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When Bigger is Better: The Impact of a Tiny Tick Size on Undercutting Behavior

Published online by Cambridge University Press:  13 October 2022

Anne H. Dyhrberg ,
Sean Foley Open the ORCID record for Sean Foley [Opens in a new window]  and
Jiri Svec
Anne H. Dyhrberg
Affiliation:
Wilfrid Laurier University Lazaridis School of Business and Economics [email protected]
Sean Foley*
Affiliation:
Macquarie University Business School
Jiri Svec
Affiliation:
The University of Sydney Business School [email protected]
*
[email protected] (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

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Economically insignificant tick sizes encourage undercutting behavior, thus harming market quality. Theoretical work shows that increasing tick sizes in unconstrained markets reduces undercutting and improves market quality. Equity market pricing grids are generally too coarse to test this prediction. We examine a cryptocurrency market with infinitesimal tick sizes where undercutting limit orders acquire price priority without meaningful economic cost. We show that increasing tick sizes reduces undercutting behavior, increases liquidity provision and quoted depth, and reduces transaction costs for institutional and retail-sized trades while decreasing short-term volatility. Tiny tick sizes are suboptimal, supporting increased minimum trading increments in tick-unconstrained markets.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 6 , September 2023 , pp. 2387 - 2416
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Angelo Aspris, Patrick Augustin, Jennifer Conrad (the editor), Amy Kwan, Albert Menkveld, Bernt Ødegaard, Peter O’Neill, Richard Phillip, Talis Putnins, Barbara Rindi (the referee), Andriy Shkilko, Elvira Sojli, Ingrid Werner, Bart Yueshen, Zhou Zhong, and Marius Zoican as well as seminar participants at VU Amsterdam, FIRN Australia, University of Western Australia, Wilfred Laurier, and McGill for useful comments and suggestions. Dyhrberg acknowledges financial support from the Capital Markets Cooperative Research Centre.

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