Adverse selection, market access, and inter-market competition

This paper investigates the role of informed trading in a fragmented financial market under the absence of inter-market price priority. Due to frictions in traders' market access, liquidity providers on alternative trading platforms can be exposed to an increased adverse selection risk. As a consequence, the main market will dominate (display better quotes) frequently albeit charging considerably higher transaction fees. The empirical analysis of a dataset of trading in French and German stocks suggests that trades on Chi-X Europe, a low-cost trading platform, carry significantly more private information than those executed in the Primary Markets. Consistent with our theory, we find a negative relationship between the competitiveness of Chi-X Europe's quotes and this excess adverse selection risk faced by liquidity providers in the cross-section.