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Trading Frictions and Market Structure: An Empirical Analysis

Authors

  • Charlie X. Cai,

    1. The authors are from the University of Leeds. They thank audiences at the 2005 EFMA conference in Milan, Italy, the 2006 SWFA conference in Oklahoma City, the 2006 EFA conference in Philadelphia and the IQPC Conference on Market Microstructure: Equities and Currencies, Le Meridian Piccadilly, London, May 2006 for helpful comments.
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  • David Hillier,

    1. The authors are from the University of Leeds. They thank audiences at the 2005 EFMA conference in Milan, Italy, the 2006 SWFA conference in Oklahoma City, the 2006 EFA conference in Philadelphia and the IQPC Conference on Market Microstructure: Equities and Currencies, Le Meridian Piccadilly, London, May 2006 for helpful comments.
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  • Robert Hudson,

    1. The authors are from the University of Leeds. They thank audiences at the 2005 EFMA conference in Milan, Italy, the 2006 SWFA conference in Oklahoma City, the 2006 EFA conference in Philadelphia and the IQPC Conference on Market Microstructure: Equities and Currencies, Le Meridian Piccadilly, London, May 2006 for helpful comments.
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  • Kevin Keasey

    Corresponding author
    1. The authors are from the University of Leeds. They thank audiences at the 2005 EFMA conference in Milan, Italy, the 2006 SWFA conference in Oklahoma City, the 2006 EFA conference in Philadelphia and the IQPC Conference on Market Microstructure: Equities and Currencies, Le Meridian Piccadilly, London, May 2006 for helpful comments.
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  • They are especially grateful for the thoughtful and thorough comments of the anonymous referees and Martin Walker, the editor of JBFA. All errors are the authors' own.

* Address for correspondence: Charlie X. Cai, Leeds University Business School, Maurice Keyworth Building, The University of Leeds, Leeds LS2 9JT, UK.
e-mail: busxc@leeds.ac.uk

Abstract

Abstract:  Market structure affects the informational and real frictions faced by traders in equity markets. Using bid-ask spreads, we present evidence which suggests that while real frictions associated with the costs of supplying immediacy are less in order-driven systems, informational frictions resulting from increased adverse selection risk are considerably higher in these markets. Firm value, transaction size and order location are all major determinants of the trading costs borne by investors. Consistent with the stealth trading hypothesis of Barclay and Warner (1993), we report that informational frictions are at their highest for medium size trades that go through the order book. Finally, while there is no doubt that the total costs of trading on order-driven systems are lower for very liquid securities, the inherent informational inefficiencies of the trading format should not be ignored. This is particularly true for the vast majority of small to mid-size stocks that experience infrequent trading and low transaction volume.

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