The Role of Tick Size in Market Quality and in SME Financing

Project Start:01/2016
Status:Ongoing
Researchers:Alejandro Bernales, Richard Payne, Satchit Sagade, Christian Westheide, Christian Wilde
Category: Financial Markets
Funded by:LOEWE

This project was part of the team project "Complex Markets: Regulation and Incentives in Secondary Market Design".

 

Topic & Objectives

We examined the link between tick sizes and small-cap capital formation. Economic growth and job creation depend on young and growing firms' ability to raise capital, an important channel of which is the market for Initial Public Offerings (IPOs). The decline in the number of small firm IPOs in Europe and the US is of concern for policymakers, exchanges, and issuers. The link between tick sizes and investor interest has been argued by Angel (1997) but has not been demonstrated empirically. We try to fill this gap. Instead, we propose to examine these same issues by analyzing the impact of a permanent change in the tick sizes of certain small and medium stocks listed on the London Stock Exchange (LSE). Considering that LSE changed its tick sizes in August 2009, we can additionally examine any potential link between tick sizes and variables like capital formation (as proxied by IPO activity), analyst coverage, and institutional ownership, which are likely to be affected at time intervals significantly larger than one year, and are also the ultimate variables of interest.

Key Findings

  • Smaller tick size results in smaller effective spreads.
  • The result is more pronounced for previously large tick stocks.
  • For small tick stocks, the drop in price impact is of similar magnitude whereas, for large tick stocks, it is smaller. Consequently, realized spreads decrease for large tick stocks.
  • Depth at top of book mechanically decreases.
  • However, the hypothetical trading costs for large trades decrease.
  • There is a slightly positive effect on trading volume.
  • The volatility is reduced for previously very high tick size stocks.
  • Market maker activity generally is unaffected. They are most of the time quoting close to their permitted spread threshold.
  • Institutional trading affected dependent on treatment intensity.

Policy Implications

  • Evidence for effects on liquidity providers predicted by proponents of larger tick size exists only for very high tick sizes.
  • Trading becomes costlier even for large trades.
  • There is no evidence of positive effects on designated market makers.
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