When bigger is better: The impact of a tiny tick size on undercutting behavior

Abstract

We show that economically insignificant tick sizes encourage undercutting behavior, harming market quality. While theory shows increasing tick sizes in unconstrained markets reduces undercutting, improving market quality, pricing grids of most markets are too coarse to test this. We examine a cryptocurrency market with infinitesimal tick sizes, where undercutting limit orders affords price priority without economic cost. Increasing tiny tick sizes reduces undercutting behavior, increasing liquidity provision and quoted depth, reducing transactions costs for both institutional and retail-sized trades while simultaneously decreasing short-term volatility. We show that tiny tick sizes are not optimal, supporting increased minimum trading increments in tick-unconstrained markets.

Keywords: market microstructure, tick size, trading behavior, bitcoin, cryptocurrency

JEL Classification: G14, G15, C580