Sacrificial lambs and unintended consequences

Christain VoigtAndy the Trader: I heard tick size is a topic in MiFID II, again. Haven’t we been through this already?

Yes, you’re right. FESE and LIBA brokered an agreement between most European equity trading venues and sell-side firms in 2009. But the topic appears again in the latest proposed amendments for MIFID II (Article 51) and on ESMA’s work program.

Andy the Trader: Once again, why should I care about tick size?

Every instrument has an optimal tick size to maximise liquidity. Put simply, the bigger the tick size, the deeper the order book and the more important time priority becomes in the open limit order book. All of these are good things. However, you don’t want to make a tick size too big, because otherwise you restrict the best bid/ask. The spread leeway tries to capture that effect by counting the number of possible prices within the spread. If the spread leeway is zero, then traders cannot reduce the spread anymore, competition is restricted and the tick size is too large. Thus, tick size should be as big as possible, but as small as necessary.

Usually, exchanges have a good incentive to figure out the optimal tick size because, with it, the most volume is traded. With the advent of fragmentation in equity markets things changed a bit because newcomers could gain extra market share by lowering the tick size. This was not in the best interests of the market as a whole, so the FESE & LIBA agreement was brokered.

Andy the Trader: So, why is tick size back on the agenda?

Some smaller markets don’t play fair and don’t honour the agreement of the major brokers and exchanges. This creates an uneven playing field, which cannot be tolerated by the regulator.

But, more importantly, tick size might be the lamb sacrificed at the regulators’ altar for the sins of HFT. Regulators might scrap the idea of minimum duration for all orders, if they can enforce an inflated tick size across Europe. It is believed that a mandated increase in tick size across all markets will force most of the HFT business out. HFTs live off tiny price movements. If the tick size is not fine enough to reflect those small price differences, HFTs can pack their bags and go home. Proposed amendments, such as that put forward by MEP Pascal Canfin, follow exactly that route. His suggestion is to “limit the minimum tick size […] to such an extent that one tick shall be close to the average spread on that financial instrument.” In other words, he wants to mandate a spread leeway of zero.

Andy the Trader: So, a mandated increase in tick size is good overall. We could get rid of the mandated minimum duration, and some of my electronic competitors, at the same time.

Unfortunately, not really. An artificially high tick size will reduce liquidity. Tick size is a very rough tool and it cannot differentiate between predatory and liquidity providing strategies. An inflated tick size impacts across the board. Furthermore, the regulator will strategically weaken primary exchanges. Firstly, empirical evidence shows that equity stocks with a higher tick size are more fragmented across different markets. Secondly, dark pools matching at midpoint become more important when you have huge tick size and no possibility to offer price improvement in the open limit order book. This is like a showcase for unintended consequences. Regulators could force more volume out of transparent order books into dark pools in equities and derivatives alike, because they want to fight HFTs.

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