By spoils, I mean the returns to market making. Right now market makers are largely rewarded for being the fastest and beating out other market makers rather than for providing the most liquidity to speculators/investors.
The markets do not do that automatically. Before automated trading, Alice could sell, but would probably have had to do so at significantly less than $10/shr, even if the market was indicating $10 was the true price of XYZ. Bob could buy, but would probably have to do so at significantly more than $10.05/shr. The primary reason for that: human beings skimming from Alice and Bob, because there was no effective way to compete.
The order book now looks like:
SELL BIG - 1000 $600
SELL SPEEDY - 200 $600
-----
Buy SPEEDY - 200 $599
BUY BIG - 1000 $599
A buy and sell order comes in for 200 shares at market, and SPEEDY makes $200. BIG makes nothing. The problem is that BIG is offering more liquidity to the market (1000 shares vs 200), but all the rewards go to SPEEDY. With a pro-rata, BIG would make $166 and SPEEDY would make $33.
Pro-rata rewards volume, FIFO rewards speed. It is debatable which is better.
It also looks like "Speed" and "Bigness" are orthogonal issues; you're just irritated that "Speed" got to the book first. But "Speed" is getting compensated for soaking up more risk; because "Speed"'s order fills first, "Big" has more time to react to negative market changes.
Note that in any case, traders are penalized in a variety of other ways for laying large block orders onto the book.
SELL BIG - 1000 $600 ----- Buy SPEEDY - 200 $599 BUY BIG - 1000 $599
Another buy order at $600 comes in and BIG makes the trade.
Now the order book looks like this:
SELL BIG - 800 $600 ----- Buy SPEEDY - 200 $599 BUY BIG - 1000 $599
At this point, SPEEDY wants to get back in so he offers 200 shares @ $600. The Order book now looks like this:
Buy SPEEDY - 200 $600 SELL BIG - 800 $600 ----- Buy SPEEDY - 200 $599 BUY BIG - 1000 $599
So now SPEEDY is sitting behind BIG and has to wait until all 800 shares of his order soaks up the market.
So, where is the problem?
What if the exchange traded once every 5 seconds in a blind auction, then there would be no real advantage to speed. Each computer would have 4.5-4.95 seconds to parse the auction results and post new orders.
Would this exchange be more or less liquid? (I don't know, but it is interesting to think about.) The barrier to entry to be a market maker would be lower. The market making code would look more like Poker bot code, rather than what HFT does now.