shall we haggle in pennies at the speed of light or in ......market-making, harming market support...

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Shall We Haggle in Pennies at the Speed of Light or in Nickels in the Dark? How Minimum Price Variation Regulates High Frequency Trading and Dark Liquidity

Robert Bartlett UC Berkeley School of Law

Justin McCrary UC Berkeley School of Law


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Recent concerns with the U.S. system of market structure have focused on proposed reforms to tick size regulation (i.e., the price at which stocks are traded):

Motivation

Section 106 of the Jumpstart Our Business and Start-ups Act of 2012 + SEC Advisory Committee on Small and Emerging Businesses (2013)

• Concern: Transition from fractional to penny-based pricing of securities in 2000 destroyed the profitability of market-making, harming market support for smaller issuers.

• Recommendation: Increase the minimum price variation (MPV) from $0.01 to $0.05 or even $0.1 for securities having low liquidity.

April 2010 Request for SEC Rule-making by BATS Exchange, Inc., NASDAQ OMX Group, Inc., and NYSE Euronext, Inc

• Concern: Displayed quote is “artificially wide” for certain lower priced, liquid securities, causing a detrimental impact to the public price discovery process.

• Recommendation: Permit quoting in ½ cent ($0.005) increments for securities trading between $1.00 and $20.00 per share.

VS


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Background on U.S. Equity Trading Environment

NYSE

Nasdaq

Boston Stock Exchange

American Stock Exchange

Cincinnati Stock Exchange

Bid: 1,000 @$9 7/8 Ask: 1,000 @ $10 3/8

Sell 1,000 shares of ABC

Buy 1,000 shares of ABC

Liquidity Providers

Bid: 1,000 @$10 Ask: 1,000 @ $10 1/8

Bid: 1,000 @$9 7/8 Ask: 1,000 @ $10 3/8

Bid: 1,000 @$9 7/8 Ask: 1,000 @ $10 3/8

Bid: 1,000 @$9 1/2 Ask: 1,000 @ $10 1/2

NBBO Bid: 1,000 @$10

Ask: 1,000 @ $10 1/8

Direct Edge Bid: 1,000 @$9 3/8

Ask: 1,000 @ $10 1/2

Investor

Investor

Broker


4


NYSE

Nasdaq




Bid: 1,000 @$9.90 Ask: 1,000 @ $10.45

Liquidity Providers

Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09

Bid: 1,000 @$9.82 Ask: 1,000 @ $10.42

Bid: 1,000 @$9.8 Ask: 1,000 @ $10.4

Bid: 1,000 @$9.55 Ask: 1,000 @ $10.5

NBBO Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09

Direct Edge Bid: 1,000 @$9.90

Ask: 1,000 @ $10.46

Internalizer/Dark Pool

(Citadel, Knight Capital)

Buys 1,000 @$10.0899 Sell 1,000 @ $10.0501

$$ Sell 1,000 shares of ABC



5


NYSE

Nasdaq




Bid: 1,000 @$9.90 Ask: 1,000 @ $10.45

Liquidity Providers

Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09

Bid: 1,000 @$9.82 Ask: 1,000 @ $10.42

Bid: 1,000 @$9.8 Ask: 1,000 @ $10.4

Bid: 1,000 @$9.55 Ask: 1,000 @ $10.5

NBBO Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09

Direct Edge Bid: 1,000 @$9.90

Ask: 1,000 @ $10.46


(Citadel, Knight Capital)

Pays access fee

Rebate $$

Sell 1,000 shares of ABC


$$


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Research Question and Hypotheses Central Research Question: What would be the consequences on market structure of either (a)

increasing tick sizes to more than a penny or (b) decreasing tick sizes further to permit subpenny quoting?

Hypotheses: Increasing tick sizes should result in: More BD internalization and dark trading but less High Frequency Trading

(HFT) on public (i.e., exchange/ECN) order books. Wider quoted spreads Greater inside depth

Decreasing tick sizes should result in: Less BD internalization and dark trading but more HFT on public order

books Narrower quoted spreads Less inside depth


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Research Design Regression Discontinuity Framework: We exploit the fact that while Rule 612 of Reg NMS requires an MPV of

$0.01 for orders, subpenny orders are permitted for orders priced less than $1.00 per share (the “Subpenny Rule”).

