Hostname: page-component-745bb68f8f-grxwn Total loading time: 0 Render date: 2025-01-20T17:45:33.313Z Has data issue: false hasContentIssue false
  • English
  • Français

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)
Get access Rights & Permissions [Opens in a new window]

Abstract

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

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

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.

References

Aitken, M., and Comerton–Forde, C.. “Do Reductions in Tick Sizes Influence Liquidity?” Accounting and Finance, 45 (2005), 171–184.Google Scholar
Aït–Sahalia, Y., and Sağlam, M.. “High Frequency Market Making: The Role of Speed.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2331613 (2017a).Google Scholar
Aït–Sahalia, Y., and Sağlam, M.. “High Frequency Market Making: Implications for Liquidity.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2908438 (2017b).Google Scholar
Anand, A., and Venkataraman, K.. “Market Conditions, Fragility, and the Economics of Market Making.” Journal of Financial Economics, 121 (2016), 327–349.Google Scholar
Angel, J. J. “Tick Size, Share Prices, and Stock Splits.” Journal of Finance, 52 (1997), 655–681.Google Scholar
Bacidore, J. M. “The Impact of Decimalization on Market Quality: An Empirical Investigation of the Toronto Stock Exchange.” Journal of Financial Intermediation, 6 (1997), 92–120.Google Scholar
Baillie, R. T., and Bollerslev, T.. “Intra Day and Inter Market Volatility in Foreign Exchange Rates.” Review of Economic Studies, 58 (1990), 565–585.Google Scholar
Bartlett, R. P., and McCrary, J.. “Subsidizing Liquidity with Wider Ticks: Evidence from the Tick Size Pilot Study.” Journal of Empirical Legal Studies, 17 (2020), 262–316.Google Scholar
Biais, B.; Foucault, T.; and Salanie, F.. “Floors, Dealer Markets and Limit Order Markets.” Journal of Financial Markets, 1 (1998), 253–284.Google Scholar
Biais, B.; Hillion, P.; and Spatt, C.. “An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse.” Journal of Finance, 50 (1995), 1655–1689.Google Scholar
Bourghelle, D., and Declerck, F.. “Why Markets Should Not Necessarily Reduce the Tick Size.” Journal of Banking and Finance, 28 (2004), 373–398.Google Scholar
Breedon, F., and Ranaldo, A.. “Intraday Patterns in FX Returns and Order Flow.” Journal of Money, Credit and Banking, 45 (2013), 953–965.Google Scholar
Buti, S.; Consonni, F.; Rindi, B.; Wen, Y.; and Werner, I. M.. “Sub-Penny and Queue-Jumping.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2350424 (2015).Google Scholar
Chao, Y.; Yao, C.; and Ye, M.. “Why Discrete Price Fragments U.S. Stock Exchanges and Disperses Their Fee Structures.” Review of Financial Studies, 32 (2018), 1068–1101.Google Scholar
Cheah, E. T., and Fry, J.. “Speculative Bubbles in Bitcoin Markets? An Empirical Investigation into the Fundamental Value of Bitcoin.” Economics Letters, 130 (2015), 32–36.Google Scholar
Chen, H.; Foley, S.; Goldstein, M. A.; and Ruf, T.. “The Value of a Millisecond: Harnessing Information in Fast, Fragmented Markets.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2860359 (2017).Google Scholar
Christie, W. G., and Schultz, P. H.. “Why Do NASDAQ Market Makers Avoid Odd‐Eighth Quotes?” Journal of Finance, 49 (1994), 1813–1840.Google Scholar
Chung, K. H.; Lee, A. J.; and Rösch, D.. “Tick Size, Liquidity for Small and Large Orders, and Price Informativeness: Evidence from the Tick Size Pilot Program.” Journal of Financial Economics, 136 (2020), 879–899.Google Scholar
Conrad, J., and Wahal, S.. “The Term Structure of Liquidity Provision.” Journal of Financial Economics, 136 (2020), 239–259.Google Scholar
Cordella, T., and Foucault, T.. “Minimum Price Variations, Time Priority, and Quote Dynamics.” Journal of Financial Intermediation, 8 (1999), 141–173.Google Scholar
Dyhrberg, A. H.; Foley, S.; and Svec, J.. “How Investible is Bitcoin? Analyzing the Liquidity and Transaction Costs of Bitcoin Markets.” Economics Letters, 171 (2018), 140–143.Google Scholar
