Decimalization and Market Quality

Abstract

The relation between tick size and market quality is of interests to both academics and practitioners. The decimalization on the NYSE offers a rare opportunity to empirically examine the effects of tick size change on market quality. This paper performs a thorough study of the influences of tick size change based on the first three pilot stocks and all the NYSE common stocks (the full samples). Our empirical results indicate that, consistent with the literature, both spreads and depth decline significantly after decimalization. Both decreases in spreads and depth suggest that traders whose trade size does not exceed the reduced depth will enjoy lower transaction costs after decimalization. However, the impact on large traders is unclear. This makes it difficult to determine whether the market quality is improved for all traders after decimalization.

Our results show that volume per trade decreases significantly after decimalization, especially for stocks that are actively traded or traded with a larger order size. Such results demonstrate that, after decimalization, either small traders participate more frequently or there are more front-runners entering the market. To examine these conjectures, we examine the changes in degree of front-running surrounding decimalization, and show that the degree of front-running does increase, especially for higher-priced stocks. These evidences support that there are more front-runners entering the decimal pricing system. Furthermore, stocks with different characteristics have different reactions to decimalization. Our results lend support to multiple optimal tick sizes for stocks with different characteristics, instead of a uniform minimum tick size for all stocks.

Keywords: Decimalization, Front-running, Market Quality, Tick Size

JEL Classification: G10, G18, G20