Tick Size, Competition for Liquidity Provision, and Price Discovery: Evidence from the U.S. Treasury Market

Abstract

This paper studies how a tick size change affects market quality, price discovery, and the competition for liquidity provision by dealers and high-frequency trading firms (HFTs) in the U.S. Treasury market. Employing difference-in-differences regressions around the November 19, 2018 tick size reduction in the two-year Treasury note and a similar change for the two-year futures eight weeks later, we find significantly improved market quality. Moreover, dealers become more competitive in liquidity provision and price improvement, consistent with the hypothesis that HFTs find liquidity provision less profitable in the lower tick size environment. Lastly, we find a significant shift in price discovery toward the cash market, which then reverses when the futures market tick size is reduced, suggesting that the finer pricing grid in the cash market allows traders to act on small information signals that are not profitable to exploit in the coarser pricing grid of the futures market. Our findings suggest that reducing the tick size in tick-constrained and highly liquid markets like the Treasury market is on balance beneficial.

Keywords: tick size, bid-ask spread, market liquidity, price efficiency, price discovery, liquidity provision, Treasury securities, dealers, principal trading firms

JEL Classification: G12, G14, G18