At the heart of our markets is the idea of fragmentation and speed. The faster and more fragmented our markets are, the more competitive they are. And competition is good ... right?
But, at some point, does a market become too fast, too fragmented and too competitive? Does the technology needed to trade in this market make that market too fragile? To answer this, we need to examine fragmentation.
Most think about fragmentation in terms of trading venues. And yes, the U.S. equity market has a number of trading venues. There are 13 exchanges, about 50 dark pools and many internalizing brokers that can match buyers and sellers. To ensure the best match, sophisticated order routers need to examine many trading venues. And without being in two places at once, the more venues checked, the greater the chance buyers and sellers miss each other.
While checking many venues complicates execution, markets also can fragment in other ways, including price and time. The more price points, the more missed trades. This is especially true as liquidity providers spread orders across more price points and venues. As fractions turn to pennies, and pennies to sub-pennies, through dark pools and the NYSE Retail Liquidity Program (RLP), trading volume becomes fragmented from 16 price points per dollar to 100, or 1,000.
The same problem exists with time. The quicker the quote timeframe, the more messages I need to produce and analyze. If I am quoting across 13 exchanges and 20 dark pools, then I need to manage my quotes across 33 venues. If my quoting frequency changes from seconds to tenths to tens of milliseconds to milliseconds, then my quoting rate increases from 33 to 330, 3,300, 33,000 quotes per second. Multiply that across 5,000 stocks trading at pennies or possibly sub-pennies and think about the massive technology and message infrastructure needed to trade.