Trading and Exchanges Chapter 26: How Markets Compete With Each Other
Should all trading in a stock happen in one place, or is it okay to have dozens of venues competing for your order? Chapter 26 is about exactly this tension, and honestly, it is one of the most relevant chapters in the whole book if you want to understand why modern markets look the way they do.
The Two Competitions That Cannot Coexist
Harris frames the whole chapter around a fundamental contradiction. Two types of competition happening at the same time, pulling in opposite directions.
First, traders compete with each other to get the best price. This works best when everyone is in the same room. More buyers and sellers in one place means tighter spreads, better fills, and less searching. This is the argument for consolidation.
Second, exchanges and trading venues compete with each other to offer better services, lower fees, and fancier technology. This competition requires multiple venues. If there is only one exchange with a legal monopoly, it has zero incentive to innovate. This is the argument for fragmentation.
You cannot fully have both at the same time. That is the core problem.
Why Markets Naturally Consolidate
Harris introduces the order flow externality. Basically the network effect applied to trading. Every trader who joins a market makes it slightly more liquid. More liquidity attracts more traders, who add more liquidity. Self-reinforcing cycle.
Think of it like a social media platform. Nobody wants to be on the new app if all their friends are on the old one. Same with trading venues. Nobody wants to send orders to a new exchange if there is nobody there to trade with.
This creates a massive first-mover advantage. The incumbent exchange can be mediocre and still win, simply because everyone is already there. Harris tells the story of Optimark, an innovative trading system from the 1990s that used a Cray supercomputer to match buyers and sellers based on preference profiles. Institutional traders loved the concept. They just never sent their orders there. The company burned through $406 million before shutting down. Could not overcome the network effect.
Why Markets Fragment Anyway
If consolidation is so powerful, why do we have dozens of trading venues? Because traders are not identical, and no single market structure serves everyone optimally.
Large traders worry about information leakage. If you need to buy a million shares, the last thing you want is for the whole market to see your order and front-run you. These traders prefer dark pools and venues where order exposure is tightly controlled.
Small retail traders have the opposite preference. They want maximum transparency and the tightest possible spreads. They do not care about information leakage because nobody is going to front-run a 100 share order.
Informed traders prefer anonymous consolidated markets where they can hide in the crowd. Uninformed traders prefer venues where they can signal that they are harmless, so dealers give them better prices.
Patient traders want order-driven systems with strict time priority, so their limit orders actually get filled. Impatient traders want quote-driven systems where a dealer is always ready to trade immediately.
No single exchange can perfectly serve all these groups. So the market fragments.
How Fragmented Markets Glue Themselves Back Together
Here is the clever part. Fragmentation does not have to mean chaos. Harris describes how fragmented markets can still function like a consolidated market through three mechanisms.
First, traders in each venue adjust their orders based on what is happening in other venues. If prices drop on one exchange, limit orders everywhere get updated.
Second, smart order routers send orders to whichever venue currently has the best price. These systems essentially shop across all venues for you.
Third, arbitrageurs. They watch prices across all venues and trade whenever they spot a discrepancy. If stock XYZ is $50.01 on NYSE and $50.03 on another exchange, arbitrageurs buy low and sell high until the gap closes. They are the duct tape holding the fragmented market together.
These forces work well as long as information about quotes and trades flows freely between venues. Without transparency, each fragment becomes an isolated pond.
The Externality Problems Nobody Talks About
Harris points out some underappreciated downsides of competition between venues. One is the race to the bottom on tick sizes. Small exchanges with few limit orders have nothing to lose by allowing tiny price increments. This lets quote matchers step ahead of genuine limit orders by a fraction of a cent. Bigger exchanges then have to match these tiny tick sizes to stay competitive, even though it hurts the limit order traders who actually provide liquidity.
Another problem is regulatory free-riding. Good regulation costs money. If one exchange spends heavily on market surveillance and insider trading enforcement, those efforts benefit the whole market. But only that exchange’s traders pay for it. Venues that skip expensive oversight can offer lower fees. Result: less regulation than is socially optimal.
What This Means Today
Harris wrote this in the early 2000s, but the dynamics he describes are exactly what played out. US equity markets fragmented dramatically. NYSE, Nasdaq, BATS, IEX, dozens of dark pools. Regulation NMS (2005) tried to balance the two competitions by requiring brokers to route to the best price across all venues while allowing venue competition. Whether it succeeded is still debated.
The consolidation wave he predicted for exchanges also happened. Mergers created ICE (which owns NYSE), Nasdaq Inc, and Cboe Global Markets. Technology costs scale better when you are big, and the order flow externality rewards size.
The core tension Harris identified has not been resolved. It probably never will be. A genuine tradeoff, not a problem with a clean solution.
Previous: Chapter 25: Internalization and Crossing