld (2008) identify two mechanisms by which spreads may reduce, the contemporaneous nature of the fee

15 reduction and the introduction of competition to the Dutch market do not allow them to independently test these two hypotheses. In anticipation of the introduction of Chi-X, the ASX almost halved their fee for continuous on market execution from 0.28 basis points to The cost for on-market crossings reduced from 0.15 basis points to 0.1. The reduction of fees on the 1 st of July, 2010 allows us to test whether this reduction lowers the average spreads in the market consistent with Foucault and Menkvelds (2008) theory that order processing costs will be reduced. To test this theory, we use the following specification: (4) 4.2 Transaction Cost Measures Quoted liquidity is measured using the time weighted quoted spread and depth. The quoted spread is the difference between the lowest ask price and the highest bid price available across the consolidated market, at each quote update. We construct this measure in basis points by dividing the quoted spread in cents by the prevailing mid-point. ( ) ( ) (5) Where is the lowest ask price prevailing across either ASX or Chi-X for stock i at time t and is the highest bid price. A time weighted quoted spread metric per stock day is constructed by weighting all quoted spreads on the consolidated ASX and Chi-X market for the stock-day by the percentage of the trading day the spreads were active. The proportion of the trading day for which quoted spreads are constrained analyses one mechanism by which the introduction of competition decreases spreads, since competition for order flow between venues is likely to result in more frequently constrained prices, resulting in reduced bid ask spreads. This metric is constructed as the percentage of the trading day for which quotes are at or below the minimum tick. (6) where is equal to one if the best bid quote is less than the best ask quote minus the minimum tick size at millisecond m and zero otherwise, and 19,800,000 is the number of milliseconds between 10:15am and 3:45pm.

16 Quoted dollar depth is the value that can be traded at the national best bid and offer (NBBO). It represents the immediately tradable value at the best prices available in the market. This value is constructed by multiplying the price and volume available across both ASX and Chi-X at the best bid and offer at any point in time, as in Equation 7: ( ) (7) where is the lowest ask price prevailing across ASX or Chi-X for stock i at time t, is the consolidated volume available on all exchanges at that best ask level, is the highest bid price prevailing across ASX or Chi-X for stock i at time t and is the volume available at that best bid level. A time weighted quoted depth metric per stock day is constructed by weighting all quoted depth observations for the stockday by the percentage of the trading day for which that depth level was active. We also examine effective liquidity measures, which capture the conditions that traders decided to act upon, rather than the posted conditions prevailing in the market. We use both effective and realised spreads. Effective spreads calculate the cost of a transaction for the liquidity demander and are measured using the difference between the transaction price and the midpoint of the bid and ask quotes at the time of the transaction. For the t-th trade in stock i on day d, the effective spread is calculated as: (8) where is the transaction price, is the midpoint of the best bid and ask quote prevailing at the time of the trade, and indicates the direction of the trade, where a buyer initiated trade takes a value of 1 and a seller initiated trade takes a value of 1. Buyer and seller initiated trades are identified by comparing the prevailing NBBO to the transaction price using the Lee and Ready (1991) algorithm. Realised spreads reflect the portion of the transaction cost that is attributed to liquidity provider revenues. We use the five minute realised spread, assuming that liquidity providers are able to reverse any position they have accrued at the midpoint five minutes subsequent to the trade. We define the realised spread as: (9)

17 where is the transaction price, is the midpoint of the quote prevailing five minutes after the time of the t-th trade, and indicates the direction of the trade, where a buyer initiated trade takes a value of 1 and a seller initiated trade takes a value of -1. We use Amihud s (2002) measure of illiquidity to determine if there has been a change in the price impact of trades. Amihud s illiquidity measure identifies the relationship between the absolute value of return over a given period and the volume transacted in that period. The intuition is that relatively illiquid shares will have their prices moved more by high trading volumes than will liquid securities. This illiquidity measure is constructed as: (10) where is the absolute return on stock i for day d in hour h and is the dollar volume transacted in that same period. 4.3 Price Discovery Measures The mandate of regulators to ensure fair and efficient markets requires a broad analysis of market quality variables. To date, studies have analysed the impact of competition using primarily transaction cost measures, with the exception of O Hara and Ye (2011). We extend our analysis to examine the impact of competition on measures of price discovery and total welfare. Two measures are used to identify the amount of information that is impounded into prices: autocorrelation-based measures and volatility-based measures. Positive or negative mid-quote autocorrelation indicates that quotes deviate from a stochastic random walk process and exhibit short-term return predictability. Such predictability is inconsistent with an informationally efficient market. We calculate first-order return autocorrelations for each stock-day, at various intraday frequencies,, following the method of Hendershott and Jones (2005): (11) Where is the t th midquote return of length k for a stock-day. Taking the absolute value of the autocorrelation yields a measure of informational efficiency that measures both the underand over-reaction of returns to information, with larger values indicating greater inefficiency.

