The Queuing Friction in Limit Order Book Markets
Western Finance Association Paper 2022, EUROFIDAI-ESSEC Paris December Finance Meeting 2022
68 Pages Posted: 20 Jan 2022 Last revised: 5 Oct 2023
Date Written: October 4, 2022
We show that the queue position in the limit order book is a friction affecting market maker liquidity provision by raising adverse selection and hindering inventory risk management. Accordingly, proprietary Canadian futures market data confirm poor risk sharing across high-frequency market makers. Analyzing quote sizes reveals that adverse selection is twice the size of inventory frictions, identified using quasi-exogenous variation in queue positions. We uncover a novel crowding-out effect: a market maker inventory shock crowds-out liquidity provision by others later in the queue. A trade-off arises, where the queuing sequence that maximizes risk sharing minimizes quoted depth, and vice versa.
Keywords: limit order books, queuing, time priority, liquidity, inventory, adverse selection
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation