The tick size is the smallest increment permitted in trading a security. It can be seen as the price of time priority in the order book. A small tick size equals a low price to get ahead in the queue; a large tick size equals the opposite. This makes tick size an important parameter in the market micro structure. Setting the “right” tick size is difficult, however; the “Laffer curve” sometimes used to describe the expected effects of taxation arguably applies to tick sizes as well.
– Too small tick size => the value of time priority decreases which leads to lower liquidity in the order book
– Too high tick size => the spread cost is considered too high and may result in lower turnover velocity.
Furthermore, the task of finding the right tick size is rather futile, since the ideal definition differs between investment firms.
Before MiFID applied in 2007, each exchange could decide on their own tick size without worrying about other venues, since all trading was in practice concentrated to the incumbent exchanges. At one point, 25 different tick size tables were used in Europe. When fragmentation started to take off after MiFID, one of the drivers was the fact that the MTFs implemented lower tick sizes than the incumbents. The use of Smart Order Routers, together with the Best Execution requirement, “forced” the order flow to the MTFs with the lower tick sizes than the incumbents. The result was a “race to the bottom” and a negative impact on market quality.
Finally in 2009 this lead to an agreement between the trading venues, through the Federation of European Stock Exchanges (FESE), to introduce a common tick size table (“FESE-2”) for the most liquid stocks. This short-lived agreement lasted until the beginning of 2011, when Euronext announced that they would use a more granular table for their most liquid stocks (“FESE-4”). Deutsche Börse soon followed with a tighter tick size table than the agreed FESE-2.
Against this background, it is no surprise that regulators now suggest centrally governed tick sizes. We now know the scope of the new tick size regime, but what consequences can we expect? Will the proposed changes find the right balance between spread cost and order book depth?
This article provides an overview of the new tick size regime under MiFID II and its possible consequences.
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