An analysis of the economic justification for consolidation in a secondary security market

This paper considers whether all trading in a listed security should be required to go through an exchange. To this end, the incentives for a brokerage firm to offer in-house execution services are discussed, and an analytical framework is developed which shows that, under idealized conditions, fragmentation of the market through in-house execution services would not result in any overall deterioration of market performance characteristics. However, when some of the idealized conditions are relaxed, the market fragmentation arising from in-house execution causes the gains to some customers to be more than overcome by the losses to others. The analysis, which also takes account of the desirability of enforcing reasonable trading priority rules (such as priority by price and time) across all traders, yields several public policy implications. For some unlikely scenarios, it would be possible, through appropriate commission sharing and a perfectly operating intermarket trading system, for optimal overall market performance to be consistent with the market fragmentation inherent in in-house execution services. However, for most realistic scenarios, fragmentation would cause a deterioration in the quality of the market. Thus it seems desirable to require that all trading go through a central exchange with a consolidated limit order book.