Market Fragmentation: Managing cross-market trading risks at The Trading Show Chicago
Dr. Anlong Li of Spot Trading brings 20 years experience in equity options to today’s presentation. Dr. Li starts by recalling the Friendship Stores in Beijing which is state run and strictly sells to travelers and government officials. The products generally sold are imported items but do sell Chinese products as well. Anyone purchasing items at these stores will find the markup considerably higher than in the originating country from which they came. This introduces the concept of the Law of Two Prices which relates to dual listed shares as a result of market segmentation.
Propagators of market segmentation with respect to dual listed shares are A-B shares i.e., A listed shares for the company and B listed shares for foreigners, Voting and non-Voting shares, and shares that come from IPO spinoffs such as 3Com/Palm. There are some advantages of having market segmentation. For one, competitive pricing becomes necessary. Secondly, the reaches from segmented but still connected markets make way for greater efficiency and innovation. Arbitrage between different trading venues is practically instant and with more opportunities to list shares, arbitrage opportunities increase as well. All things considered, there are disadvantages as well. An obvious issue is the redundancies that accumulate from the dual listings and the increased search cost associated therein.
From 2008 to 2012, the distribution of exchanges has increased which further supports market segmentation with more coming online in the very short-term future i.e., ISE Mini – Options Exchange. This begs the question of how does the market measure segmentation? The Herfindahl-Hirschman Index (HHI) provides some insight into these dynamics. As an indicator, it measures the amount of competition among the firms relative to size and industry. If we understand segmentation through competition it can be derived that US equity and options markets are segmented but still loosely connected. This makes sense as shares and assets that are illiquid have less segmentation. The past four years have seen the most segmentation in the markets and the inclusion of new markets, products, and techniques leaves plenty of work to do in understanding cross-market risks.
-Original content provided by Safraz Rampersaud, an on-site blogger at The Trading Show Chicago
