The impact of a pro‐rata algorithm on liquidity: Evidence from the NYSE LIFFE

Abstract

This study investigates the impact of introducing a pure pro-rata algorithm on the liquidity of the market for Euribor futures contracts on NYSE LIFFE. Results indicate that the Euribor market experiences deterioration in liquidity: (1) both best and total depth fall and (2) quoted spreads widen after the structural change. Results also reveal that the Euribor market becomes more active after the event; both trading volume and trade frequency increase substantially after the event. Finally, after the transition, liquidity demanders are more likely to submit smaller market orders. The reduction in depth and increase in quoted spreads suggest that liquidity demanders incur higher trade execution costs after the transition. In contrast, the transition is beneficial for the exchange since trading volume is higher under the new regime.

Time Pro‐rata Matching: Evidence of a Change in LIFFE STIR Futures

“…The authors examine the impact of the change in LIFFE's matching algorithm from a mixed price-time pro-rata allocation to a pure quantity pro-rata system of execution. 7 Contrary to the findings of Lepone and Yang (2012), Field and Large (2008) postulate that market participants rationally respond to pro-rata matching by "over-sizing" their orders. Specifically, the two key results presented in the paper are that pro-rata matching led to a reduction in prevailing and total order book depth as well as a widening of the bid-ask spread.…”

“…2. Lepone and Yang (2012) suggest that the transition from priority pro-rata to a pure pro-rata system should not influence bid-ask spreads since they are extremely tight to begin with. If rational individual traders are over-sizing their orders in a pure pro-rata system, then they also face the possibility of over-execution risk.…”

“…Perhaps the closest examination of issues dealt with in this article is provided in Lepone and Yang (2012). The authors examine the impact of the change in LIFFE's matching algorithm from a mixed price-time pro-rata allocation to a pure quantity pro-rata system of execution.…”

“…Lepone and Yang (2012) provide evidence that this change harmed market quality by reducing depth and increasing quoted spreads. The choice of a trade allocation framework is perhaps one of the most important of all market design choices.…”

“…This step shifted the emphasis onto the size of incoming orders relative to the prevailing depth, such that the time an order rested in the limit order book was no longer a relevant consideration. Lepone and Yang (2012) provide evidence that this change harmed market quality by reducing depth and increasing quoted spreads. This pro-rata mechanism was adopted until 2007 when market regulators opted to switch to a time pro-rata matching algorithm.…”