Price Discovery

A new entrant is set to hit Australia’s currently monopolised stock market environment, with the Nomura-owned trading platform, Chi-X, to start operating next week.

Much of the debate has centered purely on the cost competition – with the ASX already moving to cut fees in anticipation of the arrival of Chi-X.

A question of more central importance to this blogger is to what extent is price discovery enhanced or hampered by the existence of a more fragmented market?

Conventional wisdom suggests that the existence of more than one market trading a single security is largely an anomaly. Search costs alone should not make it a worthwhile endeavor.

Theoretical models though suggest a reason why we see multiple exchanges. Chowdhry and Nanda in a paper published in The Review of Financial Studies in 1991 develop a model based on information asymmetry where informed traders gravitate to markets where there is more liquidity.

The market with the most liquid trading, they argue, is also likely to be the one with the lowest trading costs and greatest impact on price discovery. Informed investors are likely to follow where the liquidity is to “drown” out their intentions. Thus, it is the market with most liquidity which creates the most price discovery.

The empirical evidence tends to support the general propositions of Chowdhry and Nanda.

Trading platforms such as Chi-X (and Turquoise in Europe too) typically seek to differentiate on the basis of tech, trading costs, and quality of service. Their business models seem especially suited to the requirements of high-frequency traders with their offerings of low latency trading.

These offerings have been found to enhance liquidity substantially, to the point that they do become a threat to the price discovery dominance of the incumbent exchange. In Canada, the introduction of Chi-X Canada saw bid-ask spreads constrict, volatility drop and the volume weighted average prices of small cap stocks increase – all signs of more efficient markets underpinned by better price discovery.

All of these factors were found in the UK where Chi-X also operates.

Work by German academics Riordan, Storkenmaier and Wagener suggest that if an alternative trading platform can increase liquidity (and there is no reason to suggest that Chi-X cannot do so in Australia) then investors are likely to ignore pure price considerations and instead gravitate to the exchange where search and liquidity costs can be optimally traded off.

Further, they found that although the main exchange typically maintains the highest price impact of trades, thus carrying more private information, alternatives such as Chi-X often lead in the quote based price discovery.

Evidence from around the world suggests that the competition from Chi-X should have a positive impact on market quality and price efficiency. Although the ASX will in all likelihood continue to dominate the Australian equity market, the new entrant should not be written off.