Can Sub-Penny Pricing Reduce Trading Costs?

Abstract

We examine the effect of tick size on quotation behavior in a naturally-controlled experimental setting. Of the top six Electronic Communications Networks (ECNs), three allow sub-penny quotes (group S) and three do not (group P). For a sample of stocks that trade on all six of these ECNs, we find that group S ECNs have narrower spreads than group P ECNs, especially for low-price stocks. Even after correcting for left-truncation and price discreteness, we find that spreads for the same stocks are tighter on group S ECNs, suggesting that a smaller tick size fosters greater price competition. We find that the one penny tick is frequently a binding constraint on the inside spread and that the relaxation of the binding constraint would result in a 0.7 cent (16%) reduction in the inside spread.