Market Fragmentation

Market fragmentation implies that a market is composed of several heterogeneous segments. Fragmentation in a market can be caused by several market needs, reduced levels of innovation, and economies of scale. Market fragmentation enables businesses to reach the right consumers. Remember, however, that it reduces the effectiveness of mass marketing.

Moreover, market fragmentation means that the liquidity of an asset represents a fraction of the total cash for the item. Trading the same commodity in several places enhances price and liquidity variation because the traders involved are not at the same place. The challenges caused by fragmentation can be managed using electronic algorithmic trading techniques such as liquidity aggregation and smart order routing.

Question 1

Which of the following best describes market fragmentation?

1. It is a method of estimating transaction costs by comparing the average fill prices to average market prices during a period surrounding the trade.
2. It involves measuring the total cost of implementing an investment decision by capturing all explicit and implicit trading costs.
3. It is the splitting of trading in any given instrument across multiple venues as the number of venues trading the same instruments has proliferated.

Solution

The correct answer is C.

A is incorrect. It refers to the VWAP method.

B is incorrect. It refers to the implementation of the shortfall method.

Question 2

Which of the following choices is the most fundamental reason for market fragmentation?

1. To reduce the number of customers in a franchise.
2. To create a small customer base and enhance innovation.
3. To reduce competition from businesses that trade the same instruments.

Solution

The correct answer is B.

Subdividing a homogenous business into several different segments enables the market to manage its customers easily. Moreover, it makes the new small businesses bring more innovations into the market because the trade instruments are grouped according to their distinct characteristics

Portfolio Construction: Learning Module 6: Trading Costs and Electronic Markets; Los 6(e): Describe market fragmentation