What Reserve Orders Are for

Reserve orders are specific market instruments that allow traders to submit large orders to the market while publicly displaying only a specified portion of the total order size. In recent years, the submission of reserve orders has been growing in all major exchanges. In their paper Undisclosed Orders and Optimal Submission Strategies in a Limit Order Market (Journal of Financial Economics, Vol. 109, Issue 3, September 2013, Pages 797–812, doi: 10.1016/j.jfineco.2013.04.002), Barbara Rindi (Department of Finance) and Sabrina Buti (University of Toronto) investigate traders' motivation for using such an instrument and analyse the effects of reserve orders on traders' welfare. This welfare analysis allows the authors to determine which types of investors benefit the most from the use of reserve orders.

The authors develop a theoretical framework which allows them to examine how the use of reserve orders arises as an optimal submission strategy. Reserve orders have costs and benefits. On the one hand, as the undisclosed portion of the order is last in priority, the probability of execution of such a portion decreases.On the other hand, the probability of execution of the visible part of their order increases, as by hiding part of their order, traders run a lower risk of being undercut by aggressive traders quoting more competitively. The authors study this trade-off and the result of this constrained optimization problem is that, in equilibrium, traders choose the reserve orders' size in such a way that the visible part is maximized and the probability of undercutting minimized.

Moreover, the authors provide a welfare analysis that investigates whether and how the introduction of reserve orders affects the welfare of market participants. The results suggest that traders' welfare increases when agents are given the option to use reserve orders. In addition, this welfare increase is positively related to the value of the tick size, the smallest increment by which the instrument's price can change.When the tick size is large, traders use reserve orders more extensively, andthe positive effect on traders' surplus increases. Moreover, the authors study the differential change in welfare generated by the introduction of reserve orders among different types of investors. They find that large traders always benefit from the use of this type of order whereas small traders are only better off when they are patient enough or when the tick size is large. In addition to predictions about welfare changes, the authors also deliver predictions about market quality measured by depth, spread and volume. Specifically, the model predicts that, when traders use reserve orders, depth at the best quotes increases, inside spread widens, and volume decreases. By analysing the impact of reserve orders on market quality and traders' welfare, the authors come to theoretical predictions that have significant implications for market designers.