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November 1, 2003

A Minimum Increment Solution

By William G. Christie

What a difference a decade makes! In the mid-1990's, there was a very public controversy over the inside spread on Nasdaq stocks. Professor Paul Schultz and I suggested in 1994 that Nasdaq market makers were maintaining spreads that were "too wide." That's because the inside spreads on the most active issues were bouncing between $0.25 and $0.50 per share. It was due to the avoidance of odd-eighth quotes. Nevertheless, legal and regulatory pressure - including the order handling rules - eventually ensured that individual and institutional investors were no longer subject to a lack of competition among market makers.

Now, about 10 years later, the pendulum has swung 180 degrees. Market participants and regulators are debating whether spreads are "too small" in a penny environment. The guiding logic in switching to pennies was that the market should determine the equilibrium inside spread for each issue based on its price, volatility, volume, degree of private information and other factors. It was a case of reducing the tick size to a penny for all stocks, and the invisible hand of the market would ensure that each issue trades at a competitive inside spread.

In retrospect, however, we were nave in expecting pennies to balance the interests of the many trading constituencies, since a penny tick size has destroyed the critical roles played by price priority and limit orders. Any investor, including market specialists, can offer meaningless price improvement, step in front of existing limit orders, and render such orders virtually worthless. An option that only provides you with downside risk -without the protection of upside potential - loses its value. Not surprisingly, the number of shares exposed in the market through limit orders has declined dramatically. This means that trades of anything other than minimum size are difficult, time consuming and expensive.

Since the Securities and Exchange Commission signaled its intention to begin a review of the appropriate tick size, logic has yet another chance to prevail. Let's frame the arguments by studying the marginal costs and benefits that accrue to investors from varying tick sizes. The current tick size of $0.01 exposes all market participants to the decay of price priority. This is a disincentive to submit limit orders of any real size. It is also a significant substitution of small investor interests above those of large institutions and mutual funds.

Suppose the SEC were to advocate a tick size of $0.05. Who wins and who loses? Let's begin with the winners. Empirical evidence accumulated over the years and across markets suggests that price priority will regain its appropriate role, limit order investors will reveal greater size, and institutions/mutual funds will be able to execute larger trades at lower costs. Who loses? Opportunistic traders who add little liquidity to the markets and the smallest of retail investors who trade in the most active issues. The question then boils down to the balance between the two. My research with Jeffrey Harris (University of Delaware) and Eugene Kandel (Hebrew University) strongly suggests that the marginal benefits of moving to a $0.05 tick size clearly outweigh the marginal costs. In a nutshell, equilibrium inside spreads under $0.05 are relevant for only a handful of the most active stocks. Yet a tick size of $0.01 imposes the above mentioned costs on the entire universe of stocks.

What is a reasonable solution? Move the minimum tick size to $0.05. Such a decision will (a) have no impact on the willingness of small investors to participate in our markets, (b) return price priority to a meaningful standard of trade allocation, and (c) increase the depth exposed to the market. The downside is that the trading costs among investors in the most active issues may indeed exceed the true equilibrium by a few pennies per trade. This is a small price to pay to preserve the integrity and vitality of the entire market. It is a far cry from the spreads of yesteryear that bounced between $0.25 and $0.50 per share. Tradeoffs among constituents are unavoidable. Still, a $0.05 tick size offers a reasonable compromise that promotes liquidity, depth and true price improvement.

William G. Christie is Dean and Professor of Management, Vanderbilt University, Nashville, TN.