What If Time Priority Is Not Enforced Among Traders?

Abstract:     
Do traders who place orders early necessarily trade first? In some trading systems, the answer is no. Such systems often give preference to larger orders instead. Institutional arrangements such as "preferencing" and "payment-for-order flow" also violate time priority. In an international context, too, time priority is difficult to enforce across different geographical markets. Using data from the Toronto Stock Exchange, this paper examines how violation of time priority affects trader strategies and market liquidity. I find that, without time priority, traders compete less on prices, and instead, indulge in gaming strategies to increase their chances of execution. This is especially pronounced in periods when such strategies are relatively less risky. The resultant effect on market quality is twofold: one, it widens bid-ask spreads, and second, it reduces incentives of traders to expose themselves early. The latter reduces time-weighted quoted depth. The results have important implications for trading systems, especially newer electronic systems, where multiple traders compete to offer liquidity. The analysis also provides insights into why we might expect to see diminished price competition in NASDAQ where time priority among dealers is not enforced.

Number of Pages in PDF File: 48

JEL Classification: D49, G19

working papers series