Tick Size Constraints , High-Frequency Trading , and Liquidity

We argue that the uniform one-cent tick size imposed by SEC rule 612 drives speed competition in liquidity provision for low-priced securities. A large relative tick size (one cent divided by price) constrains price competition, creates higher revenue in liquidity provision, and encourages HFTs to achieve time priority over non-HFTs at constrained prices. Our difference-in-differences test using splits/reverse splits as exogenous shocks demonstrates that a large relative tick size harms liquidity and encourages HFT liquidity provision. These results undermine the rationale for maintaining a uniform tick size and the recent policy proposal to increase the tick size to five cents. Chen Yao is from the University of Warwick and Mao Ye is from the University of Illinois at UrbanaChampaign. Please send all correspondence to Mao Ye: University of Illinois at Urbana-Champaign, 340 Wohlers Hall, 1206 South 6th Street, Champaign, IL, 61820. E-mail: maoye@illinois.edu. Telephone: 217-2440474. We thank Jim Angel, Shmuel Baruch, Robert Battalio, Dan Bernhardt, Jonathan Brogaard, Jeffery Brown, Eric Budish, John Campbell, John Cochrane, Amy Edwards, Robert Frank, Thierry Foucault, Harry Feng, Slava Fos, George Gao, Paul Gao, Arie Gozluklu, Joel Hasbrouck, Frank Hathaway, Terry Hendershott, Björn Hagströmer, Yesol Huh, Pankaj Jain, Tim Johnson, Charles Jones, Andrew Karolyi, Nolan Miller, Katya Malinova, Steward Mayhew, Albert Menkveld, Maureen O’Hara, Neil Pearson, Richard Payne, Andreas Park, Josh Pollet, Ioanid Rosu, Gideon Saar, Ronnie Sadka, Jeff Smith, Duane Seppi, Chester Spatt, Clara Vega, Haoxiang Zhu, an anonymous reviewer for the FMA Napa Conference, and seminar participants at the University of Illinois, the SEC, CFTC/American University, the University of Memphis, the University of Toronto, HEC Paris, the AFA 2014 meeting (Philadelphia), the NBER market microstructure meeting 2013, the Midway Market Design Workshop (Chicago Booth), the 8th Annual MARC meeting, the 6 annual Hedge Fund Conference, the Financial Intermediation Research Society Conference 2013, the 3rd MSUFCU Conference on Financial Institutions and Investments, the Northern Finance Association Annual Meeting 2013, The Warwick Frontiers of Finance Conference, the China International Conference in Finance, the 9th Central Bank Workshop on the Microstructure of Financial Markets, and Market Microstructure: Confronting many Viewpoints Conference in Paris for their helpful suggestions. We also thank NASDAQ OMX for providing the research data. This research is supported by National Science Foundation grant 1352936. This work also uses the Extreme Science and Engineering Discovery Environment (XSEDE), which is supported by National Science Foundation grant number OCI-1053575. We thank Robert Sinkovits and Choi Dongju of the San Diego Supercomputer Center and David O’Neal of the Pittsburgh Supercomputer Center for their assistance with supercomputing, which was made possible through the XSEDE Extended Collaborative Support Service (ECSS) program. We also thank Jiading Gai, Chenzhe Tian, Rukai Lou, Tao Feng, Yingjie Yu, Hao Xu and Chao Zi for their excellent research assistance.