Market fragmentation, mini flash crashes and liquidity Ester F´elez-Vi~nas∗ Stockholm Business School January 12, 2017 Abstract This study analyzes the impact of market fragmentation on liquid- ity with a focus on episodes of mini flash crashes (defined as large price changes that are reversed within seconds). I find that in normal mar- ket conditions, market fragmentation improves liquidity as measured by quoted spreads and depth at best prices. When focusing on episodes of mini flash crashes, the results show that market fragmentation reduces the number of mini flash crashes and speeds up their recovery. Furthermore, market fragmentation is not a source of market instability. Liquidity shocks are mostly less harmful in fragmented, but interrelated markets than in concentrated markets. ∗Contact: [email protected] 1 1 Introduction Stock markets have evolved from local concentrated exchanges to fragmented structures that are comprised by traditional regulated exchanges and alterna- tive trading platforms such as Multilateral Trading Facilities (MTFs). Market fragmentation is the consequence of the implementation of recent regulations aiming to enhance fair competition in financial markets.1 Despite the raise in market fragmentation, its effects on market quality and especially, on market stability, are unclear. Regulatory authorities are concerned that market frag- mentation is a source of market instability and that it is behind recent episodes of liquidity dry-ups. To my knowledge, this paper is the first to analyze the im- pact of market fragmentation on liquidity in the presence of mini flash crashes, which are defined as large price changes that are reversed within seconds. First, I evaluate the effect that market fragmentation has on liquidity in normal market conditions. In a concentrated market, all liquidity is located in one venue, which facilitates finding a counterparty and speeds up execution time (Mendelson, 1987). In fragmented markets, liquidity is scattered across trading venues, which constrains order matching. In line with this, my first hypothesis is that market fragmentation deteriorates liquidity. On the other hand, fragmentation enables competition, which potentially leads to reduced trading costs (Foucault and Menkveld, 2008), and accommodates traders with distinct needs (Harris, 1993). Accordingly, I develop an alternative hypothesis stating that market fragmentation does not deteriorate liquidity. Further, I investigate the impact of market fragmentation on liquidity when stocks experience liquidity shocks in the form of mini flash crashes. The con- centration of liquidity provides markets with a greater ability to absorb trades without causing large price impacts. Under market fragmentation, individual markets have thinner books making it more likely to experience sudden price changes (Madhavan, 2012). Thus, I formulate an hypothesis stating that mar- ket fragmentation is detrimental for market stability. In particular, I measure market stability as changes experienced in market liquidity in the occurrence of mini flash crashes. However, if fragmented markets are perfectly interrelated, their consolidated ability to absorb trades should not be lower than than in con- centrated markets. This leads to an alternative hypothesis stating that market fragmentation is not detrimental for market stability. Following Degryse et al. (2015), I evaluate my hypotheses for both the lo- cal and the consolidated order book. The first is the order book of the local regulated exchange. The latter is constructed by aggregating the individual order books of the different trading venues under consideration (i.e., local reg- ulated exchange and MTFs), and it mirrors the liquidity that is available to traders with access to several venues. Not all traders have access to the different 1In the European Union, the implementation of the Markets in Financial Instruments Directive (MiFID) in 2007 boosted market fragmentation. In 2005, the Regulation-National Market System (Reg-NMS) led to the proliferation of alternative trading systems in the US. 2 venues, nor do all allocate resources to continuously monitor them. Depending on whether traders operate locally or at several trading venues, they are exposed differently to the effects of market fragmentation. Furthermore, the direction of the effect is not straightforward. For the local regulated exchange, the reduc- tion in market share due to competition may harm its ability to absorb trades, causing a negative impact on liquidity when there is a liquidity shock. On the other hand, competition reduces transaction costs, which incentivises trading and should equip the market with greater depth and ability to absorb shocks. For the consolidated order book, if fragmented markets are interrelated, traders with access to all venues should not encounter greater liquidity impacts when a stock experiences a liquidity shock than without fragmentation. However, if markets are not perfectly interrelated, liquidity shocks may be amplified due to a significant reduction in the participation of liquidity providers (Cespa and Vives, 2016). The empirical setting for this study is the Spanish stock market. Following the implementation of a new regulation (Title V), and the lift of short-selling bans, the Spanish stock market started to fragment on February 1st 2013. That is, about five years later than its EU counterparts. This unique event provides a quasi-natural experiment setup for examining the effects of fragmentation. I use as benchmark the Italian stock market, whose level of fragmentation re- mained constant throughout the sample period (November 2012 - April 2013) and who, by the end of the sample period, presented similar fragmentation levels to the ones of the Spanish stock market (≈ 20%). The analysis is conducted by means of an event study approach. It relies on the estimation of a difference-in- differences regression to determine the impact of market fragmentation on liq- uidity in normal market conditions, and a difference-in-difference-in-differences regression to evaluate the impact of fragmentation on market stability. In this way, I control for different types of endogeneity problems, making the analysis more robust. In particular, this study focuses on the impact of lit market frag- mentation. Lit venues such as regulated exchanges and MTFs, are characterised by displaying their limit order books to market participants. In contrast, dark markets (e.g., dark pools) only display information on executed trades. The lack of order book information provided by dark markets, hinders the possibility to study the effects of dark fragmentation on market stability. The results mainly support the hypothesis stating that market fragmentation does not deteriorate liquidity in normal market conditions. In fact, the results show that liquidity improves after the fragmentation event. The relative quoted spread of the treatment group falls significantly relative to the one of the control group both at the local regulated exchange and for the consolidated order book. The decrease in trading costs boosted by competition incentivises trading, which translates into a significantly lower fall in depth at best prices than the one experienced by the control group. This is more evident for the consolidated order book, where the difference between the treatment and control group is higher than in the local exchange. Depth at the local regulated exchange deteriorates for small stocks. The migration of liquidity to MTFs leads to significantly 3 thinner books for the less liquid stocks of the sample. For these stocks, market fragmentation harms traders that only trade locally. Further, the results support the hypothesis stating that market fragmenta- tion does not deteriorate market stability since it does not aggravate liquidity shocks. First, I find evidence of a decrease in the number of mini flash crashes after the fragmentation event both at the local regulated exchange and for the consolidated order book. Moreover, after fragmentation, the time it takes for prices to recover after a crash decreases notably. Further, I find that when measuring liquidity by quoted spreads, market fragmentation makes liquidity shocks less harmful. When turning to depth at best prices, in most cases there is no significant evidence that fragmentation contributes to a greater liquidity deterioration relative to a scenario of concentrated markets. This is not the case for the consolidated order book of small stocks, whose depth significantly dete- riorates. The migration of liquidity of the less liquid stocks makes them more vulnerable to liquidity shocks if markets are not perfectly interrelated. This deterioration especially occurs at the newly entrant MTFs. MTFs have thin- ner books relative to the dominant local exchange, and are less able to absorb liquidity shocks on their own. This study adds to the literature analysing the impact of market fragmenta- tion on liquidity. Previous literature has empirically analysed the link between these two variables under normal market conditions. Consistently with the re- sults presented in this study, Foucault and Menkveld (2008) find that after the entry of a new MTF at the Dutch equity market, consolidated depth increases and so does depth at the local regulated exchange. The reason is found in the decrease in trading costs, which incentivises trading at the local exchange. In contrast, Degryse et al. (2015) show that while lit market fragmentation im- proves quoted spreads and depth at the consolidated