Trading Interest

$.99 $1.00 $1.01

Stock Price Per Share


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Research Design Regression Discontinuity Framework: We exploit the fact that while Rule 612 of Reg NMS requires an MPV of

$0.01 for orders, subpenny orders are permitted for orders priced less than $1.00 per share (the “Subpenny Rule”).

Trading Interest

$.99 $1.00 $1.01

Stock Price Per Share

Penny Price

Increment

Trading interest at $.99

Trading interest at $1.00

Trading interest at $1.01


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NYSE Trade and Quote Data for 2011 (~7,083 securities)

Focus on quotations/trades in securities that had at least one trade below $2.00 per share in 2011 974 securities issued by 962 firms Generated ~ 271 million trades and 3 billion updates of exchanges’ BBOs

Financial/accounting data pulled from CapitalIQ

Data


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Sample Firms vs. CRSP Firms Table 2: Sample Description and Sample Selection Comparison


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Sample Firms vs. CRSP Firms Table 2: Sample Description and Sample Selection Comparison


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Examination of Treatment Effect: Incidence of Subpenny Orders Above & Below $1.00/Share

0.2

.4.6

.8%

of O

rder

s M

ade

in S

ub-P

enni

es

0 .5 1 1.5 2Two-Decimal Bid Price ($)

Average Subpenny RateFit, -.208 (.034)

National Best Bids Priced Less Than $2.00/shareFigure 1(a): Incidence of Sub-Penny Bids in 2011


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0.2

.4.6

.81

% o

f Ord

ers

Mad

e in

Sub

-Pen

nies

0 .5 1 1.5 2Two-Decimal Offer Price ($)

Average Subpenny RateFit, -.219 (.05)

National Best Offers Priced Less Than $2.00/shareFigure 1(b): Incidence of Sub-Penny Offers in 2011

Examination of Treatment Effect: Incidence of Subpenny Orders Above & Below $1.00/Share


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2011 Trading of Sample Securities by Venue:


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Incidence of FINRA/TRF Trades Above & Below $1.00/Share

0.1

.2.3

.4P

erce

nt o

f All

Rep

orte

d Tr

ades

0 .5 1 1.5 2Two-Decimal Trade Price ($)

Percent of All Trades in 2011Fit, .08 (.008)

Figure 3(a): Incidence of FINRA-Reported Trades in 2011As a Function of Two-Decimal Trade Price


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2011 Trading Volume Above & Below $1.00/Share

050

000

1000

0015

0000

Mill

ions

of S

hare

s Tr

aded


Total 2011 Volume at Price PointFit, 9602.655000000001 (3452.51)

Figure 3(b): 2011 Trading Volume As a Function of Two-Decimal Trade Price


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Measuring HFT: Rate of Updating of Exchanges’ Best Bid/Ask

Updates per second: 10:56:41 1

10:56:42 2

10:56:43 0

10:56:44 1

10:56:45 5

10:56:46 0

10:56:47 0

10:56:48 0

10:56:49 0

10:56:50 9


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Rate of Updating of Exchanges’ Best Bid/Ask: Average Above & Below $1.00/Share

0.2

.4.6

.8B

BO

Upd

ates

Per

Sec

ond

0 .5 1 1.5 2Two-Decimal Ask Price ($)

Average Rate of BBO UpdatesFit, -.241 (.047)

Figure 4: BBO Updates Per SecondAs a Function of Two-Decimal Ask Price


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.02

.04

.06

.08

.1Fr

actio

n of

Sec

urity

-Sec

onds


Average Incidence of Security-Seconds with > 1 UpdateFit, -.006 (.006)

Figure 5(a): Incidence of Security-Seconds Having At Least One BBO Update

0.0

01.0

02.0

03Fr

actio

n of

Sec

urity

-Sec

onds


Average Incidence of Security-Seconds with > 50 UpdatesFit, -.001 (0)

