Crossing Networks and Dealer Markets: Competition and Performance

This paper studies the interaction between dealer markets and a relatively new form of exchange, passive crossing networks, where buyers and sellers trade directly with one another. We find that the crossing network is characterized by both positive ~“liquidity”! and negative ~“crowding”! externalities, and we analyze the effects of its introduction on the dealer market. Traders who use the dealer market as a “market of last resort” can induce dealers to widen their spread and can lead to more efficient subsequent prices, but traders who only use the crossing network can provide a counterbalancing effect by reducing adverse selection and inventory holding costs. COMPETITION BETWEEN EXCHANGES for order f low is a growing phenomenon in financial markets. From London to Paris to Tel Aviv, exchanges and trading systems are introducing new trading mechanisms that compete for order f low. In the United States, the SEC promulgated new rules that redefine the regulation of Alternative Trading Systems and intensify the competition between existing exchanges and new electronic markets. Indeed, new electronic trading venues are cited as the reason for a decline in the value of seats on major exchanges, even though trading volumes are growing rapidly. What will be the impact of new trading mechanisms on market participants and on existing dealer markets ~DMs!? In this paper we study the effect of introducing a passive call market that competes with an existing traditional DM. The DM is based on competing market makers as in Nasdaq, the London Stock Exchange, the Foreign Exchange market, and the U.S. government securities market. An important benefit provided by the DM is the assurance of immediate execution. An important disadvantage is the cost: the bid-ask spread, which can be substantial. Traders who do not place a high value on immediacy and assured execution can try to reduce their trading costs by searching for counterparties on their own. As computing and communication costs have declined, electronic communication networks have been increasingly deployed to reduce search costs, making it less costly for traders to find one another and reducing the demand for DMs. * Simon School of Business, University of Rochester, and the Graduate School of Business, Stanford University. Helpful comments and suggestions by an anonymous referee, René Stulz ~the editor!, and Robert Hendershott are gratefully acknowledged. THE JOURNAL OF FINANCE • VOL. LV, NO. 5 • OCT. 2000