Network Externalities , Market Quality and Trading Activity

This paper analyzes the impact of network externalities and market quality on trading costs and activity. The price impacts of trades of stocks cross-listed on two international stock exchanges are found to be significantly lower on one of the exchanges. Foreign exchange conversion costs, and differences in tick size and the network externalities associated with how the upstairs markets on the two exchanges are regulated do not fully explain the difference in price impacts. Furthermore, neither exchange dominates the other in terms of information flow. Rather we attribute the lower trading cost and greater trading activity on the one exchange to superior market quality as measured by better quoted prices and greater depth at the market in its limit order book as well as to better price continuity. Consistent with this finding, individual trades are most likely to occur on the market which offers better quoted prices and greater depth on its limit order book. Clientele effects are also important in determining the trading venue. Network Externalities, Market Quality and Trading Activity The purpose of this study is to examine the impact of network externalities and market quality on trading costs and activity. The global integration of financial markets, evidenced by the worldwide increase in cross-border activity on the part of issuers and investors, necessitates a better understanding of the differences in order execution due to network externalities and market quality. Pulatkonak and Sofianos (1999) report that the number of non-US companies listed on the New York Stock Exchange (NYSE) increased from 54 in 1985 to 379 in 1998. Since its opening in 1985, London’s SEAQ International (SEAQ-I) has attracted a considerable number of cross-listings from continental Europe. The growth in cross-border trading is a key factor behind the proposed mergers and alliances of international exchanges. Competition between exchanges and the recent explosive growth of Electronic Communications Networks (ECNs) and anonymous order entry systems, such as Island and Instinet raises the question of which market structure is most operationally efficient. Analyzing the impact of network externalities and market quality on order execution is essential in order to explain the emergence and continuation of these trends. We examine the effect of network externalities by studying order execution costs on two exchanges where the primary difference is regulatory structure. The paper also studies the impact of market quality on trading activity. By examining the same securities cross-listed on the New York and the Toronto stock exchanges, we can isolate the impact of network externalities and market quality. Both the New York and the Toronto stock exchanges operate during identical trading hours in the same time zone, open as call markets, function as continuous auction markets after the open, and employ a similar market making structure. The two primary consequences of differences in regulation between the markets are order exposure and the development of an upstairs market as discussed in Smith, Turnbull and White (2000).