FLASH FRIDAY is a weekly content series looking at the past, present and future of capital markets trading and technology. FLASH FRIDAY is sponsored by Instinet, a Nomura company.
When academics Paul Schultz and William G. Christie conducted research in the mid 1990s, the tick size, or minimum price increment change, in U.S. equity trading was $0.125.
Christie, currently a professor of management in finance and a professor of law at Vanderbilt University, was referenced in a January 1998 Traders Magazine article, and then quoted in a 2003 article. His premise at the time was that penny pricing had gone too far.”
The research “uncovered a collusive agreement that market makers would avoid odd-eighth quotes in selected stocks, thereby increasing the difference between adjacent quotes to $0.25, thereby doubling the trading costs for investors and increasing profits to market markers by 50%.”
“Once the new order handling rules required Nasdaq market makers to include limit orders from investors in their own quotes, the pricing convention collapsed and spreads fell by over 35%,” Christie told Traders Magazine earlier this week.
He said his advocacy of a $0.05 tick size was meant as a compromise between the benefits to investors who had paid $0.125 and would now pay $0.05, and the cost to intermediaries who had received $0.125 and would now receive $0.05 for providing liquidity.
“I don’t think that anyone who participated in those markets could have ever anticipated the changes in technology that would make concerns about tick size evaporate,” he said.
He added that the US markets moved first to ‘sixteights’, or increments of $0.0625, and then to decimals, or $0.01.
“Once our markets joined the rest of the world in quoting in decimals, the competition across markets and institutions shifted from spreads to speed of execution,” Christie said. “In other words, spreads are not the point of distinction across trading venues and they have little bearing on total round-trip trading costs.”
In 2019, Nasdaq proposed a more flexible “intelligent” tick size structure, which Christie believed was an interesting and thoughtful suggestion.
“However, it seems more reasonable to set the minimum tick size at $0.01,” he noted. “If stocks are less actively traded or impose otherwise higher risks for investors, intermediaries will competitively set quotes at higher increments than $0.01 to reflect compensation for risk-taking.”
“Stocks that would warrant smaller tick sizes can accommodate trade prices with price increments lower than $0.01,” Christie continued. “But again, for any individual investor, buying or selling a stock with a spread of $0.01 is inconsequential now, when 25 years ago the spread was $0.25.”
According to Prof. Christie, institutions are far more concerned with the speed of execution given the spreads have fallen to a minimum of $0.01.
“In retrospect, my suggestion of a $0.05 tick size was naïve as I did not anticipate the advances in technology that would make spread differentials immaterial relative to the speed of execution. Just as I would have been naïve to think that using platforms such as Zoom would ever be effective in teaching and communicating with students,” he said.
For Mao Ye, associate professor of finance at the University of Illinois at Urbana-Champaign, “intelligent tick is intriguing,” but it is not the best solution for low liquidity of high-priced stocks. “The reason for these stocks to have a large bid-ask spread is not because their tick size is too small, but because their lot size is too big,” he argued.
In 2020 research, Ye together with Ph.D. student Sida Li predicted that a firm achieves its optimal price when “its bid–ask spread is two ticks wide, when the marginal contribution from discrete prices equals that from discrete lots.”
Empirically, Ye and Li found that stock splits improve liquidity when they move the bid–ask spread towards two ticks; otherwise, they reduce liquidity.
They argued that the regulators can change both tick and lot sizes, whereas firms can only use nominal prices to trade off the proportional tick and lot sizes. Therefore, policymakers have two degrees of freedom, and firms have only one.
“My model recommends policymakers reduce both tick and lot sizes so that neither discrete price nor discrete quantity will be a constraint for the market,” he added.
Going forward, Ye thinks that regulators will “surely reduce tick size,” otherwise there will be more and more creative innovations, trying to bypass the tick size, perhaps via different fees or order types.
