Tick Size Constraints, High-Frequency Trading and Liquidity (with Lofchie Comment)
In a paper published by the Social Science Research Network titled "Tick Size Constraints, High Frequency Trading, and Liquidity" (the "Paper") authors Warwick University Assistant Finance Professor Chen Yao and University of Illinois Assistant Finance Professor Mao Ye examine the relationship between high-frequency trading firms, liquidity and tick size. The was funded through a grant program with the National Science Foundation. The paper maintains that the uniform one-cent tick size (for all listed equity securities priced equal to or greater than $1.00 per share) as imposed by Regulation NMS Rule 612, results in larger relative tick sizes for low-priced stocks (one cent divided by price) and, accordingly, increases revenues for liquidity providers in these Paper stocks.
According to the Paper, the larger relative tick sizes for low-priced stocks make it difficult for liquidity providers to compete for order flow based on price. Instead, liquidity providers must compete for order flow in these stocks based on speed, which "encourages HFTs to achieve time priority over non-HFTs at [such] constrained prices." Based on the test results included in the Paper, the authors conclude that "a large relative tick size [actually] harms liquidity and encourages HFT" liquidity providers over non-HFT liquidity providers.
Notably, the authors' conclusions run counter to the notion that a larger relative tick size should increase liquidity in a stock due to the opportunity for increased revenues for liquidity providers. This notion is in part the impetus for the SEC's Tick Size Pilot Program, which examines the effect of increasing the tick size for lower-priced stocks from one cent to five cents.
Lofchie Comment: This article provides further support for the previously stated proposition (see news item and commentary linked below), that if the government genuinely wants to encourage small companies to go public, it should try to find more direct ways to decrease the costs and increase the benefits.
See: "Tick Size Constraints, High Frequency Trading, and Liquidity," by Chen Yao and Mao Ye. Related news: SEC Approves Pilot Program to Assess Tick Size Impact for Smaller Companies (with Lofchie Comment) (May 6, 2015).