Tick Size and Trading Costs: NYSE vs. NASDAQ

Abstract

Theory suggests that a reduction in tick size will cause spreads to narrow on the NYSE due to the time priority rule which encourages specialists and traders to improve price. The effect of tick size on spreads is likely to be small in dealer markets (such as Nasdaq) because dealers have little incentive to improve price. Our empirical results show that the tick size reduction has no impact on the spread of Nasdaq issues that were not subjected to the new order handling rules (OHR). In contrast, the tick size reduction has a significant effect on the spread of NYSE issues and Nasdaq issues that were subjected to the OHR. These results indicate that the new OHR compel Nasdaq dealers and limit order traders to compete on price to obtain order flow. We find that the tick size change has a significant effect on the quoted depth of NYSE issues, but no effect on the quoted depth of Nasdaq issues. Our results indicate that decimalization is likely to narrow spreads, decrease dealer payments for order flow, and reduce order preferencing arrangements.

Keywords: Spreads, depths, time precedence, minimum price variation

JEL Classification: G14