Island Goes Dark: Transparency, Fragmentation, Liquidity Externalities, and Multimarket Regulation

<p>In response to a regulatory enforcement, the Island electronic communications network recently stopped displaying its limit order book in the three most active exchange-traded funds (ETFs). As a result of this reduction in pre-trade transparency, this dominant venue's share of trading activity and price discovery falls, fragmenting the market. ETF prices adjust more slowly when Island goes dark, and substantial price discovery moves from the ETF market to the futures market. Island's effective and realized spreads increase, while effective and realized spreads fall in other markets. The increase in spreads on Island more than offsets the reduction in trading costs in other markets, increasing overall trading costs. Overall ETF market quality falls. </p> <p><em>© The Author 2005. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org</em></p>