The Impact of Decimalization on Market Quality: An Empirical Investigation of the Toronto Stock Exchange

Abstract

Much recent debate has revolved around "decimalization", i.e., the trading of securities on cent ticks as opposed to fractions of a dollar. Advocates of decimalization argue that such a move will reduce the costs of trading by permitting liquidity providers to tighten the bid-ask spread. Recently, the major Canadian stock exchanges moved from fractional pricing to decimal pricing in an attempt to lower the costs of trading. I examine the effect switching to decimal pricing has had on market quality using data acquired from the Toronto Stock Exchange, the largest and most active of the Canadian exchanges. I find that quoted and effective spreads decline significantly following the switch to decimal trading, indicating that trading costs incurred by investors are reduced. Quoted depths in the post-decimalization period, however, also decline dramatically. Furthermore, I find that the change in volume is not sufficient to offset the per share profit decline experienced by liquidity providers in the post- decimalization period. This result indicates that part of the gain to investors is simply a wealth transfer from liquidity providers.

JEL Classification: G12, G15