Competition for Order Flow and the Theory of Global Games

Advances in information technology and the advent of alternative trading platforms have increased the level of competition between securities exchanges tremendously over the last years. However, the nature of competition between stock markets is very different to that of other product markets due to network externalities such as liquidity spillovers. It is therefore necessary to have a clear understanding of the market outcome in order to evaluate the efficiency of unregulated competition and to design adequate regulatory frameworks. Economists have not yet provided a sound theory on the desirability of free competi tion in the area of competing securities markets. The fundamental problem is that theoretical models of securities market competition usually have multiple equilibria. It is very hard to devise rules for regulators or strategies for exchanges from these models, since it is a priori unclear which equilibrium will be realized. Jutta Donges solves this basic problem by applying the recently developed theory of global games onto the analysis of stock market competition. The theory of global games introduces a small amount of heterogeneous information among investors about the value of some relevant parameters of market choice and thus, derives a unique equilibrium. The model produces a number of convincing results. Jutta Donges shows as one example, that the migration of investors from the traditional exchange to a newly opened crossing network is smaller than the efficient level of migration. Regulatory support for new entrants can, therefore, be justified on the ground of the analysis."