Market Making Rents Under Discrete Prices - Theory and Evidence

Abstract

The paper presents a value maximizing rationale for an exchange imposed restriction on prices to be multiple of (for example) 1/8th of a dollar. The minimum "tick size" poses a barrier to competing forces, thereby creating positive profits for the market maker. Discrete prices can, therefore, serve as a credible mechanism for enforcing cartel-like behavior of market makers. We also show thatthe effective commissions in a discrete price economy depend on the location of the underlying fundamental value. Discreteness of prices, per se, can cause asymmetric ask and bid commissions as well as market breakdowns. Interest- ingly, discrete prices need not always result in additional transaction costs for liquidity traders. Informed traders respond to the additional transaction costs by investing less in acquiring information. Thus, discrete prices can reduce the asymmetry of information. We find on both the bid and ask sides of the market, locations of the underlying fundamental value for which the effective commissions are less than the continuous-case equilibrium commission. Our model predicts that the variance of the location of the fundamental value is decreasing in the quoted spread. We use intraday transaction data to test this implication and report evidence consistent with our model.

JEL Classification: G14, G18