Island Goes Dark: Transparency, Fragmentation, and Regulation

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Abstract
Responding to a September 2002 regulatory enforcement, the Island electronic communications network stopped displaying its limit order book in the three most active exchange-traded funds (ETFs) where it was the dominant venue. Island’s share of trading activity and price discovery fell, fragmenting the market. ETF prices adjust more slowly when Island goes dark, and there is substantial price discovery movement from ETFs to the futures market. Trading costs increase on Island and decrease off Island, with higher trading costs overall. When Island later redisplays its orders, market quality improves, with transparency and the reduction in fragmentation both playing important roles.