Streetwise Professor

A brief follow up to my earlier post on HFT and SEC Chair Mary Schapiro’s suggestion of a minimum time in force for all limit orders.

My criticism of this idea focused on one aspect of limit orders: their optionality, that exposes limit order submitters to losses if price-affecting information arrives and they cannot revise their quotes accordingly.  A time in force minimum increases the option cost of a limit order, and will induce limit order traders to quote less aggressively.  This will widen spreads and reduce depth.

This paper by Fong and Liu discusses another important aspect of quote revision: non-execution risk.  A limit order trader is not guaranteed an execution.  If the market moves away from him, his order will not be executed.  Traders who want to provide competitive quotes will revise their quotes if another trader betters them on price, or on some dimension (e.g., size) that affects secondary priority.  Thus, quote revision is part of the process of competition between liquidity suppliers (although informed traders can also be limit order traders.)

The effects of a time in force minimum on this aspect of limit orders on competition is more complicated than its effect on the option feature.  Knowing that they cannot respond to the entry of a better quote for some time, traders may quote more aggressively in the first place.  (It should be noted they can match or beat an order that under/over-cuts them, but only by entering a new order and leaving the original order in force, thereby raising their risk.)  Thus, it is difficult to determine on net whether a time in force rule intensifies competition between limit order submitters.

One last remark.  On floor-based auction markets, like futures floors, it is said that bids and offers are good only as long as the trader’s breath is warm.  This is intended to limit the options that traders provide gratis to the market.  This system has exhibited tremendous survival value, suggesting that there are some efficiency benefits to allowing liquidity suppliers to reduce their exposure.  The same principles apply in electronic markets too.  That should be remembered before requiring electronic traders to breathe long and deep, as it were.