Transparency and Bypass in Electronic Financial Markets

Electronic markets use information technology to disseminate information on prices, quantities, and buyer and supplier identities. In spite of the recognized benefits of electronic markets, increased visibility and transparency may introduce imperfections, and create profitable opportunities to bypass markets that generates the information. In the U.S. securities markets, dissemination of market data has equipped several firms to develop competing, off-exchange trading mechanisms that rely on market price data, but whose transactions bypass the established market. Concern is rising that the growing volume of trading occumng away from the main market may reduce liquidity, and increase transactions costs. A simulation model of securities trading in a continuous auction market (similar to the market structure of the New York Stock Exchange) is used to examine the market quality effects of increasing levels of trading activity through an offexchange dealer. Market characteristics, such as transactions costs, are measured as off-exchange trading increases from zero percent to 20 percent of the total trading volume. The results indicate that competition from an alternative trading venue reduces some trading costs borne by investors. Contrary to regulatory goals, however, off-market trading expands the role of profit-seeking dealers, and lowers the probability that some investors' orders will execute.