Tick Size Regulation, Intermarket Competition and Sub-Penny Trading

Abstract

The minimum price variation, or tick size, is at the center of the current regulatory debate as it a¤ects competition for liquidity provision in limit order books. A reduction in the tick size is …rstly shown to have a detrimental e¤ect on the quality of illiquid stocks as it worsens both spread and depth; but it bene…ts liquid stocks as it reduces inside spread and increases market depth. Then we build a dual-market model and examine how competition between two public limit order books (PLB) ends up with liquidity concentration on the market with a smaller tick size. By introducing di¤erent trader type, we adapt this dual-market framework into a model with a PLB competing with another book characterized by a smaller tick size, namely Internalization Pool (IP). In this way we are able to investigate the issue of sub-penny trading that is discussed in the SEC concept release on Equity Market Structure (2010). Our …ndings are as follows: for illiquid low priced stocks, the quality of a PLB is dramatically worsened when broker-dealers are able to use an internalization pool (IP) to provide price improvement by a fraction of the tick size; for liquid stocks however, the introduction of an IP fosters competition and improves both spread and depth. In addition our model predicts that broker-dealers use IP more intensively for low priced liquid stocks. AbstractThe minimum price variation, or tick size, is at the center of the current regulatory debate as it a¤ects competition for liquidity provision in limit order books. A reduction in the tick size is …rstly shown to have a detrimental e¤ect on the quality of illiquid stocks as it worsens both spread and depth; but it bene…ts liquid stocks as it reduces inside spread and increases market depth. Then we build a dual-market model and examine how competition between two public limit order books (PLB) ends up with liquidity concentration on the market with a smaller tick size. By introducing di¤erent trader type, we adapt this dualmarket framework into a model with a PLB competing with another book characterized by a smaller tick size, namely Internalization Pool (IP). In this way we are able to investigate the issue of sub-penny trading that is discussed in the SEC concept release on Equity Market Structure (2010). Our …ndings are as follows: for illiquid low priced stocks, the quality of a PLB is dramatically worsened when broker-dealers are able to use an internalization pool (IP) to provide price improvement by a fraction of the tick size; for liquid stocks however, the introduction of an IP fosters competition and improves both spread and depth. In addition our model predicts that broker-dealers use IP more intensively for low priced liquid stocks.

Do Dark Pools Harm Price Discovery?

“…Most models of limit order books have pure private values and do not have asymmetric information regarding the asset value. Papers taking this approach include Parlour (1998), Foucault (1999, Foucault, Kadan, and Kandel (2005), Goettler, Parlour, and Rajan (2005), Rosu (2009), andButi, Rindi, Wen, andWerner (2011), among others. Chakravarty and Holden (1995), Kaniel and Liu (2006), and Goettler, Parlour, and Rajan (2009) allow informed traders, but incorporating a dark pool into their models is far from trivial.…”

The Rise of the Dark Side; Dark Pool Trading and the Two-Tiered Implication

“…This type of transactional control coming out of the private sector of the market has often been sighted as a cause of increased spread in prices and increased market volatility (Degryse 2011, Jiang 2011, Weaver 2011, Comerton-Forde 2012 discussed the market share held in the private sector of the market as being indicative of volatility levels). Others have found that the market shares associated with a dark or private sector behaving in this manner may not lead to increasing volatility (Buti 2011, Ye 2011. The previous studies relating the behavior of private sector participants and the volatility of the market as a whole have generally assumed that the private sector of the market reports its volume and price informational parameters to the public real time.…”