Tick Size and Listings

by on June 21, 2012 at 10:41 am in Data Source, Economics | Permalink

In earlier posts I have argued for a smaller tick size to reduce rent-seeking. The Wall Street Journal reports today that there is a move to increase tick size in order to increase rent seeking.

Smaller and lesser-known companies could benefit from being nickel-and-dimed, at least on stock markets.

Allowing thinly traded stocks to rise or fall in broader increments–five or ten cents versus the current penny, for instance–could help those securities draw more investors and make their shares easier to trade, according to exchange and brokerage executives.

Publicly traded companies or those eyeing an initial public offering should have the ability to choose whether they want their shares to move cent-by-cent or in larger steps, executives told lawmakers at a Wednesday hearing in Washington.

In other cases, exchanges ought to be able to transact the most heavily traded shares in fractions of a cent, some said.

There is a case for having a tick-size function, in which tick sizes would change with share price and perhaps also volume. Many exchanges in the world have such tick functions. I am suspicious, however, when industry insiders plump for higher tick sizes as being in the public interest. In particular, I have doubts that this is true:

Wall Street’s current methods for trading stocks have helped fuel a slide in the number of publicly traded companies, according to David Weild, senior adviser with Grant Thornton LLP. He told lawmakers Wednesday that the number of U.S.-listed companies has declined steadily for the last 15 years, with an average 208 listings falling off exchanges per year since 2002.

The increments by which stocks can be bought or sold, known as their “tick size,” are a key factor, Weild said at the hearing. Trimming the increment to one cent created more potential prices at which shares can trade, making it more work for traders to ensure liquidity, he said.

IPOs and listings are down but I think tick size is at most a minor reason. There are more plausible reasons for declining listings including more competition from abroad, greater use of private equity, increased stringency of regulation in the United States (SOX) and perhaps also declining profitability of small firms.

FYI, here is the testimony from the hearing before the House Financial Services Committee.

Hat tip: John Welborn.

tgrass June 21, 2012 at 11:46 am

Any proposals for a more meaningful layman’s synonym for ‘rent-seeking’?

Jacob June 21, 2012 at 1:25 pm

Selfishness? The definition is pretty clear, no? Rent seeking is making money without adding any value to society.

tgrass June 21, 2012 at 5:40 pm

The definition is clear – but the phrase is impotent in a summary when I want to share the article with folks whose last econ book was The Communist Manifesto when they were 17.

Kenn July 15, 2012 at 10:20 am

Parasitism?

Dave Barnes June 21, 2012 at 11:47 am

Wouldn’t a smaller tick size lead to an increase in the number of cases of Lyme Disease?

Anthony June 21, 2012 at 12:13 pm

Is there any evidence from other stock exchanges regarding changes in price quantum and increasing or decreasing listings, or even evidence of difficulties in making markets?

Ben June 21, 2012 at 12:37 pm

One important thing to realize is that many market-makers are not particularly sophisticated. They’re able to make a living, often a good one, because wide spreads mean that the gains from offsetting order flow exceed the losses from their information disadvantage. But if you reduce tick sizes, thereby narrowing spreads, they’ll be completely unable to compete and leave the market. I used to work for an options group that did exactly this: tick sizes shrank in equity options, they became uncompetitive, and so they moved to fixed-income options.

I shed no tears for traders who have to close their business because they’re not good enough at it, but there definitely is a trade-off between smaller tick sizes and more liquidity. The more profitable market-making is, the more capital will be allocated to it.

Jamie June 21, 2012 at 2:57 pm

When a trader says the word “liquidity”, I reach for my wallet.

Alex Tabarrok June 21, 2012 at 3:09 pm

Jamie nails it.

Doug M June 21, 2012 at 4:26 pm

In the bond world, shrinking bid as spreads is an indication of improved liquidity. When the regulation forced the the spread narrower for equities they say it killed liquidity.

There is little doubt that decimalization killed the PCOS and is killing the NYSE. Maybe that is a good thing. Improved efficiency and all that.

The small tick size created a challenge for institutional traders. Big Institutional Player is looking to buy a million shares of PDQ, they put out their order for all to see. Everyone can slip in and buy shares for a penny more than BIP is willing to bid, knowing that there is a floor underneath them. This has lead to the creation of dark pools and the like.

