HFT versus the sub-optimal Tick

Felix Salmon has an interesting follow-up to my post, Should Stocks Trade in Increments of $.0001?  First he notes (as did Chris Stuccio) that for stocks above say $50 the sub-penny rule doesn’t make much difference.

Here’s the chart, from Credit Suisse via Cardiff Garcia:

The y-axis shows the bid-offer spread on any given stock, in basis points; the x-axis shows the price of the stock, in dollars. Clearly, there’s an artificial clustering around that curve. For a lot of stocks trading at less than $50 a share, the market would happily provide bid-offer spreads of less than a penny if it could; but it can’t. And when stocks get really cheap, the bid-offer spread becomes enormous. For instance, an eye-popping 3.766 billion shares of Citigroup were traded on December 17, 2009, when the stock fell 7.25% to $3.20. At that level, a one-penny bid-offer spread is equivalent to a whopping 31 basis points; if Apple traded at a 31bp spread, then its bid-offer spread would be almost $2.

Clearly, the traders were the big winners when Citi was trading at a very low dollar price — if you make the assumption that traders capture half the bid-offer spread on each trade, then the traders made almost $20 million trading Citigroup alone, in one day.

On the other hand, it seems that the market almost never trades stocks at a bid-offer spread much below 2bp. Which in turn means that for stocks over $50 per share, we’re pretty much already living in Stuccio’s ideal world, where the spread is determined by traders, rather than by an artificial rule barring increments of less than a penny.

Salmon then makes another point – firms may use stock splits and IPO pricing to deliberately price their stocks below $50. Salmon says this is in part to grease their relationship with Wall Street but one could also say this is done in order to create more liquidity. In fact, there is good evidence for Salmon’s hypothesis that firms care about nominal share price; In Tick Size, Share Prices, and Stock Splits (JSTOR, H/T OneEyedMan) James Angel makes the interesting point that even as the S&P and CPI soared between 1924 and 1994 the average nominal price of a stock was very flat near $32. Angel’s explanation is that firms use the IPO price and splits to keep a consistent relationship between tick size and share price because:

A large relative tick size also encourages dealers to make a market in a stock….a larger tick provides a higher minimum round-trip profit to a dealer who can buy at the bid and sell at the offer.

Angel even notes the potential for rent-seeking that motivated the original argument to eliminate the sub-penny rule:

If the relative tick size is too big, the profits from a wider tick size may be dissipated through vigorous competition for order flow and payment for order flow.

Overall, I find these arguments continue to favor eliminating the sub-penny rule but these results indicate that firms already have some control over the extent of HFT so the net benefits may be smaller than at first imagined. It is probably easier to split than to combine shares to raise price, however, and social benefits may exceed private benefits so I still see an argument for eliminating the rule. See Felix’s post also for a number of very good comments.