Anticompetitive Price Referencing

Off-exchange trades are often executed by referencing on-exchange prices. In equilibrium, such price referencing softens market makers’ on-exchange competition and makes liquidity expensive for investors. Additionally, by equalizing on- and off-exchange prices, price referencing guarantees “best execution” and makes investors indifferent where to trade. Market makers effectively obtain a license to fragment orders off exchange, raising their profits but reinforcing market-wide illiquidity. This inefficiency remains tenacious even if more market makers enter and if they are forced to compete off exchange, as in the SEC’s proposed order-by-order auction. The model yields important implications for regulating off-exchange trading.