Steve June 21, 2012 at 9:25 pm

What’s a tick, in this context?

David Krych June 22, 2012 at 1:23 am

The tick size is the amount by which prices must be rounded in the market. A one cent tick means that prices must be e.g. $9.87 or $9.88, but not $9.875. A five-cent tick means that $9.85 and $9.90 are valid prices in the market, but you cannot trade at $9.87 or $9.88.

If the tick size is binding on the bid-offer spread (meaning that e.g. people would be willing to offer to buy at $9.87 and sell at $9.88 but the tick size is five cents and so instead they offer to buy at $9.85 and sell at $9.90) it tends to increase transaction costs for people who want to acquire/sell stock, and that acts as a tax on transactions in the markets, which overall makes them less efficient. However if the tick size is economically meaningless (e.g., $.0000000001), very fast traders can always step in front of slower traders (in this case, defining fast and slow as a matter of microseconds versus milliseconds). The ideal tick size balances these considerations.

In Europe and most Asian countries, the price of a stock determines its tick size so that the tick size is roughly a constant proportion of the price. In some Asian countries (particularly Japan), every stock is evaluated quarterly based on its price and volume and an optimal tick-size calculated which is used for the next quarter. The US and Canada are rare in that the tick size is $.01 for everything, except for stocks less than $1 which have a tick size of $.0001.

Doc Merlin June 22, 2012 at 3:03 am

“However if the tick size is economically meaningless (e.g., $.0000000001), very fast traders can always step in front of slower traders (in this case, defining fast and slow as a matter of microseconds versus milliseconds). ”

The theory is that the tick size serves as an inducement for people to keep open orders on the market. This artificially limits the tail of the price distribution throughout the day.

However, in the US, tick size only applies to quotes not to trades, so people can still do the above. That is what HFT is all about. It takes advantage of the market inefficiency due to incomplete information to try to make money.

Doc Merlin June 22, 2012 at 3:04 am

Remember tick size law only applies to quotes, not trades. This means that the larger the tick the more money you can make using HFT.

RoadRunner June 22, 2012 at 5:31 am

I know a fair bit about HFT and I have no idea at all what you are talking about. Care to elaborate?

Doc Merlin June 23, 2012 at 5:37 pm

Example:

The actual prices of the bids and asks are not at the ticks, thats just what is quoted from the exchange. This creates inefficiencies that are exploitable. Some HFT strategies revolve around finding this hidden liquidity and exploiting it.

For example: “Dark Sub Penny Queue Jumping”
” HFTs are using continuous dark pools to sub-penny passive
orders in the visible book. If for example a client places a size visible bid at .50, the HFT will place a
continuous dark pool bid at a fraction of a penny higher. As a result, when an aggressive order flows
through the pool they will buy stock at a price less than 1 tick away from the visible bid. They often
‘steal’ priority away, from the visible bid that created price discovery, by as little as 2/10ths of a
penny.” – http://qes.bmocm.com/papers/8_BMO_ImpactOfHFT.pdf

There’s many other strategies that are similar. During the big flash crash recently, you could see some of the HFT algos trying to discover the sub penny resolution of actual prices that were very different from the quoted prices when liquidity dried up. It was fascinating.

While this isn’t necessarily happening at sub-penny resolution here’s an example of an algo trying to take advantage (unsuccessfully) during a low liquidity event. The blog author things its just quote stuffing, but I think its something more than that. http://3.bp.blogspot.com/-DE4_tWOGOVU/TpDZ1ucjf3I/AAAAAAAAAj8/sXVijdOhWPc/s1600/1857.jpg

Robert June 22, 2012 at 2:10 pm

Crazy. Executive go to DC to ask to be able to increase their tick size? They HAVE to know (or their CFO knows) that with a constant $0.01 tick they can effectively double the tick size in their stock by doing a 2-1 split. Makes me think there has to be something more to the story.

Petras Kudaras June 25, 2012 at 5:15 am

I am still baffled why tick sizes should be regulated at all — any exchange should be able to make up its own rules.

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