Tick size falls in the field of market microstructure is, in broad terms, explained as the trading rules and systems used by a capital market (Harris 2003). Market microstructure is concerned with the actual trading process and how the specific mechanisms of a capital market affect market quality as a whole (Johnson 2010). Studies in the field focus on analysing these effects and shed light on whether or not these mechanics work towards an efficient capital market. Provisions of liquidity play a key role in achieving an efficient capital market. In literature it is widely recognized that liquid markets offer trading with little or no impact on price. Hence, the interest in provisions of liquidity for different capital markets has grown over the last two decades due to rapid changes in structure and technology. These changes arose with the demutualization of many exchanges, making them profit based enterprises, and an increase in intra-market competition (Johnson 2010).
The applied tick size regime is an important mechanism of capital markets. A fair amount of research in the field have addressed its relationship to market quality and in particular the provisions of liquidity on the market. The effects of tick size change on provisions of liquidity will act as this paper’s foundations.
The tick size of a particular security is defined as the minimum price increment, meaning the smallest amount by which a trader can improve a price. For example, a Large Cap stock trading at 140 before June 2010 on the SSE had a tick size of 0.25 and could assume prices such as 140.25, 140.50, 140.75 and so on. Directly following the change to the tick size re-gime, that same stock would have a tick size of 0.1 and could assume prices such as 140.1, 140.2, 140.3 and so on. When regulators change the tick size regime for stocks, they do so in an attempt to harmonize the public limit order book (PLB) with regards to the two priority rules of the PLB:
- Price Priority Rule
- Time Priority Rule
The price priority rule simply states that the better price on the PLB is executed before the worst price. The Time priority rule means that the oldest price, or the one that “came there first”, is executed first when there are separate orders for the same price. This creates a bal-ance between the two rules when setting the tick size as a trader might find that the cost of “waiting” due to the Time Priority rule to be too long with regards to the price risk of un-dercutting the current price. Therefore, if the tick size is too small then too much bias is given to the price priority rule meaning that market participants will have less of an incentive to place limit orders as other participants can undercut them with a small fraction, also known as “front running”. If instead the tick size is too large then the opposite happens and the time priority rule has an advantage over the price priority rule (Harris 2003). It is because of this reason that the tick size cannot be zero, as it would diminish incentives to post limit orders to the PL
Optimal Tick Size
The topic of an optimal tick size is something that has been frequently debated over the last two decades. Today, the idea of a uniform tick size that fits all has been cast aside. Instead, the trade-offs from setting a tick size regime on a particular capital market is the main topic of debate.
When the tick size is large it creates a greater incentive for market participants to place a limit order, thereby enhancing displayed orders and provisions of liquidity. However, the conse-quence of this is a larger bid-ask spread which increases participant transaction costs when executing an order. This, in turn, diminishes the trading incentive and the provisions of li-quidity (Angel, 2012). Furthermore, the model developed by Cordella & Foucault (1996) suggests that a zero minimum price variation never minimizes the expected trading costs.
The reason for the difficulties when defining an optimal tick size is mainly because it is not necessarily the same for all securities traded. Smaller capitalization securities in particular can benefit from a larger tick size relative to price, resulting in a liquidity boost due to the in-creased incentives to place limit. In contrast, Large Capitalization securities in general are naturally more liquid. If a larger tick size was imposed on Large Capital securities, then li-quidity could suffer due to the increase in transaction costs that would follow. Alternatively, the provisions of liquidity might gain from a lower tick size. (Seppi 1997)
Finally, capital markets across the world do not have the same market structure which makes an optimal tick size across markets difficult to envision. On a dealers market, the tick size sets the minimum spread, i.e. the profit realized by the dealers. In these markets, dealers incur inventory costs, adverse selection costs, and order processing costs. Thus, when a larger tick size is applied incentives for dealers to place limit orders could increase as they realize a greater profit covering potential costs. (Angel, 2012)
Provisions of liquidity on the PLB
The incentive to post limit orders on the PLB is closely related to what tick size regime is imposed, and the trade-off between the two different priorities consequently affects the pro-visions of liquidity. In broad terms, liquidity is recognized as the level of ease that one can convert a given asset into cash. Moreover, the level of liquidity provision on a PLB can reflect the ease of doing so for a given security. This dates back to Harold Demsetz’s (1968) view that expresses liquidity in terms of immediacy, meaning it reflects the ability to trade imme-diately by executing at the best available price.
The level of liquidity provisions on a capital market can therefore be seen as the ability to trade quickly at prices that are reasonable with regards to supply or demand conditions. Hence, if a capital market is considered to be liquid, it can be regarded as a meeting place where buyers and sellers can buy and sell large volumes quickly without effecting share prices (Schwartz 1993). In terms of the PLB, the book should have a high trading volume with a low cost of immediacy, i.e. trading cost, to be considered a liquid PLB (Johnson 2010)
The estimation of the provision of liquidity on any given security is derived from certain characteristics of the PLB which are referred to as parameters. Johnson (2010) identifies three main features of the PLB used for estimation: Width, Depth, and Resiliency. Another renowned author, Schwartz (1993), presented these same features in his literature but in-cluded two additional features: Breadth and Immediacy. These five features of the PLB are within the amount of previous research that have been most frequently applied when meas-uring provisions of liquidity on capital markets.
