Relative Tick Size and the Trading Environment

Abstract

This paper examines how the relative tick size influences market liquidity and the biodiversity of trader interactions. Using unique NYSE order-level data, we find that a larger relative tick size benefits High-Frequency Trading (HFT) firms that make markets on the NYSE: they leave orders in the book longer, trade more aggressively, and have higher profit margins. The effects of a larger relative tick size on the market are more complex. In a one-tick spread environment, a larger relative tick size results in greater depth and more volume; in a multi-tick environment, the opposite outcome prevails. The negative impact on depth and volume in the multi-tick environment is consistent with greater adverse selection coming from increased undercutting of limit orders by informed HFT market makers. Our work suggests why a one-size-fits-all spread policy is unlikely to be optimal, and we propose an alternative policy.