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Gaming In Futures Market Suggests Model Could Be Improved – CMCRC

Date 17/02/2015

Research from the Capital Markets Cooperative Research Centre (CMCRC) has found that changes to the matching algorithm used in futures markets leads to new strategic behavior by traders.

The research examines the 2007 change in LIFFE STIR futures contracts. LIFFE moved to time pro-rata allocation, which considers the size of an order and its relative position in the order book in determining what proportion of an incoming market order will be allocated to each order. Evidence suggests prior to this, traders were drowning the market with oversized orders, increasing their allocation under a pure pro-rata matching algorithm.

In the wake of the change to a time pro-rata mechanism, order depths reduced from over £10 million to less than £500,000. Similarly, the average notional size of submitted and cancelled orders dropped from over £4 billion to less than £1 billion.  

Dr Foley said that while this reduction in depth may sound like a bad outcome for the market, the reason that depth was so high was that participants were submitting orders many times larger than their desired allocation, however the vast majority of this depth was subsequently cancelled.

 “This ‘over-sizing’ of orders increased traders’ proportional fill of any incoming market orders. What we’ve found is that the time pro-rata mechanism reduces the incentive to oversize orders and provides a more accurate representation of the level of liquidity, allowing traders to enter orders which reflect their true desire to trade.“

The removal of over-sized orders also means that traders no longer need to cancel the unexecuted portion of their oversized orders. This reduces the cost of managing these unexecuted orders, reflected in the significant reduction in the order to trade ratio, from 25:1 prior to the change down to 12:1 after. Owing to the market being predominantly constrained at one tick, no change was observed in transaction costs, measured using quoted and effective spreads.