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 aects competition for liquidity provision in limit order books. A reduction in the tick size is …rstly shown to have a detrimental eect 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. Finally, we adapt this dual-market framework into a model with a PLB competing with another book char- acterized by a smaller tick size, namely Internalization Pool (IP), accessible only to broker-dealers. 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: when broker-dealers are able to use an IP to provide price improvement by a fraction of the tick size, the quality of a PLB is considerably wors- ened for illiquid low priced stocks; 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.