Views on improving the integrity of global capital markets
01 February 2011

Market Fragmentation: Even the Playing Field

Posted In: Market Structure, MiFID

Traditional exchange markets in Europe have been buffeted in recent years by regulatory changes and new advances in trading technology. Market fragmentation has been the result, in which trading concentrated on traditional exchanges has given way to a new landscape of trading venues and execution facilities. In Europe, 46 percent of trades are now executed in some sort of off-exchange venue.

But allowing new trading venues without uniform regulation hasn’t been without problems. In particular, our newly released research The Structure, Regulation, and Transparency of European Equity Markets under MiFID(PDF) suggests that market transparency has suffered as a regulatory patchwork creates different disclosure obligations for different venues. Quite simply, depending on where a trade is directed, the visibility of prices, trading interest, and executed trade details can be quite different.

So-called “dark” venues aren’t without some benefit. In particular, investors seeking to trade large positions may find some advantage to opaqueness. But the integrity of capital markets depends on robust price discovery, whereby the information that is relevant to the price of a security is readily available for synthesis by buyers and sellers to arrive at a market price. Surely, supply and demand for securities figures prominently in the price-discovery process.

Market transparency influences investor confidence, and our research supports the linkage between transparency and liquidity. We examined key European markets and constructed transparency measures: for those markets with high degrees of transparency, spreads tended to be narrower.

Going back to a world of highly centralized exchanges isn’t likely. What’s needed is synchronization of pre-trade and post-trade reporting requirements, so that whether a trade is exchange-traded or OTC), lit market or dark, investors have the same opportunity to assess overall supply and demand in deciding at what price to trade. The current European Commission consultationon the review of the Markets in Financial Instruments Directive (MiFID) offers the opportunity to begin the necessary reforms to level the playing field across all trading venues.

Find out more about the market fragmentation and transparency issues in this short Financial Times video segment produced on 21 January.

About the Author(s)
Rhodri Preece, CFA

Rhodri Preece, CFA, is Senior Head of Industry Research for CFA Institute. He is responsible for building and maintaining the global research function at CFA Institute, including leading the planning, coordination, and creation of research content across CFA Institute research platforms, which include the Future of Finance, the CFA Institute Research Foundation, the Financial Analysts Journal, and the Enterprising Investor blog. Preece formerly served as head of capital markets policy EMEA at CFA Institute, where he was responsible for leading capital markets policy activities in the Europe, Middle East, and Africa region. Preece is a former member (2014-2018) of the Group of Economic Advisers of the European Securities and Markets Authority (ESMA) Committee on Economic and Markets Analysis. Prior to joining CFA Institute, Preece was a manager at PricewaterhouseCoopers LLP where he specialized in investment funds.

4 thoughts on “Market Fragmentation: Even the Playing Field”

  1. x3er says:

    In web-time, the organisational or physical centrality of exchanges is almost irrelevant – what is all important, however, is the set of rules that apply. That set needs to be the focus of any organisation’s effort which is interested in financial market integrity. Market integrity is a human category and thus a function of the perceptive capacity of the human mind. Organisational market fragmentation can be repaired using information systems, but temporal fragmentation (bid / ask that live for a computer cycle only, flashing) cannot be healed that way and therefore constitute the opposite of market integrity or robust discovery, to witness the flash crash). Indeed, isn’t fragmentation the opposite of integrity?On a less philosophical note, though: Is this study an update of your earlier work?

  2. Bob Dannhauser, CFA says:

    You’re giving more credit to computers than may be deserved x3er – after all, it is the lowly human who is still programming the computer to facilitate the “temporal fragmentation,” consciously (perhaps) stretching the notion of market integrity in favor of profit. Regulation and rulemaking in turn are always playing catch-up as new technology is deployed in new and novel ways. So I don’t think fragmentation is necessarily the opposite of integrity – it is just an evolution that puts market integrity in new context. Smart regulation hopefully finds the right boundaries of that evolution that preserves the benefit of innovation without tearing the fabric of integrity. Easy to say, hard to do.This study is an extension of Rhodri Preece’s work in 2009 ( that looked at how markets fragmented under MiFID and the impact on price formation. And both of these papers inform our regulatory consultations as the EC reviews MiFID; we’ll have our consultation response posted on the CFA website in the next week or two.

  3. x3er says:

    Oh, I don’t think I do give them undue “credit”, Bob. You’re right, of course, that it’s the lowly human programming it. But that’s part of the problem: Computer science teaches that every adequately complex system has faults. And then, there’s rapid systemic interaction that may lead to (or has led to) the system as a whole to go haywire. We’ve seen it happening recently. The problem is well known in (nuclear) engineering. That’s what multiple, redundant fail-safe mechanisms in industrial safety are for. Here’s a good piece on the topic: In financial markets, we only have the most rudimentary of devices to do the job. “Stretching the notion of integrity” … doesn’t sound particularly appealing to me.

  4. Bob Dannhauser, CFA says:

    Great article. And now I’m thinking about what the current regulatory equivalent to the zirconium filter might be. The comments below the article were almost as interesting as the article itself! Thanks for the link.

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