Why Do Stock Exchanges Compete on Speed, and How?

Abstract

This paper shows that a key driver of stock exchanges' competition on order-processing speeds is the Order Protection Rule, which requires an exchange to route its customers' orders to other exchanges with better prices. Faster exchanges attract more price-improving limit orders because the probability of being bypassed by trades with inferior prices on other exchanges is reduced. When all exchanges speed up, this probability can increase, potentially harming the welfare of investors. In contrast, increasing connection speeds between exchanges raises investor welfare by reducing this probability. Nevertheless, no exchange wants to improve connection speeds because this will reduce its trading volume. I provide empirical evidence showing that slow exchanges lose trading volume to fast exchanges as the latter attract more price-improving orders. I first show that a slow exchange's (IEX) market share of trading volume in stocks with a five-cent tick, the minimum price movement, increases by 13 percent relative to one-cent tick stocks after the introduction of Tick Size Pilot Program in 2016, because price improving is less likely with larger tick size. I then show that after switching from a dark pool to a public exchange, IEX attracts more trading volume in stocks that are more likely to have one tick bid-ask spread as price improving is impossible with binding spread.