Tick size, order handling rules, and trading costs

Financial Management (Financial Management Association), Spring, 2004 by Kee H. Chung, Chairat Chuwonganant

We show that the effect of the tick-size change on NASDAQ spreads depends critically on the Order Handling Rules (OHR). Our empirical results show that the tick-size reduction has no impact on the spread of NASDAQ issues that were not subject to the new OHR, but has a significant effect on the spread of NASDAQ issues that were subject to the OHR. These results indicate that smaller tick sizes are valuable in reducing market friction only if market makers compete on price with public traders. Our results are in line with the finding of prior studies that execution costs are lower in auction markets than in pure dealer markets.

**********

In this study, we examine how market structure moderates the effect of the minimum price variation on execution costs. Our study is in the same spirit of a recent study by Huang and Stoll (2001) who show that the need for and effect of the minimum price variation rule are a function of market structure. The New York Stock Exchange (NYSE) is an auction market in which both the specialists and public traders (through their limit orders) establish prices. In contrast, until 1997 NASDAQ was a quote-driven dealer market in which dealers established prices. However, with the implementation of the new Order Handling Rules (OHR) in 1997, NASDAQ has become more of an order-driven auction market like the NYSE.

Prior studies (see Huang and Stoll, 1996; Barclay, 1997; Chung, Van Ness, and Van Ness, 2001; and Huang and Stoll, 2001) show that traders incur greater execution costs in dealer markets than in auction markets. Heidle and Huang (2002) show that the probability of encountering an informed trader is higher in dealer markets than in auction markets. Whether one market structure is better than the other is an important concern to regulators as well as traders. It is also of considerable interest to corporate managers, because the location of their stock listings can affect investor trading costs, required returns, and thus the cost of capital. Prior studies show that stock returns are significantly and positively related to the bid-ask spread (see Amihud and Mendelson, 1986, 1989; Amihud, Mendelson, and Lauterbach, 1997; Amihud, 2002; and Easley, Hvidkjaer, and O'Hara, 2002).

Tick size and order handling rules are two important protocols of securities markets that affect trading costs and market quality. Tick size affects market quality because it limits the prices that traders can quote and thus restricts price competition. Order handling rules affect market quality because they determine the nature and degree of competition among market participants in the price discovery process. In this study, we show how tick size and order handling rules affect execution costs on NASDAQ.

On June 2, 1997, the minimum price variation (i.e., tick size) on NASDAQ was reduced from $1/8 to $1/16 for stocks selling at prices greater than or equal to $10. In addition, the Securities and Exchange Commission (SEC) enacted major changes in the OHR on NASDAQ from January 20, 1997 through October 13, 1997. The new rules allow greater competition between liquidity providers (dealers and public traders) in the quote-setting process. The close timing of these two changes provides an excellent opportunity to analyze the complementary nature of their effects on market quality.

Although prior studies (see, e.g., Barclay, Christie, Harris, Kandel, and Schultz, 1999 and Bessembinder, 2000) examine the effects of changes in the OHR or tick size on NASDAQ spreads, whether these effects are interdependent has not been well understood. In this paper, we show that the effect of the tick-size change on NASDAQ spreads depends critically on the OHR. We show that changes in tick sizes exerted a significant impact on NASDAQ spreads only after the implementation of the new OHR. This finding is important, because it underscores the fact that smaller tick sizes are valuable in reducing market friction (Stoll, 2000) only if market makers compete on price with public traders for order flow.

Ahn, Cao, and Choe (1996) examine the change in liquidity when the Amex reduced the minimum price variation. They find that the bid-ask spread declined after the tick-size reduction. Bacidore (1997), Porter and Weaver (1997), Ahn, Cao, and Choe (1998), and Griffiths, Smith, Turnbull, and White (1998) examine the impact of the tick-size change on liquidity for stocks listed on the Toronto Stock Exchange (TSE) and show that the spread declined after the tick-size reduction. Bollen and Whaley (1998) and Goldstein and Kavajecz (2000) find similar results for NYSE-listed stocks.

Harris (1994, 1997) holds that the effect of tick size on execution costs is likely to be significant only in markets with a price-time priority rule. Harris conjectures that the tick-size change will have a significant effect on NASDAQ spreads only if market makers compete with public traders. Although previous studies show that the tick-size change has a significant effect on spreads in hybrid (e.g., NYSE and Amex) or purely order-driven (e.g., TSE) markets, its effect on the spread of NASDAQ issues has not been well documented. In this study, we perform empirical analysis of the effect of the tick-size change on NASDAQ spreads.