Evans, M. D. D.; O’Neill, P.; Rime, D.; and Saakvitne, J.. “Fixing the Fix? Assessing the Effectiveness of the 4pm Fix Benchmark.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3270844 (2018).Google Scholar
Fleming, M. J.; Nguyen, G.; and Ruela, F.. “Tick Size Change and Market Quality in the U.S. Treasury Market.” FRB of New York Staff Report, 886 (2019), 1–46.Google Scholar
Foley, S.; Li, S.; Malloch, H.; and Svec, J.. “What is the Expected Return on Bitcoin? Extracting the Term Structure of Returns from Options Prices.” Economics Letters, 210 (2022), 110196.Google Scholar
Foley, S.; Meling, T. G.; and Odegaard, B. A.. “Tick Size Wars: The Market Quality Effects of Pricing Grid Competition.” Review of Finance, forthcoming (2023).Google Scholar
Foley, S., and Putniņš, T.. “Should We Be Afraid of the Dark? Dark Trading and Market Quality.” Journal of Financial Economics, 122 (2016), 456–481.Google Scholar
Foucault, T.; Kadan, O.; and Kandel, E.. “Limit Order Book as a Market for Liquidity.” Review of Financial Studies, 18 (2005), 1171–1217.Google Scholar
Goldstein, M. A., and Kavajecz, K. A.. “Eighths, Sixteenths, and Market Depth: Changes in Tick Size and Liquidity Provision on the NYSE.” Journal of Financial Economics, 56 (2000), 125–149.Google Scholar
Griffith, T. S., and Roseman, B. G.. “Making Cents of Tick Sizes: The Effect of the 2016 U.S. SEC Tick Size Pilot on Limit Order Book Liquidity.” Journal of Banking and Finance, 101 (2019), 104–121.Google Scholar
Harris, L. “Stock Price Clustering and Discreteness.” Review of Financial Studies, 4 (1991), 389–415.Google Scholar
Harris, L. “Minimum Price Variations, Discrete Bid–Ask Spreads, and Quotation Sizes.” Review of Financial Studies, 7 (1994), 150–178.Google Scholar
Harris, L. “Does a Large Minimum Price Variation Encourage Order Exposure?” New York Stock Exchange (1996).Google Scholar
Kurov, A. “Tick Size Reduction, Execution Costs, and Informational Efficiency in the Regular and E-Mini Nasdaq-100 Index Futures Markets.” Journal of Futures Markets, 28 (2008), 871–888.Google Scholar
Lau, S. T., and McInish, T. H.. “Reducing Tick Size on the Stock Exchange of Singapore.” Pacific-Basin Finance Journal, 3 (1995), 485–496.Google Scholar
Mahmooddzadeh, S., and Gencay, R.. “Human vs. High-Frequency Traders, Penny Jumping, and Tick Size.” Journal of Banking and Finance, 85 (2017), 69–82.Google Scholar
McInish, T., and Wood, R. A.. “An Analysis of Intraday Patterns in Bid/Ask Spreads for NYSE Stocks.” Journal of Finance, 47 (1992), 753–764.Google Scholar
O’Hara, M.; Saar, G.; and Zhong, Z.. “Relative Tick Size and the Trading Environment.” Review of Asset Pricing Studies, 9 (2018), 47–90.Google Scholar
Porter, D. C., and Weaver, D. G.. “Tick Size and Market Quality.” Financial Management, 26 (1997), 5–26.Google Scholar
Ranaldo, A. “Segmentation and Time-of-Day Patterns in Foreign Exchange Markets.” Journal of Banking and Finance, 33 (2009), 2199–2206.Google Scholar
Rindi, B., and Werner, I. M.. “U.S. Tick Size Pilot.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3041644 (2019).Google Scholar
Seppi, D. J. “Liquidity Provision with Limit Orders and Strategic Specialist.” Review of Financial Studies, 10 (1997), 103–150.Google Scholar
Stock, J. H., and Yogo, M.. “Testing for Weak Instruments in Linear IV Regression.” In: Andrews DWK Identification and Inference for Econometric Models. New York: Cambridge University Press (2005), 80–108.Google Scholar
Van Kervel, V. “Competition for Order Flow with Fast and Slow Traders.” Review of Financial Studies, 28 (2015), 2094–2127.Google Scholar
Werner, I. M.; Wen, Y.; Rindi, B.; and Buti, S.. “Tick Size, Trading Strategies, and Market Quality.” Management Science, forthcoming (2023).Google Scholar
Supplementary material: PDF

Dyhrberg et al. supplementary material

Online Appendix

Download Dyhrberg et al. supplementary material(PDF)
PDF 1 MB