Jul 24, 2018
Eurex | Eurex Clearing
The art of designing markets. Part 1
Market design recognizes that well-functioning markets are more than the confluence of supply and demand. They depend on detailed rules. Market designers try to understand the rules and procedures as well as the workings and requirements of particular markets well enough to fix problems or to build completely new markets when they seem promising.
This is the first article in a series of topics related to market design of electronic market places. This article focusses on different execution models and answers questions such as after orders or quotes reach the order book, how do they interact with each other and/or are placed in the order book.
Randolf Roth, Member of Eurex Frankfurt Executive Board, responsible for market design
The establishment of the central limit order book
With the rise of electronic trading, starting in the 1980s, came the establishment of the central limit order book – where each participant’s order can freely interact which all other participants’ orders – and the use of price-time priority as the most used electronic execution model.
The success of price-time priority is a result of its generally fair and easy-to-understand logic that serves most of the highly liquid products best. The principle simply says: whenever an executable order arrives in the order book and there are several competing orders in the order book on the other side, then the incoming executable buy (sell) order is first executed against the order with the best ask (bid) price. If there are several orders at this best price, it matches first against the order that has first been established at that price level, i.e. has time priority. This execution logic also creates the display of the central limit order book, where the lowest ask (highest bid) are shown as the best ask (bid), and, in addition, bids (asks) at the same price level are ranked by their arrival time in the order book.
The most prominent alternative
Another execution principle to price-time priority is price pro-rata priority, whereby bids and asks at the same price level are treated equally independent of their arrival time. In case an incoming order matches this price level, it matches against all parties providing resting liquidity on that price level pro-rata to the size provided on that price level; this means the participants with the resting liquidity get the same percentage of their orders filled against the incoming order. This has historically been used only in products with very low volatility such as short-term interest rate products where resting orders would stay on the same price level for hours. Starting with the electronification of the U.S. equity options market, the mechanism is now also sometimes used in option products. At Eurex, we have had positive results with pro-rata matching in Dutch equity options and are considering whether to roll it out to more products.
The major difference of price pro-rata matching versus price-time priority is that it rewards higher size rather than earlier provision of prices. In options the differences in arrival time of quotes are very small and to a large extent technology-driven; thus price pro-rata can be a useful stipulation for participants to show bigger size.
In addition, Eurex also has a mixture of the two described algorithms in its execution model toolbox, called price-time pro-rata. In this case, the incoming order is also split between different participants providing resting orders at the same price to the order book, but the allocation does not only reflect the size but also the arrival time. To what extend the time matters relative to the size in the allocation can be steered via a parameter.
In the next article, I will discuss connectivity, i.e. the path orders/quotes take into the market. Further market design topics will follow.
