What is the Optimal Tick Size? A Cross-Sectional Analysis of Execution Costs on NASDAQ

Abstract

The tick size is the single most important market design parameter, yet its effects on market quality are poorly understood. By using recent tick-by-tick data from NASDAQ we find that transactional execution costs are non-monotonic in the relative tick size. Execution costs are minimal at a relative tick of roughly 1.6 basis points. We identify this value with the optimal tick size and also show that both the fraction of price improvements by hidden orders and adverse selection of liquidity providers is minimal at the optimal tick. We therefore hypothesize that transactional execution costs, price transparency, and market maker revenues can be increased by changing the tick to its optimal value. We further argue that the “one size fits all” tick size policy in the U.S. is sub-optimal. The recent fears expressed by regulation agencies about excessively small tick sizes seem therefore to be justified.