Width can also be referred to as the bid-ask spread. The bid-ask spread is an important feature in financial markets as a whole, however for the common trader it might first and foremost be associated with the transaction cost upon execution. In addition, it is also commonly viewed as an important feature when determining liquidity. This is because the transaction cost is the cost of immediacy, hence the price they have to pay directly. Traders that demand immediacy will buy or sell at the national best ask price (NBA) or national best bid price (NBB) respectively, resulting in the cost being the distance between the two. From the deal-ers’ or market makers’ perspectives, the bid-ask spread represents the reward for providing immediacy on the PLB (Harris 2003). An immediacy demanding trader therefore values a smaller bid-ask spread to a larger one, while dealers or market makers value a larger bid-ask spread as it will maximize profits.
Depth measures the order volume at all price levels. In terms of provision of liquidity, depth is an important feature. When the depth level of the PLB is large, it is considered to enhance liquidity. Harris (2003) defines depth as “the quantity of shares that can be traded at a given cost of liquidity”. Another way to define it is by a PLB’s ability to handle larger market orders with little price impact.
Notable about depth is its relationship to tick sizes and institutional investors, which is dis-cussed further in section xx in regards to previous research findings. When the tick size is small, a trader placing a large order faces an increased exposure to the risk of other traders front-running them. Other traders might think that the trader possesses superior infor-mation, because of the large order, and will then attempt to “free-ride” on that information. With the tick size being small, other traders are able to place orders that are slightly higher at relatively low costs based on the price priority rule. If that is the case then it might diminish institutional investors incentive to place larger orders, thereby having a negative effect on depth (Harris 2003)
Breadth is defined as the how much volume is available at the best bid and ask price. A PLB is considered to be broad when there is a large order volume at NBA and NBB. The rela-tionship between tick size and breadth can be closely linked to how the tick size effects bid-ask spread. The incentive to undercut the NBA or NBB is large when a small tick size is applied, which most often causes the new NBA or NBB to have a lower order volume than before. This could result in the liquidity provisions on the top of the book to diminish (Harris 2003).
Resiliency is the measurement of how quickly the PLB recovers from a shock on the market. A resilient PLB will suffer less price discrepancies from trading, meaning changes in price would have little effect on trading volumes or order volumes (Johnson 2010).
Immediacy is the measurement of the time it takes to execute an order of a given size. When the PLB is considered liquid orders are executed quickly, meaning a high immediacy. This feature is a useful parameter in regards to dealers markets as it is dependent on dealers and market makers to undertake the risk of the order before execution. Their willingness to do so contributes to the immediacy level of the PLB (Schwartz 1993).
This paper will use the first two features of the PLB to determine the provision of liquidity; width (bid-ask spread) and depth. These two measures are most commonly used in previous research papers when measuring liquidity. The breadth is at times held equally as important as width and depth, but due to a lack of resources this study will not incorporate this feature. Although a powerful tool in theory, resiliency is harder to define in practice. This is due to the uncertainty surrounding what constitutes a temporary or permanent imbalance caused by a particular event. immediacy is excluded in this study as it might be possibly unnecessary. Both depth and width (bid-ask spread) represents similar measurement in regards to handling different order sizes
Stockholm Stock Exchange
The Stockholm Stock Exchange (SSE) is the primary securities market in Sweden. In 1998 the SSE merged with NASDAQ OMX and is today run as NASDAQ OMX Stockholm. As of the beginning of the 2000’s, the SSE had an electronic order-driven market which displays all bid and ask quotes from market participants, where market makers/dealers compete on equal terms with other market participant for liquidity. The benefit of this type of market is said to be its transparency, while its disadvantage is a lower degree of liquidity compared to a quote-driven market. In contrast, a quote driven market depends on market makers/dealers quoting bid and ask quotes, meaning that they can more easily manipulate the degree of liquidity on the market. (Harris, 2003)
The SSE consists of three market capitalization segments: Small Cap, Mid Cap, and Large Cap. The different segmentations are defined by their value of market capitalization. The Large Cap segment includes companies with a market capitalization equivalent to EUR 1 billion or more, the Mid Cap segment includes companies with a market capitalization of EUR 150 million or more, and the Small Cap segment includes companies worth a market capitalization of less than EUR 150 million. (NASDAQOMX Stockholm, 2015)
SSE Tick Size Structure
On the 25th of September, 2009, NASDAQ OMX Stockholm announced through an Ex-change Notice that the FESE tick size table 2 would be introduced for all OMXS30 stocks as of 26th of October, 2009. As of October 2009, 43 Large Cap stock were incorporated in the OMXS30 and were affected by the implementation of the new tick size regime. Approx-imately 8 months later, the same tick size table was implemented for the remaining 36 stocks in the Large Cap stocks segment. The decision to implement the tick size change was made in cooperation the Nordic Securities Dealers Association and the Association for Financial Markets in Europe, in an attempt to further harmonize tick sizes across Europe. The aim of the change was to lower the transaction costs of trades on the Nordic, while simultaneously increasing provisions of liquidity
1.1 Purpose and Contribution
1.2 Research questions
2 Market Microstructure
2.1 Tick Size
2.2 Provisions of liquidity on the PLB
2.3 Stockholm Stock Exchange
2.4 Regulation Debate
3 Literature Review
3.1 Bid-Ask Spread
3.3 Volume Traded
4.1 Data Collection
5 Empirical Findings & Discussion
5.1 Bid-ask Spread
5.3 Trading Volume
6 Concluding Remarks
7 Future Research
List of Reference
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