Selling trading advantages in financial markets

We model the feedback loop between the sales of trading advantages (e.g., data or co-location services) and traders’ endogenous participation in financial markets. Whereas a trader’s benefit from purchasing trading advantages increases with aggregate market participation, the benefit from participating decreases with other traders’ purchases of trading advantages that impose negative externalities on counterparties. In equilibrium, sellers of trading advantages (e.g., data providers or securities exchanges) may maximize their profits by prompting inefficiently low market participation and liquidity. We study the consequences of altering the market structure and show that the resulting policy prescriptions contrast sharply with standard models.