18 The second measure of informational efficiency used is the standard deviation of returns. A lower standard deviation indicates greater informational efficiency, since stock prices exhibit lower price volatility. We calculate standard deviations of returns for each stock-day, at various intraday frequencies,, (12) where is the t th mid-quote return of length k for a stock-day. 5. Summary Statistics and Results 5.1 Summary Statistics Table 4 provides summary statistics for the variables utilised in our sample. These are broken up into two periods the 4 months prior to the introduction of Chi-X and 9 months beginning 6 months after the introduction. Panel A provides details on the liquidity metrics constructed. Whilst mean quoted spreads have increased slightly from to 33.1, median spreads have experienced a decline over the same period. Declines are also observed in effective spreads, reducing by 1.77 basis points. We also observe a slight increase in quoted depth and a significant increase in the proportion of time spent at or below the minimum tick size from 68% to 75%. A decline is also observed in the Amihud Illiquidity metric, implying that prices are better able to absorb large transactions, consistent with increases in quoted depth. Panel B describes summary statistics for informational efficiency measures. Whilst very minor increases are observed in autocorrelation from the pre-chi-x period to post, there are much greater magnitude reductions reported in the mean and median standard deviations of prices at all frequencies, implying whilst prices may be more sluggish to impound new information, they are much less volatile.. Panel C presents descriptive statistics for the control variables. The increase in price inverse implies a reduction in average stock price from $2.37 to $2.04 over the pre-post period. Commensurate with this slight reduction in price we observe the number of stock days trading with ½c tick size increases from 27% to 28% of the sample. Traded value declines slightly over the sample period as does volatility. < Insert Table 4 here >

19 Figure 2 shows that the mean proportion of crossed spreads has increased as Chi-X s market share has grown. The mean proportion of constrained spreads also increased steadily, peaking and plateauing in June This indicates that the entry of Chi-X has encouraged competition between liquidity providers on each venue, resulting in an increase in the frequency of locked and crossed spreads, reducing the average implicit costs of trading. Such an occurrence provides one insight into how multiple markets may mechanistically reduce the transaction costs of participants, providing instances when they can buy and sell at the same prices in different markets. < Insert Figure 2 here > 5.2 Empirical Results Our first set of results documents the impact of the introduction of Chi-X using one pre-competition period and two post-competition periods; one six months subsequent to Chi- X introduction, and the other after one year. Table 5 documents the impact of Chi-X introduction on stock liquidity, with stocks separated into quartiles based on 2011 market capitalisation. Declines of between 1.62 and 2.87 basis points are observed for each quartile of the ASX200, both 6 months and 1 year subsequent to the introduction of Chi-X. These spread reductions are greatest for the smallest half of stocks in our sample likely as these have the largest spreads to start with. These declines are mirrored by similar reductions in effective spreads, though with magnitudes of these reductions are more pronounced the smaller the securities. Declines in realised spreads are not identified until one year after the introduction of Chi-X. This may reflect the time that is necessary for competition amongst liquidity providers to generate such reductions. Quoted consolidated depth experiences both incrases and decreases as a result of competition, whilst ASX only depth experiences an increase. This is as a result of tighter spreads existing on Chi-X. If a BBO price is imporved only on Chi-X with relatively thin depth, this will tend to reduce the depth available at the BBO. Consistent with an increase in main market depth, Amihud Illiquidity reduces with competition. Finally, the percent of the day for which stocks prices are constrained by the minimum tick size increases by between 6% and 11.5% for the least liquid third of stocks, with stocks in the largest quartile constrained an additional 20% of the time with competition. < Insert Table 5 here >

20 Panel A of Table 6 shows the results of our analysis of the impact of competition using the fraction of Chi-X traded volume. This is constructed over a period of 9 months, beginning 6 months after the introduction of Chi-X. Consequently the level of fragmentation experienced in each stock-day varies significantly, with average Chi-X volume increasing from 2% at the start of the sample to 11% by the end. O Hara and Ye (2011) use a similar metric of fragmentation, which allows for a more concise exposition of the relationship between changes in efficiency and increases in competition. Consistent with our first specification, we find that increasing Chi-X volume reduces quoted spreads, with a 10% Chi- X share leading to a basis point reduction in the quoted spread amongst the most actively traded ASX securities. These findings are similar to those of O Hara and Ye (2011), who find that effective spreads decrease basis points for each 10% of US equities volume reported to trade reporting facilities. Similar to our analysis of the All Ordinaries securities we find reductions in the effective and realised spreads of larger magnitudes to quoted spreads, representing reductions in the cost of liquidity provision. This implies that competition for order flow is intensified as more order flow migrates to the Chi-X venue. There is a significant increase in quoted depth as Chi-X market share increases, consistent with the increased duplication of limit orders by market makers identified by Van Kervel (2012). This increase in depth appears to increase the markets ability to absorb large orders, lowering the Amihud illiquidity metric. Panel B shows the same liquidity metrics constructed using quote data for the ASX only. This overcomes any potential issues with non-synchronised time-stamps between venues and illustrates the extent to which locked and crossed markets contribute to the observed improvements in liquidity. Each of the constructed spread measures are between basis points larger when constructed using only the ASX data. This implies that at most 20% of the observed improvement in liquidity is due to the mechanics of locked or crossed markets. Whilst the depth increase for Chi-X volume is larger in Panel B this is likely due to the larger nature of stocks with high Chi-X volume. If volume is duplicated in stocks that are constrained on the ASX in order to queue jump, this will result in greater increases in consolidated depth than in ASX-only depth. Interestingly, the observed improvement in the level of constraint when measured for the consolidated market is not present in our ASX-only analysis. This is due to the inability of quotes to be locked or crossed with only one venue. < Insert Table 6 here > Table 7 documents the impact of competition on the price discovery of market-wide stock prices. Mid-quote autocorrelation is measured at the 30second, 60second and 5minute intervals. Table 7 shows that apart from the 5-minute measurements the level of

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