Chapter 7

Market Fragmentation

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7.7 Exercises

2. Optimal order splitting. Consider an order of total size q that can be split
into two orders qA and qB to be executed in markets A and B. The security traded
in these two markets has expected value and variance 2v . Markets A and B are
populated by KA and KB competitive dealers with no initial inventories and identical
risk aversion , as in section 7.2.2. Show that equation (7.10) is the optimal split of
the total order q between the two markets.

4. Competition between limit order markets with uniformly distributed

market orders. Consider the model of section 7.4.2 and assume that the size of
e has a uniform distribution on [0, X]. That is, F (x) =
the market order (X) x
. We
X

denote by Yjk () the cumulative depth posted at the ask price Ak = +k in market
j 2 {I, E} when the fraction of investors submitting market orders in both markets
I and E is , and by cj the submission cost in market j.

a. Assume that 2cI and that = 0. Show that the equilibrium cumulative
depth at price Ak is
" #
2cI
YI1 (0) =X 1 . (7.18)

b. Now suppose that is high enough and that the other parameters are such
that YI1 () > 0, YE1

() > 0, but YI1 () + YE1

() < X. Compute YI1 () and YI1 ()
as a function of . Deduce further from the result that the conditions YI1 () > 0
4cI 4cE
and YE1 () > 0 are satisfied if (2)+2cE
< 1 and +2cI
< . Moreover deduce that
the condition YI1 () + YE1

() < X is satisfied if 4 (cI + (2 )cE ) > (2 ).
c. Deduce from question (b) that the two markets can coexist even if their order
submission costs dier and = 1.

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 d. Why does the cumulative depth at price A1 in one market decrease with the
order submission cost in this market but increase with the cost in the competing
market?
e. Consider the case = 1 and suppose that 4 (cI + cE ) < and 4cI < .
Compute YI1 (1) and YE1

(1).
f. Under the assumptions in question (e), what is the number of shares oered
at price Ak > A1 ? Is the result dierent when = 0?

7.8 Solutions

Exercise 2: To show that equation (7.10) is the optimal split of the total order q
between the two markets we need to show that qA and qB are the quantities which
minimize the execution price for the entire order q.
Given that the equilibrium prices in the two markets are:
2 2
pA = + v qA and pB = + qB .
KA KB v
The liquidity buyers problem is:

min qA pA + qB pB

subject to the constraint

qA + qB = q

This problem is equivalent to:

! " ! "
2 2
min qA + qA + q B + qB =
qA ,qB KA v KB v

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 ! " # $
2 2
= qA + qA + (q qA ) + (q qA ) =
KA v KB v

2 2 2
= qA + v qA + (q qA ) + v (q qA )2 .
KA KB
The first-order condition of this problem is:

@(.) 2 2
=+2 v qA 2 (q qA ) = 0,
@qA KA KB v

and the second order condition is clearly satisfied. Hence

KA KB
qA = q and qB = q qA = q
KA + KB KA + KB

which is exactly the optimal split order as expressed in equation (7.10).

Exercise 4:
Xx
a. Using equation (7.13) and the fact that (1 F (x)) = X
, we deduce that the
zero profit condition imposes:

X YI1 (0) 2C
= ,
X

which yields the desired result.

b. To prove this result, we use the zero profit conditions (7.14) and (7.15). If
YI1 () > 0, YE1

() > 0 and YI1 () + YE1

() < X, they impose:
# $
1 X YI1 () X (YI1 () + YE1

()) C
(1 )( )+ ( ) =
2 2 X 2 X
#
$
X YE1 () X (YI1 () + YE1 ()) C
( )+( ) =
4 X X

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We then obtain the desired result by solving this system of equations for YI1 () and

YE1 (). We obtain:

4X cE 2cI
YI1 () = (1 + ),
4 2
4X 1 2(cI 2cE 1 )
YE1 () = ( + ).
4 2

It is then easily seen that the conditions YI1 () > 0 and YE1

() > 0 are satisfied if
4cI 4cE
(2)+2cE
< 1 and +2cI
< while the condition YI1 () + YE1

() < X is satisfied if
4 (cI + (2 )cE ) > (2 ).
4cI
c. The two markets co-exist if YI1 () > 0 and YE1

() > 0, that is i (2)+2cE
<
4cE
1 and +2cI
< . These two conditions do not require cE = cI , even if = 1.
d. An increase in the order submission in one market makes the expected profit
on the marginal limit order in one market smaller. Hence it decreases the depth
at price A1 in this market. As a result, the execution probability of the marginal
limit order at price A1 in the other market gets higher. Thus, the expected profit on
this order gets higher and as a result the depth at price A1 in the other market gets
higher.
e. Now we consider the case = 1 and suppose that 4 (cI + cE ) < . In this
case, we know from question b) that the consolidated depth at price A1 is higher
than the maximum size of the market order, X. Thus, the analysis of this case is
a bit dierent because (1 F (YI1 () + YE1

())) = (1 F (X)) = 0. Thus, the zero
profit conditions (7.14) and (7.15) impose:
! "
1 X YI1 () C
(1 )( ) =
2 2 X
!
"
X YE1 () C
( ) =
4 X

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We deduce then that the cumulative depths at price A1 in each market is:

4cI
YI1 (1) = X(1 )

4cE
YE1 (1) = X(1 )

f. Under the assumptions considered in question c) all investors optimally split

their market orders between both markets ( = 1) and the consolidated depth at
price A1 exceeds the largest possible market order size, X. Hence, limits orders
behind the best quotes have no chance of execution, which means that there will be
no limit orders behind the best quotes. Note that this is very dierent from the case
= 0. In this case, the cumulative depth at price A1 is always smaller than X since
YI1 (0) < X.