A Theory of Stock Exchange Competition and Innovation: Will the Market Fix the Market?

Abstract

Will stock exchanges innovate to address latency arbitrage and the arms race for speed? This paper models how exchanges compete in the mod-ern electronic era and how this shapes incentives for market-design innovation. In the status quo, exchange trading fees are competitive, but exchanges earn economic rents from selling speed. These rents create a wedge between private and social incentives to innovate and support the persistence of an inefficient market design in equilibrium of a market-design adoption game. We discuss implications for policy and insights for the literatures on market design, innovation, and platforms.