Does the Prohibition of Trade-Through Hurt Liquidity Demanders?
31 Pages Posted: 24 Jul 2017
Date Written: July 19, 2017
A particular rule of the Regulation National Market System (Reg NMS) established by the United States Securities and Exchange Commission, called the Order Protect Rule (OPR), generally prohibits any trade-through, which is defined to be a market order that is not executed at the best possible price among all trading venues. The benefit of such regulation to liquidity providers (those who place limit orders) is studied by Foucault and Menkveld (2008). We present a general model to study the potential impact of the regulation on liquidity demanders (those who place market orders). For a general limit order book model with multiple trading venues and stochastic market depths, we find that, although there are examples such that a liquidity demander can intentionally exploit trade-throughs to reduce the total execution cost and the average effective spread, the benefit is marginal for small trades and liquid stocks. This is consistent with empirical findings in Hendershott and Jones (2005).
Keywords: Optimal order execution, order routing, dynamic programming
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