Figure 5(b): Incidence of Security-SecondsHaving At Least Fifty BBO Updates

Rate of Updating of Exchanges’ Best Bid/Ask: Incidence of Strategic Runs


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Quoted Spreads Above & Below $1.00/Share

.02

.04

.06

.08

.1S

prea

d as

a %

of Q

uote

Mid

-Poi

nt


Average spread as % of quote mid-pointFit, .011 (.003)

Figure 6: Quoted Spreads At the $1.00 Cut-off


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Inside Depth Above & Below $1.00/Share 0

100

200

300

Quo

ted

Bid

Dep

th


Average quoted bid depthFit, 126.957 (16.387)

Figure 7(a): Quoted Bid Depth At the $1.00 Cut-off

010

020

030

040

0Q

uote

d A

sk D

epth


Average quoted ask depthFit, 73.961 (17.31)

Figure 7(b): Quoted Ask Depth At the $1.00 Cut-off


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Sell 1,000 ABC

Buy 1,000 ABC

Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09

NBBO Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09


(Citadel, Knight Capital

$$

Robustness Check: Maker/Taker Fees at $1.00

Pays access fee?

What if access fees for subdollar stocks decline below the $1.00 cut-off?

Route to NBBO vs. Internalize?


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Robustness Check: Maker/Taker Fees at $1.00

Fees and rebates as a percentage of a $10,000 trade of a stock valued at either $1.00 or $0.99 in 2011:

Do exchanges that lower fees below the $1 cut-off see an uptick in subdollar trading?


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Trading Volume at the $1.00 Cut-Off: 2010 vs. 2011

050

000

1000

0015

0000

2000

00M

illio

ns o

f Sha

res

Trad

ed0 .5 1 1.5 2

Two-Decimal Trade Price ($)

Total 2010 Volume at Price PointFit, -66333.87300000001 (5925.532)

Figure 8(a): 2010 Trading Volume As a Function of Two-Decimal Trade Price

050

000

1000

0015

0000

Mill

ions

of S

hare

s Tr

aded


Total 2011 Volume at Price PointFit, 9602.655000000001 (3452.51)

Figure 3(b): 2011 Trading Volume As a Function of Two-Decimal Trade Price


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2010 Trading Volume for High Rebate Exchanges vs. FINRA

010

0020

0030

00M

illio

ns o

f Sha

res

Trad

ed


Total Volume at Price PointFit, 406.407 (133.451)

NYSE MKT (American) Stock Exchange

050

0010

000

1500

020

000

Mill

ions

of S

hare

s Tr

aded


Total Volume at Price PointFit, -9018.772999999999 (1849.025)

NASDAQ OMX BX (Boston) Stock Exchange

020

000

4000

060

000

8000

0M

illio

ns o

f Sha

res

Trad

ed



Financial Industry Regulatory Authority (FINRA)

010

000

2000

030

000

Mill

ions

of S

hare

s Tr

aded



Chicago Board Options Exchange


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Conclusions: Overall, analysis of the 2011 trading data confirms each of the

predicted effects of changing the MPV: Compared to trades/orders priced under $1/share, trades/orders

priced above $1/share reveal: More BD internalization and dark trading but less HFT on public order

books. Wider quoted spreads Greater inside depth

Conversely, trades/orders below $1.00 per share reveal: Less BD internalization and dark trading but more HFT on public order

books Narrower quoted spreads Less inside depth

Effects are robust to changes to maker/taker fees at $1.00 2010 data also reveals incentive for market manipulation where maker

rebate>quoted spread.


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Conclusions: At their most general level, these results suggest increasing tick

sizes will do little to bring back market support and analyst coverage for smaller companies. Beneficiaries of larger spreads in the current trading environment are

primarily BD internalizers, dark pools, and (possibly) stock exchanges, none of which can be expected to subsidize research for smaller issuers. Such a change will have real trading costs in the form of higher

spreads and longer cues at the inside bid.

Conversely, decreasing tick sizes will result in less dark trading but greater HFT within public order books. Such a change will lower quoted spreads with lower depth at inside

bid. Any such change should be accompanied by formal limitations on the

amount of maker rebates to ensure they do not exceed MPV.

shall we haggle in pennies at the speed of light or in ......market-making, harming market support...

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