Tick Size, Trading Strategies and Market Quality

Abstract

We investigate the effects of a tick size change on market quality by modeling a multi-period public limit order book with endogenous liquidity demand and supply. We single out four channels of transmission and show that layering and mechanical change in spread prevail for liquid, tick size constrained stocks; while undercutting prevails for illiquid stocks. We examine the robustness of our results when order flows migrate to a competing venue. We find empirical support for our predictions by analysing tick size reductions respectively for a market with low (Tokyo Stock Exchange - 2014) and one with high fragmentation (U.S. Tick Size Pilot - 2018).

Keywords: limit order markets, tick size, liquidity, market microstructure

JEL Classification: G10, G20, G24, D40