How do Tick Sizes Affect Stock Exchange Trading?
Updated: Jan 25
The tick size on Exchanges has been subject of various regulatory efforts by legislators in the past. Based on emprical evidence, regulators assume that the granularity of the tick size has an impact on the functioning and resilience of the markets. This is in particular true for markets where high-freqency traders are present. This article provides an overview of the main effects of tick size on exchange trading.
Definition of Tick Size
"Tick size" refers to the possible distance between two price levels (limit levels) of orders, according to recital 8 of Delegated Regulation (EU) 2017/588. The tick size needs to be defined by the trading venue operator and tells trading participants which price levels are permissible when entering order limits. The limit of an order must be an integer multiple of the tick size specified for the respective financial instrument. For example, with a tick size of EUR 0.01, a limit of EUR 1.11 would be permissible, whereas a limit of EUR 1.115 would not. As a result of the defined tick size, the trading system can only determine prices that correspond to the tick size.
Tick Size Units
The unit of the tick size depends on the type of quotation. Basically, two types of quotation can be distinguished from each other. In the case of unit quotation, the price of a financial instrument and consequently also the limit of an order are shown in EUR or another currency per unit. In the percentage quotation, the respective price is expressed as a percentage of the nominal value, which is the standard for debt instruments (e. g. 97.6 % of a nominal amount of EUR 10,000).
Impact of Tick Size on Trading
The effects of tick size and its changes on securities trading have already been the subject of various empirical studies. These are based on data from 1996, for example, when Canadian trading centres switched completely to the decimal system. In this context, the tick size for share prices from 5.00 CAD was adjusted from "Eighth" (0.125 CAD) to 0.05 CAD. Furthermore, the research is based on data from the year 2000, when the SEC ordered a change in trading from "Sixteenth" to the decimal system. This change was accompanied by a reduction in tick size from 1/16 USD (0.0625 USD) to 0.01 USD. The most recent event that provided comprehensive data sets for empirical studies was the Europe-wide introduction of the tick size system in terms of Art. 49 MiFID II on 3 January 2018.
Findings
Die empirischen Untersuchungen belegen, dass die Höhe der Tick Size die Marktqualität, insbesondere den Spread und die Markttiefe, sowie das Mitteilungsaufkommen beeinflusst:
It was found that the spread tightens with a lower tick size; the opposite is true with a higher tick size.
Tick size also has an effect on market depth, i.e. the ability of a market to provide a steady stream of transaction interest near current market prices in order to provide sufficient transaction opportunities even in the face of shock price changes and to prevent trading from drying up. As orders tend to concentrate on a smaller number of possible price levels with a higher tick size, market depth tends to increase. The opposite is true with a smaller tick size.
The tick size also affects the volume of messages. The message volume comprises the number of messages transmitted to a trading system in a certain period of time, in particular the transmission, modification and cancellation of orders or quotes. With a higher tick size, a tendency towards reduced message volume was observed. An increasing volume of messages was observed with a lower tick size. The increased volume of messages results in particular from an increased splitting of orders into more and more small orders. Due to the increased data traffic, the legislator fears that a data congestion could theoretically occur in the electronic trading systems because they can only process a certain amount of data per time unit.
Tick Size FAQ
What means "message volume" in stock exchange trading?
What is a tick size?
What is market depth?
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Attorney-at-law, LL. M. (UCL)
