18.III.2.2 Concentrated versus fragmented markets

A main element of a market structure is whether trading is concentrated or fragmented. A concentrated market refers to centralised trading of a financial instrument on one (or a few) venues. The opposite is true with fragmentation, which refers to the situation where trading in a financial instrument splits across multiple venues.1 Fragmentation can arise due to inter-exchange (RMs) or alternative order-execution competition (e.g. MTFs and/or SIs).2

The degree of fragmentation or concentration is in great part the result of the underlying philosophy of financial market.3 As noted, the market-shaping philosophy has traditionally preferred concentrated forms of trading, based on arguments such as improved investor protection, price formation and liquidity.4 Advocates of the market-shaping philosophy highlight the risks of trading outside centralised markets, such as reduced client protection and price formation.5 By contrast, the market-led philosophy has traditionally emphasized the importance of a competitive market, stating this results in reduced trading costs, while supporting innovation, and investor choice.6

The market-shaping perspective agreed on a competitive market setting under MiFID I, but only if properly compensated through equity pre- and post-trade transparency rules, not only for RMs and MTFs, but also outside such venues (e.g. SIs and for so-called client limit orders).7 The market-led perspective disagreed, which ultimately resulted in a complex MiFID I compromise on SIs and the client limit order display-rule. The debate between the market-led and market-shaping philosophy continued under MiFID II. The result is a more market-shaping transparency regime. Although still competitive in nature, MiFID II emphasizes (i) concentration of trading (share trading-obligation), (ii) high quality and reliable consolidated equity data (in particular the CTP regime for post-trade data), and (iii) access to such data (pricing rules apply). The market-shaping elements are in place to address fragmented liquidity, which implies data quality, consolidation, pricing, and level playing field issues. This is because equity pre- and post-trade data needs to be published, consolidated and bought from multiple, instead of one or a few venues. A competitive market setting can reduce fees (both for trading and market data services) and enhance investor choice and innovation. However, experience from the ISD to MiFID II shows that the market-led philosophy can also result in new transparency issues due to a fragmented market setting.8

In sum, a main factor for the EU perspective on the ‘optimal degree’ of equity pre- and post-trade is whether the market is concentrated or fragmented. Combinations of the market-led and market-shaping philosophy have been apparent from the ISD to MiFID II. The effect has been different EU perceptions as to what constitutes the optimal degree of equity transparency and how it should be achieved (top-down versus bottom-up). Concentrated markets require less intervention through harmonised transparency rules, whereas the opposite is true for a fragmented market (see also section III.2 below).