Precedence rules in matching algorithms

Abstract

Markets with time priority rules incentivize efforts to increase trading speeds. In particular, revenues resulting from liquidity provision due to discrete pricing can often accrue to the fastest traders, those who can hold favorable queue positions. We examine the impact of precedence rules for a single market that switched to a first-in-first-out (FIFO) matching algorithm from one primarily based on pro-rata. Due to a technology issue, in May 2015 the two year Treasury futures contract unexpectedly switched from partially pro-rata to FIFO for several days. We study the effects of this switch through a difference-in-difference comparison with a related futures contract that had no change in priority rules. We find that compared to FIFO, orders placed later in time are significantly more profitable under pro-rata. However, the lower profitability of earlier orders in the queue under pro-rata matching causes prices to be less efficient under pro-rata rules. Secondary results find that order sizes and cancellations increase under pro-rata. While analyzed using the Treasury futures market, our findings are applicable to commodity futures as well, where both FIFO and pro-rata are widely used.