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, the bypassing probability can increase, potentially harming the welfare of investors. In contrast, increasing connection speeds between exchanges raise investor welfare by reducing the bypassing probability. Nevertheless, no exchange wants to improve connection speeds because this will reduce its trading volume. I provide empirical evidence supporting these predictions. Overall, my findings suggest that exchanges do not necessarily compete on liquidity-enhancing dimensions.

Keywords: Exchange Speed, High-frequency Trading, Trade-through, Order Delay

JEL Classification: D47, G10, G14, G18