Essays in Market Microstructure

This thesis examines the impact of various financial market innovations on trading in limit order markets, with a focus on financial market quality and investor welfare. Chapter 1 is a joint work with Katya Malinova. We model a financial market where privately informed investors trade in a limit order book monitored by low-latency liquidity providers. Price competition between informed limit order submitters and low-latency market makers allows us to capture trade-offs between informed limit and market orders in a methodologically simple way. In Chapter 2, I develop a model to examine the impact of dark pool trade-at rules. Dark pools—trading systems that do not publicly display orders—fill orders at a price better than the prevailing displayed quote, but do not guarantee execution. This improvement is known as the “trade-at rule”. In my model, investors, who trade on private information or liquidity needs, can elect to trade on a visible market, or a dark market where limit orders are hidden. A competitive liquidity provider participates in both markets. The dark market accepts market orders from investors, and if a limit order is available, fills the order at a price better than the displayed quote by a percentage of the bid-ask spread (the trade-at rule). The impact of dark trading on measures of market quality and social welfare depends on the trade-at rule, relative to the price impact of visible limit orders. A dark market with a large (but not too large) trade-at rule improves market quality and welfare; a small trade-at rule, however, impacts market quality and social welfare negatively. Price efficiency declines whenever investors use the dark market. For a trade-at rule at midpoint or larger, the liquidity provider does not post limit orders to the dark market. Chapter 3 is also a joint work with Katya Malinova. We study a financial market where investors trade a security for liquidity reasons. Investors pay a ‘take’ fee for trading with market orders, or a ‘make’ fee for limit orders—so-called ‘maker-taker pricing’. When all investors face the same fee schedule, only the total exchange fee per transaction has an economic impact, consistent with previous literature. However, when a subset of investors pay only the average exchange fee through a flat fee per trade---a common practice in the industry---maker-taker fees have an impact beyond the total fee. In comparison to a single-tier fee system, a ‘two-tiered’ fee system leads to a fall in trading volume and investor welfare; investors who pay maker-taker fees directly earn higher average profits than investors that pay an average flat fee per trade. Under this “two-tiered pricing”, increasing or decreasing the maker rebate can improve trading volume and welfare; however, only a reduction in the maker fee maximizes volume and welfare, and reduces differential profits to zero.Ph.D