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 Justin McCrary UC Berkeley School of Law UC Berkeley School of Law for internal use only 1
Motivation 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): April 2010 Request for SEC Rule- Section 106 of the Jumpstart Our making by BATS Exchange, Inc., Business and Start-ups Act of 2012 + NASDAQ OMX Group, Inc., and SEC Advisory Committee on Small and NYSE Euronext, Inc Emerging Businesses (2013) • Concern: Displayed quote is • Concern: Transition from fractional “artificially wide” for certain lower to penny-based pricing of securities VS priced, liquid securities, causing a in 2000 destroyed the profitability of detrimental impact to the public market-making, harming market price discovery process. support for smaller issuers. • Recommendation: Permit quoting • Recommendation: Increase the in ½ cent ($0.005) increments for minimum price variation (MPV) from securities trading between $1.00 $0.01 to $0.05 or even $0.1 for and $20.00 per share. securities having low liquidity. for internal use only 2
Background on U.S. Equity Trading Environment Investor NBBO NYSE Bid: 1,000 @$10 Ask: 1,000 @ $10 1/8 Boston Stock Bid: 1,000 @$9 1/2 Ask: 1,000 @ $10 1/2 Exchange Bid: 1,000 @$9 7/8 Sell 1,000 Ask: 1,000 @ $10 3/8 shares of ABC American Stock Exchange Bid: 1,000 @$9 7/8 Ask: 1,000 @ $10 3/8 Broker Cincinnati Stock Buy 1,000 Exchange shares of ABC Bid: 1,000 @$10 Ask: 1,000 @ $10 1/8 Direct Edge Nasdaq Bid: 1,000 @$9 3/8 Bid: 1,000 @$9 7/8 Ask: 1,000 @ $10 1/2 Ask: 1,000 @ $10 3/8 for internal use only Investor 3 Liquidity Providers
Background on U.S. Equity Trading Environment NBBO NYSE Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 Boston Stock Bid: 1,000 @$9.55 Ask: 1,000 @ $10.5 Exchange Bid: 1,000 @$9.8 Sell 1,000 Ask: 1,000 @ $10.4 $$ shares of ABC Internalizer/Dark Pool American Stock (Citadel, Knight Capital) Exchange Buys 1,000 @$10.0899 Bid: 1,000 @$9.82 Sell 1,000 @ $10.0501 Ask: 1,000 @ $10.42 Cincinnati Stock Buy 1,000 Exchange shares of ABC Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 Direct Edge Nasdaq Bid: 1,000 @$9.90 Bid: 1,000 @$9.90 Ask: 1,000 @ $10.46 Ask: 1,000 @ $10.45 for internal use only 4 Liquidity Providers
Background on U.S. Equity Trading Environment NBBO NYSE Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 Boston Stock Bid: 1,000 @$9.55 Ask: 1,000 @ $10.5 Exchange Bid: 1,000 @$9.8 Sell 1,000 Ask: 1,000 @ $10.4 $$ shares of ABC Internalizer/Dark Pool American Stock (Citadel, Knight Capital) Exchange Bid: 1,000 @$9.82 Ask: 1,000 @ $10.42 Pays access fee Cincinnati Stock Buy 1,000 Exchange shares of ABC Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 Direct Edge Nasdaq Rebate $$ Bid: 1,000 @$9.90 Bid: 1,000 @$9.90 Ask: 1,000 @ $10.46 Ask: 1,000 @ $10.45 for internal use only 5 Liquidity Providers
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 for internal use only 6
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 $1.00 $.99 $1.01 for internal use only Stock Price Per Share 7
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 Trading interest at $1.00 at $1.01 Trading Trading interest Interest at $.99 Penny Price $1.00 $.99 $1.01 Increment for internal use only Stock Price Per Share 8
Data 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 for internal use only 9
Sample Firms vs. CRSP Firms Table 2: Sample Description and Sample Selection Comparison for internal use only 10
Sample Firms vs. CRSP Firms Table 2: Sample Description and Sample Selection Comparison for internal use only 11
