Commonality in liquidity and multilateral trading facilities

• Author: Sandra Mortal,Mohamed Mekhaimer,Pankaj K. Jain
• Published date: 01 August 2020
• DOI: http://doi.org/10.1111/fire.12225
• Date: 01 August 2020

DOI: 10.1111/fire.12225

ORIGINAL ARTICLE

Commonality in liquidity and multilateral trading

facilities

Pankaj K . Jain1Mohamed Mekhaimer2Sandra Mortal3

1Department of Finance, Insurance,and Real

Estate, The University of Memphis, Memphis,

Tennessee

2Department of Accounting and Finance, School

of Business, St. John Fisher College, Rochester,

New York

3Department of Economics, Finance and Legal

Studies, University of Alabama, Tuscaloosa,

Alabama

Correspondence

MohamedMekhaimer, Department of Account-

ingand Finance, School of Business, St. John

FisherCollege, Salerno 138, Rochester, NY

14618.

Email:mmekhaimer@sjfc.edu

Abstract

We use the introduction of two multilateral trading facilities (MTFs)

to examine the impact of market fragmentation on commonality in

liquidity. We find that the introduction of MTFs following the Mar-

kets in Financial Instruments Directive increases the comovement

of stocks’ liquidity with MTF liquidity, while the comovement with

the home market liquidity generallydecreases. We also find that the

higher the MTF trading volume or the number of MTFs trading a

stock, the stronger the effect. Further, we find that the commonal-

ity in liquidity remains unchanged for a matched control sample of

stocks that do not trade on MTFs.

KEYWORDS

commonality in liquidity, market fragmentation, multilateral trading

facilities, NYSE-Arca Europe, Turquoise

JEL CLASSIFICATIONS

G11, G12, G14

1INTRODUCTION

In the last decade, regulatory changes, technological advancement, and the unprecedented wave of mergers among

stock exchanges have sparkedcompetition in the equity market all over the world. In the case of Europe, the imple-

mentation of the Markets in Financial Instruments Directive(MiFID) in November 2007 has shifted trading away from

primary home exchangesby allowing multilateral trading facilities (MTFs) and systematic internalisers (SIs) to compete

for order flow and market share.1In general, MTFs surpass primary exchangesin multiple aspects including execution

speeds and access to lit and dark order books simultaneously, and providemake/take fee structure that remunerates

liquidity providing orders and charges aggressive orders (Gresse, 2017). According to a recent report, the share of

European trading taking place on primary exchangeshas fallen significantly to around 60% in 2018 (Oxera, 2019). This

1TheMiFID categorizes order execution venues in Europe into regulated markets (RMs, primary exchanges), MTFs, and (SIs). An MTF is a system, or “venue,”

that brings together multiple third-party buying and selling interests in financial instruments. On the other hand, SIs are bilateral trading markets, where

institutionslarge enough can match client orders internally or against their own books.

Financial Review.2020;55:481–502. wileyonlinelibrary.com/journal/fire c

2020 The Eastern Finance Association 481

482 JAIN ETAL.

change in market structure has invited researchers to investigatepostfragmentation market competition (Hoffmann,

2016), distribution of marketshare across trading venues (He, Jarnecic, & Yubo, 2015), and the liquidity of equity mar-

ket (Gresse,2017). Yet, we do not know much about the impacts of market fragmentation and the introduction of MTF

trading venues on commonality in liquidity.

Chordia, Roll, and Subrahmanyam (2000) provide the first empirical evidence of commonality in liquidity in the

NYSE, showing that individual stock’s liquidity covaries with the market-wide liquidity. Other studies (e.g., Brock-

man, Chung, & Pérignon, 2009; Karolyi, Lee, & van Dijk, 2012) confirm that the covariation in liquidity with primary

exchanges’ aggregate liquidity is also present in severalinternational markets. In contrast to primary exchanges that

list and trade mostly domestic stocks, MTFs admit stocks for trading from major European and American exchanges,

creating a basket of international stocks that can be traded in the same trading venue. As MTFs gain more volume,

market share, and influence in the global market, the nature of the factors driving a stock’s liquidity is fundamentally

altered to reflect not only the liquidity of the primary exchangebut also the forces of the new market entrants. In this

research, we hypothesize that the European market fragmentationand the introduction of MTF trading venues bring

about a new source of cross-border liquidity commonality that has not been studied in prior literature.

To what extentthe introduction of MTFs may affect the liquidity comovement is still an open empirical question.

On the one hand, MTF facilitates the trading of international stocks, which may incentivize investors to bundle MTF

stocks as a basket of trading, instead of trading exclusivelydomestic stocks at primary exchanges, causing liquidity to

covary more across MTF assets—the bundling hypothesis. Consistent with this argument, previousliterature provides

empirical evidencesuggesting that a bundle of stocks that share the same trading venue (Kaul, Mehrotra, & Stefanescu,

2016) and investors pool (Corwin& Lipson, 2011; Koch, Ruenzi, & Starks, 2016), or have similar characteristics (Boyer,

2011;Froot & Teo, 2008) tend to show higher levelsof comovement. Another example of the bundling effect can also be

observed in exchange-tradedfund (ETF) trading. Agarwal, Hanouna, Moussawi, and Stahel (2018) show that ETF own-

ership significantly increases commonality in liquidity across underlying stocks.2The bundling effect may also change

liquidity comovement in the home market. For example, tradersmay concentrate trading of MTF stocks in the new

trading venue—MTF,away from the primary exchange, causing MTF stocks to comove less with the primary exchange

assets (Kaul et al., 2016). Alternatively, they may use trading information from the MTF trading venues to develop

trade strategies in the home market(Cespa & Foucault, 2014). In this case, we would expect that MTF stocks’ liquidity

covariation with the home marketremains unchanged in the post-MTF period.

On the other hand, the proliferation of trading venues and the intermarket competition may encourageinvestors

to deliberately direct orders to specific trading venuesaccording to their needs, rather than concentrating trades on a

single MTF or a specific basketof stocks, leading to less comovement across MTF stocks—the intermarket competition

hypothesis. Hoffmann (2016) suggests that the limited access to MTFs, except for a subset of traderpopulation, and

absence of intermarket price priority under MiFID motivate investors to choose tradingvenue according to the infor-

mation they possess and the potential adverse selection risks. He further argues that in light of such market frictions,

primary exchanges maydominate trading, offering better quotes frequently, albeit with fierce competition from MTF

trading venues. Hence, we would expect to observe stronger (weaker) comovementacross primary exchange (MTF)

assets in the post-MiFID period. Overall, previous evidence is mixed as to whether European marketfragmentation

brings more or less MTF liquidity comovement.

The introduction of MTFs provides a unique opportunity to answer our researchquestion for various reasons. First,

the stocks’ entry dates to MTF tradingvenue vary significantly among traded stocks and serve as exogenous shocks for

many but not all American and European stocks. Such diversity in eventdates facilitates estimating pure MTF impacts

and allows us to control for potential confounding effects including time trends that are not related to the introduction

of MTFs. Second, MTFs trade selected stocks from multiple primary exchanges, which enables us to create match-

ing samples that share the same primary home market but are not traded in an MTF.Finally, the MTF constituent list

2These results are also aligned with Gorton and Pennacchi’s (1993) theoretical model, which predicts lesser informed trading to tradecomposite securities

insteadof individual securities, causing commonality in liquidity to increase.