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

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

The tick size of a security is the minimum increment by which the price of a security can change. It affects market quality by influencing traders' order routing decisions in several ways. In the first study associated with this topic, we plan to examine the impact of tick size on

market quality in today’s fragmented markets. Most of the existing literature examines the impact of changes in tick sizes in the 1990s and in 2001 when markets were less automated and less fragmented than today's equity markets. We propose to extend the dynamic models developed by Goettler et al. (2009) and Bernales (2014) to a fragmented market with two trading venues, both organized as limit order markets and each operating its own tick size. As opposed to the US, in the EU, each trading venue is free to choose its optimal tick size. Between 2008 and 2010, European markets witnessed several changes in tick sizes. Since 2010, tick sizes across markets are harmonized under an unofficial arrangement. We use these events to test the model’s implications. These events form a perfect setting to examine the above question as we have multiple, staggered changes, the exact timing of which can reasonably be considered exogenous. In a second study we fill examine 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 policy-makers, exchanges, and issuers. In June 2014, the Securities and Exchange Commission (SEC) asked US exchanges to conduct a pilot study investigating whether an increase in tick sizes for small cap stocks would benefit US investors and issuers by affecting liquidity, volatility, market-maker profitability, and transaction costs. As part of this study, the tick size of select small cap stocks will be increased for a temporary period of one year, after which the impact of this event on liquidity, volatility, market-maker profitability, transaction costs, etc. will be analysed. The link between tick sizes and investor interest has been argued by Angel (1997) but has not been demonstrated empirically. In this paper we will try to fill this gap.