Risk sharing in time-priority markets

Abstract

We document low cross-sectional correlations between market maker (MM) inventory positions in Canadian futures markets, suggesting imperfect risk sharing. We build a model to understand how cross-sectional heterogeneity in inventories shapes liquidity provision in time-priority markets. The optimal limit order size depends on inventory, which in turn affects successors' queue positions and adverse selection risk. Depth is maximized (minimized) if large inventory MMs arrive early (late) in the queue. Empirically, this effect explains 8% of depth variability in our sample. Further, our model allows us to cleanly distinguish between inventory frictions and adverse selection using quote sizes.

Keywords: limit order markets, time priority, risk sharing, adverse selection, inventory risk

JEL Classification: G11, G12, G14