A mandated lower tick size provides lower trading costs at the touch, but disadvantages institutional investors with higher costs for larger orders, according to a recent paper by Giovanni Cespa, professor at Bayes Business School.
The paper, entitled ‘Tick size, market quality, and market structure’, discusses how the magnitude of the tick size impacts the distribution of trading surplus between the buy and sell sides, market quality and the trading industry’s structure.
A lower tick size creates a tension between the advantages of lower trading costs at the touch often for retail investors, and the disadvantages of potentially higher costs for institutional investors and smaller rewards for liquidity providers, found the research.
Cespa notes varied results from efforts to lower tick size at a market-wide level, stating that “the effect of a change in tick size seems related to the scope of its impact”.
He explains that while a reduction in tick size has been seen to produce a consistent reduction in spreads on a market-wide level, and subsequently reduced costs for retail investors, they have also been seen to occur alongside a decline in depth available at the quotes. This “tends to amplify institutional traders’ trading costs, since these traders typically post larger orders”, he says, and produces “smaller rewards for liquidity providers”.
Although some in the market may be at a disadvantage, Cespa affirms that without a regulated minimum price variation, “tick size reductions that result from exchanges’ competitive decisions seem to have an overall positive impact on market quality”.
He advises that a “reasonable” tick size regime should balance the need to discourage frequently outbidding and favouring price stabilisation (too small) with the need to avoid the formation of large quotation sizes as a substitute for quote competition (too large). The latter could prompt a “migration of liquidity provision towards venues that speed up fulfilment or allow subpenny price improvements”, Cespa concludes.
The research is particularly relevant given the market structure reforms currently under review by the US Securities and Exchange Commission (SEC), one of which proposes a reduction in minimum pricing increments (tick size) of certain stocks
A panel at the Equities Leaders Summit in Miami earlier this year suggested that while the proposal makes sense conceptually, it risks backfiring if ticks are made too narrow.
“There are a number of securities that can benefit from tighter ticks, usually lower-priced stocks, but one-tenth (of a penny) is too much,” said Sean Paylor, trader at Acadian Asset Management. “Maybe start with a half penny and go from there with an iterative approach.”
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