How Does EU and U.S. Fragmentation Compare?

One thing that regulators in Europe and the United States have done a great job of is introducing competition for venues. However, how that works in each region is quite different.

But competition for venues isn’t without costs – it results in significant fragmentation of liquidity, which adds to investor liquidity search costs and likely adds to opportunity costs when liquidity at hidden and better prices than the market can’t be found.

It's also important to note that competition for venues does not equate to competition for quotes. In fact, if segmentation is also occurring, competition for public quotes may actually fall.

For today, we keep it simple and use a tool of Nasdaq Ventures portfolio company BMLL, a leading provider of proprietary Level 3 order book data and analytics for traders, quants and researchers, to look at how the fragmentation in U.S. and European Union markets compare.

Fragmentation in the U.S.

In the U.S., the introduction of Unlisted Trading Privileges (UTP in 1994) allowed any exchange to trade any ticker—regardless of where that stock was listed. Then in 1998, Reg ATS added dark pools to the list of non-listing venues able to trade stocks. Today there are:

• Sixteen exchanges that comply with the Exchange Act.
• More than two dozen equity dark pools that comply with Reg ATS.
• Single Dealer Platforms (SDPs) and agreed block trades that brokers print directly to the TRF.

The economics and rules for exchanges, ATSs and proprietary TRF trades can vary significantly. That tends to create costs, often opportunity costs and benefits for using each type of venue.

So, what does this do for liquidity?

Chart 1: U.S. market fragmentation (measured in shares)

According to BMLL data, for the 500 largest U.S. stocks:

• Around 60% of all U.S. trading occurs on-exchange. However, primary listing venues are a fraction of total “lit market” trading. BMLL data also shows that in the U.S., closing auction trading adds to over 10% of all trading.
• Dark pools, or ATSs, add up to less than 13% of all liquidity, with the largest (UBS) trading more than 2% of all shares in the U.S.
• Other TRF trades add to over 27% of all liquidity and include retail facilitation and block trades.

We know from other work that off-exchange trading is even higher in smaller-cap stocks. For instance, in May 2023 for small-cap stocks on-exchange market share was 58%, the dark pool market share was 12%, and the Other TRF market share was 30%.

Fragmentation in Europe

The Markets in Financial Instruments Directive (MiFID) in Europe has some similarities and contrasts to the U.S. market.

Primary exchanges in Europe are regional (country specific) and generally only trade stocks listed in that country (even though, in reality, the actual trading operations are often consolidated in one country). Although consolidation across the region has led to exchange groups managing listings for multiple countries, which in turn has led to consolidation of the geography of trading and data centers.

MiFID also caps dark pool trading but allows multilateral trading facilities (MTFs). MTFs often have public “lit” quotes and more open access than U.S. ATSs. But similar to U.S. dark pools, MTFs are allowed to trade any European stock.

Europe also allows Systematic Internalizers (SIs), which are similar to SDPs in the U.S. and can also trade any stock listed in the European market. Although European SI’s fill orders on a bilateral and proprietary basis, they are required to publish an accessible quote but are only required to do this for small-sized trades.

Arguably Europe has more extremely small reporting venues. But they also have a more subjective best-ex rule that doesn’t require all traders to connect to all venues. European markets also differ from the U.S. on rules around tick sizes and round lots.

Europe also measures market share (and block trade sizes) in notional (typically Euro) instead of shares.

So, what does this do for liquidity?

Chart 2: EU market fragmentation (measured in Notional)

Again, we turn to BMLL data. From April 1, 2022 - April 30, 2023 (rolling 12 months) for the largest 600 European securities by market cap (including the U.K.), BMLL’s European data shows:

• Around 63% of all European trading occurs on-exchange. However, primary listing venues are a fraction of total “lit market” trading.
• The Closing Auction trading adds to over 10% of all trading.
• Dark venues and periodic auctions add up to around 7% of all liquidity, with the largest (CBOE Europe) trading more than 2% of all shares in Europe.
• Other TRF (referred to as Approved Publication Arrangements or APA) trades add to over 27% of all liquidity.

Fragmentation: A cost or a benefit?

While regulators have pushed to foster competition across trading venues, academic studies suggest that market fragmentation does not always lead to better trading outcomes.

On the one hand, market fragmentation that fosters competition among trading venues generally leads to lower transaction costs and increased informational efficiency – see O’Hara & Ye (2011) or Foley & Putniņš (2016).  

Although, as we’ve noted before, academics tend to equate informational efficiency with worse mark-outs, which may not be as good for markets as it sounds. Consistent with that, other studies find that market fragmentation has a negative effect on market liquidity when it is conceived as a tool to conceal uninformed order flow or when it’s excessive (see Degryse, de Jong & Van Kervel (2015) or Hatheway, Kwan & Zheng (2017)).

Other studies suggest fragmentation harms smaller stocks, which already have higher costs of capital, by increasing effective spreads and degradation in price efficiency for the smallest firms.

Fragmentation also adds to fixed costs and search costs. Brokers need more physical connections and better routers. One report found that Korea actually has the best liquidity in the world (low spreads and deep liquidity) after controlling for company size. Korea is similar to the U.S. in that retail participation is high, but also different from the U.S. in that the market is much less fragmented. The report further notes that “fixed costs of accessing this liquidity in the U.S. (market data, colos, sophisticated SOR technology, etc.) is different by orders of magnitude.”

Fragmentation also makes spread capture harder for market makers as bids and offers trade in different venues. That, in turn, can lead to wider spreads as market makers price in more adverse selection. That’s consistent with a recent paper by Guo & Jain (2023), which finds that a 1.6% increase in lit market fragmentation leads to a 2.9-basis point increase in price impact due to order flow migration to MEMX.

Fragmentation is the other half of the competition story

If there is a lesson to come from this comparison, it is that countries that allow investors choice and encourage competition across venues usually end up with a lot more complexity and fragmentation than simpler nationalistic stock-market models.

The economic benefits of competition are frequently cited. But something less understood and harder to compute are the additional fixed costs the industry must bear – and the opportunity costs to investors from searching for offsetting liquidity across so many venues and market structures.

But back to our earlier question: Is the EU more fragmented than the U.S.?

Although the markets and the rules are different, the level of fragmentation, looked at in this way, actually seems surprisingly similar.

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Phil Mackintosh

Nasdaq

Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

Read Phil's Bio