Society could save billions of dollars every day if trading in commodities, energy and securities was made more competitive through a minor rule change, according to research by Professor Pär Holmberg, published in the October 2017 issue of the Economic Journal.
Changing the rules would give traders the incentive to buy or sell at more competitive prices, the research suggests, making trading more efficient – and thereby saving large sums for governments and other organisations that trade through auctions and exchanges.
''By changing the rules, even small reductions in transaction prices would still save a lot of money for society and taxpayers'', says the author, who is an associate professor in economics at the Stockholm''s Research Institute of Industrial Economics (IFN).
''For auctions with a high turnover, the cost to implement such a rule change would be negligible compared with the savings.''
Every day, auctions and exchanges around the world trade bonds, stocks, currencies, electricity, metals, commodities, securities and financial instruments worth trillions of dollars.
Most trading platforms apply ''precedence rules'', which determine in which order instructions from traders should be executed – normally sell orders with a low ask price and buy orders with a high bid price are executed first.
Precedence rules also decide how orders should be ranked in case of ties – for example, when two traders submit sell orders with identical offer prices. Such a rule is often referred to as a ''tie-breaker'' or ''rationing rule''.
Sometimes priority is given to the order that was submitted first. Other exchanges might prioritise an order with a large volume over a small order with the same offer price, or even the other way around.
The new tie-breaker developed at IFN is different in that orders with the same offer price are prioritised according to whether the offer price is high or low.
Offers become more competitive if the rationing rule gives higher priority to sell orders with a small volume when ties occur at high offer prices. The effect is largest in markets such as security exchanges, where orders are entered at just a few price levels, so that rationing becomes more important.
Under the most beneficial circumstances, the research shows that the new rationing rule would have the same effect as if the number of traders was doubled, thereby increasing the competition and forcing the trade to be conducted more efficiently.
In a procurement auction where sell orders are entered at 10 different price levels with a mark-up of around 10%, the procurement price can be reduced by roughly 1%, leading to huge savings on large contracts. So government bodies that carry out procurement auctions or sell spectrum licences, emission permits or treasury bills would save billions in taxpayers'' money.
Savings would be similar in a sales auction when applying pro-competitive rationing to buy orders, but then the rationing rule should give higher priority to buy orders with a small volume when ties occur at low bid prices.
By cleverly designing the tie-breaker rules in this way, trading orders become less strategic and better represent the traders'' true preferences.
''Pro-competitive Rationing in Multi-unit Auctions'' by Pär Holmberg is published in the October 2017 issue of the Economic Journal. Pär Holmberg is associate professor at the Research Institute of Industrial Economics (IFN) in Stockholm, Sweden.
