Third Markets and the Second Best

The costs and benefits of third markets for financial instruments are widely debated. Contrary to claims that it is inefficient for third markets to free ride off of a primary exchange's price discovery, this article presents a model that implies that (1) third markets actually improve welfare, and (2) the increase is often greatest when third markets free ride. The microstructure of financial trading allows exchanges (primary markets) to restrict inefficiently the supply of liquidity and risk bearing services. Third markets mitigate this source of inefficiency, and sometimes do so most effectively when they free ride. Thus, although free entry to the exchange would maximize welfare, encouragement of a third market (by making price information a public good, for instance) may be a second-best response to exchange market power.