Off-exchange Trading in Modern Equity Markets : A Market Microstructure Perspective on Systematic Internalizers

Abstract: Off-exchange trading has become a feature of the equity markets. This dissertation contains three articles that examine how off-exchange trading through systematic internalizers (SIs) affects inter-market competition and various features of market quality.Article I studies SIs' characteristics and the impact of SI operations on price efficiency. Using high-frequency measures of price efficiency, the results show that SIs' activities improve the informativeness of prices on exchanges. The article further indicates that market making is an important factor in a firm's decision to operate as an SI and that the heterogeneity in the level of market making among SIs matters for market efficiency analysis. Efficiency is improved only through the activities of those SIs with the highest level of market making on exchanges.Article II investigates the role of SIs run by HFTs in equity markets, with a focus on the impact of HFT SI operations on HFTs’ inventory management behavior, their liquidity provision on exchanges, and, ultimately, market quality with respect to liquidity. The results show that the trading activity of HFT SIs leads HFTs to manage their inventory imbalances by taking liquidity and reducing their liquidity provision on exchanges. The exchanges' bid-ask spreads therefore widen and the order books become thinner.Article III analyzes competition between SIs and exchanges, with a focus on the determinants of traders' choice of venue and trading costs. The findings indicate that SI trades are less informative than exchange trades, implying that uninformed traders are more likely to interact with SIs. Due to their ability to avoid trading with informed investors, SIs often undercut the exchange bid-ask spread when the spread is wide and the tick size is not binding. SIs can thus offer lower trading costs and gain a higher market share relative to exchanges.