TECH TUESDAY is a weekly content series that covers all aspects of capital markets technology. TECH TUESDAY is produced in collaboration with Nasdaq.
We have spent a lot of time talking about tick sizes, stock splits and perfect stock prices over the past few years. That’s because research suggests getting the tick right can boost stock valuations and reduce cost of capital for companies. That’s good for investors and companies.
But research also suggests not every company should have the same sized tick. In fact, as stock prices rise, studies by academics, market makers, us and even regulators in Europe have found that the best tick leaves a stock trading with a spread between 1 and 2 ticks wide.
Chart 1: Spread costs are smallest when stocks trade 2-ticks wide
Today we look at more data from the tick pilot that confirms this result. We find the tick pilot created data that proves:
- Making stock ticks constrained increases costs and hurts valuations.
- But too many ticks are bad for trading too.
- Setting tick sizes so that a stock trades 2-ticks wide reduces costs and improves valuations, even if that means increasing tick sizes.
Constantly reducing tick size doesn’t help all stocks
The U.S. equity market has seen two significant tick size reductions – first from an eighth of a dollar (12.5 cents) to a sixteenth (6.25 cents) in 1997, then to a cent following decimalization rules added in 2001. The data in Chart 2 shows how dramatically spread costs fell as a result.
That left all stocks with a 1-cent tick, where they have (mostly) remained.
Since 2001, as stock prices rose, the cost of that 1-cent tick (in basis points) kept falling. However, spreads have remained flat, and, more recently, it’s possible spreads are rising, especially for all the high-priced stocks in the market. A sign that too many ticks that generate too small economic profits to attract liquidity providers is bad too.
Chart 2: Tick size reduction has helped reduce average spreads materially, but since decimalization, spreads have actually drifted wider in cents
We also know that decimalization has left many stocks trading with spreads more than 25 ticks wide, even if we look at spreads in odd-lots. In short, for many stocks, the 1-cent tick is too small.
Chart 3: For many stocks, the 1-cent tick is too small
The Tick Size Pilot widened spreads on some stocks
Back in 2016, the SEC was convinced that too many ticks were a problem, at least for some stocks. And so, the much-maligned tick pilot was born.
The tick pilot set ticks to 5 cents for a wide range of 1,200 (mostly) small-cap stocks.
The problem with the tick pilot was that many of the stocks added to the pilot were actually trading at or near their optimal 1-2 cents spreads already. And for those stocks, the tick pilot forced their spreads much wider, making them “tick constrained” instead of optimally priced.
The impact is clear in Chart 1 of this previous report – where the tick pilot stocks form in a row with much wider spreads than “normal” stocks but also longer queues (larger circles). It is also clear in the data from the official tick pilot report (left columns of Chart 4 below). It was also hoped that deeper queues would add to overall liquidity, but instead, liquidity in these stocks fell.
Chart 4: Spread changes caused by the new 5-cent tick
Because investors typically cross spreads more than they capture them, especially as liquidity fell, it was no surprise that experts suggested that the tick pilot cost investors between $300 million – $900 million over the course of two years.
New research finds the Tick Size Pilot also affected valuations
It turns out that these wider spreads didn’t just add to trading costs. A new academic study finds that wider spreads also hurt stock price performance of tick pilot stocks. Specifically, it finds that the newly tick-constrained stocks’ valuations fell around 3% over the course of the pilot (Chart 5).
Using a back-of-envelope calculation, the paper estimated the price decline is equivalent to a loss of about $2.6 billion in market capitalization.
Chart 5: Price impact for tick-constrained stocks
We find spreads and valuations improved for stocks when the tick was “right-sized”
But that’s made us wonder (given what we believe about stocks with “too many ticks”), what happened to the tick pilot stocks where a 5-cent tick was closer to optimal for them?
So, we turned our attention to determine whether stocks with spreads in the “10 cents or greater” category – where a 5-cent tick suddenly made their trading 2-ticks wide – were closer to “optimal” based on all the other research we discussed above.
The data in Chart 4 shows that spreads in these stocks actually decreased by around 8%. So, fixing for “too many ticks” can actually reduce spreads by encouraging liquidity providers to materially improve spreads if they want queue priority.
More importantly, we found that the stocks where the tick pilot “right-sized” their tick (from too many ticks to a 2-tick spread) prices, on average, actually outperformed.
Chart 6: Price impact for stocks moving to 2-tick wide
In short, increasing the tick size to 5 cents was actually good for some stocks, especially those with a natural spread of around 10 cents. That’s consistent with picking a tick that puts spreads on these stocks close to their optimal return for tradability — where the 5-cent tick made them trade 2-ticks wide (a natural $0.10 spread = 2 x 5-cent ticks).
As a result, these stocks not only saw their spreads costs fall, but they also outperformed.
Important implications for future tick size design
The tick pilot was derided because it unnecessarily added trading costs to so many stocks.
But this new research also shows that stocks can also have too many ticks – and that consolidating ticks where this is the case also reduces investor costs by tightening spreads, which in turn improves valuations and, therefore, the cost of capital for a firm.
In summary, the findings highlight the importance of getting ticks size right – for all prices of stocks – breaking down spreads for tick constrained stocks as well as consolidating quotes for stocks with too many ticks under the current rules.
This also shows that one tick size does NOT fit all stocks. Something regulators in many other regions have known for quite some time.
Phil Mackintosh is Chief Economist at Nasdaq.
Shiyun Song, Lead Economic & Statistical Researcher for Economic Research at Nasdaq, contributed to this article.