Examination of Treatment Effect: Incidence of Subpenny Orders Above & Below $1.00/Share Figure 1(a): Incidence of Sub-Penny Bids in 2011 National Best Bids Priced Less Than $2.00/share Average Subpenny Rate .8 Fit, -.208 (.034) % of Orders Made in Sub-Pennies .6 .4 .2 0 0 .5 1 1.5 2 Two-Decimal Bid Price ($) for internal use only 12
Examination of Treatment Effect: Incidence of Subpenny Orders Above & Below $1.00/Share Figure 1(b): Incidence of Sub-Penny Offers in 2011 National Best Offers Priced Less Than $2.00/share 1 Average Subpenny Rate Fit, -.219 (.05) % of Orders Made in Sub-Pennies .8 .6 .4 .2 0 0 .5 1 1.5 2 Two-Decimal Offer Price ($) for internal use only 13
2011 Trading of Sample Securities by Venue: for internal use only 14
Incidence of FINRA/TRF Trades Above & Below $1.00/Share Figure 3(a): Incidence of FINRA-Reported Trades in 2011 As a Function of Two-Decimal Trade Price .4 Percent of All Trades in 2011 Fit, .08 (.008) Percent of All Reported Trades .3 .2 .1 0 0 .5 1 1.5 2 Two-Decimal Trade Price ($) for internal use only 15
2011 Trading Volume Above & Below $1.00/Share Figure 3(b): 2011 Trading Volume As a Function of Two-Decimal Trade Price 150000 Total 2011 Volume at Price Point Fit, 9602.655000000001 (3452.51) Millions of Shares Traded 100000 50000 0 0 .5 1 1.5 2 Two-Decimal Trade Price ($) for internal use only 16
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 for internal use only 17
Rate of Updating of Exchanges’ Best Bid/Ask: Average Above & Below $1.00/Share Figure 4: BBO Updates Per Second As a Function of Two-Decimal Ask Price .8 Average Rate of BBO Updates Fit, -.241 (.047) BBO Updates Per Second .6 .4 .2 0 0 .5 1 1.5 2 Two-Decimal Ask Price ($) for internal use only 18
Rate of Updating of Exchanges’ Best Bid/Ask: Incidence of Strategic Runs Figure 5(a): Incidence of Security-Seconds Figure 5(b): Incidence of Security-Seconds Having At Least One BBO Update Having At Least Fifty BBO Updates .003 .1 Average Incidence of Security-Seconds with > 1 Update Average Incidence of Security-Seconds with > 50 Updates Fit, -.006 (.006) Fit, -.001 (0) Fraction of Security-Seconds Fraction of Security-Seconds .08 .002 .06 .001 .04 .02 0 0 .5 1 1.5 2 0 .5 1 1.5 2 Two-Decimal Ask Price ($) Two-Decimal Ask Price ($) for internal use only 19
Quoted Spreads Above & Below $1.00/Share Figure 6: Quoted Spreads At the $1.00 Cut-off .1 Average spread as % of quote mid-point Fit, .011 (.003) Spread as a % of Quote Mid-Point .08 .06 .04 .02 0 .5 1 1.5 2 Two-Decimal Bid Price ($) for internal use only 20
Inside Depth Above & Below $1.00/Share Figure 7(a): Quoted Bid Depth At the $1.00 Cut-off Figure 7(b): Quoted Ask Depth At the $1.00 Cut-off 300 400 Average quoted bid depth Average quoted ask depth Fit, 126.957 (16.387) Fit, 73.961 (17.31) 300 200 Quoted Ask Depth Quoted Bid Depth 200 100 100 0 0 0 .5 1 1.5 2 0 .5 1 1.5 2 Two-Decimal Bid Price ($) Two-Decimal Ask Price ($) for internal use only 21
Robustness Check: Maker/Taker Fees at $1.00 NBBO Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 Route to NBBO vs. Internalize? Sell 1,000 What if access $$ ABC fees for subdollar Internalizer/Dark Pool stocks decline (Citadel, Knight Capital below the $1.00 cut-off? Pays access fee? Cincinnati Stock Buy 1,000 Exchange ABC Bid: 1,000 @$10.05 Ask: 1,000 @ $10.09 for internal use only 22
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 for internal use only see an uptick in subdollar trading? 23
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