Misdirected by Rule 605: Bias in the Effective Bid-Ask Spread

47 Pages Posted: 10 Nov 2017 Last revised: 27 Apr 2018

See all articles by Björn Hagströmer

Björn Hagströmer

Stockholm University - Stockholm Business School

Date Written: April 25, 2018


I show that the effective spread measured relative to the spread midpoint overstates the true effective spread in markets with discrete prices and elastic liquidity demand. The average bias is 17% for S&P 500 stocks in general, and more than 80% for stocks with high relative tick size. The bias varies with exchange fees, implying that liquidity rankings of trading venues are biased too. I find that venues that charge high fees to liquidity suppliers appear artificially liquid, which may influence order routing decisions. The bias differs substantially across investor types, leading less sophisticated investors to overpay for liquidity.

Keywords: midpoint, micro-price, liquidity demand elasticity, liquidity, illiquidity, Rule 605, NBBO, TRTH

JEL Classification: C15, G12, G20

Suggested Citation

Hagströmer, Björn, Misdirected by Rule 605: Bias in the Effective Bid-Ask Spread (April 25, 2018). Fifth Annual Conference on Financial Market Regulation. Available at SSRN: https://ssrn.com/abstract=3068623

Björn Hagströmer (Contact Author)

Stockholm University - Stockholm Business School ( email )


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