Is small beautiful?

Smaller tick sizes are often seen as a force for good in Europe's equity markets, narrowing spreads and increasing efficiency for buy- and sell-side firms. But could small ticks actually be disadvantaging long-only institutional investors?

Smaller tick sizes have been hailed as positive for all market participants, reducing spreads and helping financial institutions cut costs. But is that justified? 

A mounting body of evidence suggests long-term institutional investors are disadvantaged by a global trend – visible on lit venues across the US, Europe and Asia – towards smaller tick sizes.

A decline in tick size, the minimum price increment for a stock on a trading venue, by definition increases the number of price points at which it is possible to trade. Conventional wisdom holds that shrinking tick sizes is a positive development, because with them come narrower spreads. The difference between the buyer’s bid and the seller’s offer is reduced, so it becomes easier to find a deal close to the desired price. 

However, there is a downside. Smaller tick sizes also fragment the available liquidity. A long-term institutional investor seeking to buy 10,000 shares may find the shares are spread across multiple price points. Trying to gather up liquidity becomes more complicated and time-consuming. Market participants must go deeper into the book to find the liquidity they need, because there are less shares available to buy at any one given price point. The extra complexity involved in filling a large order increases costs for buy-side firms.

What about the argument that small tick sizes tend to narrow spreads and increase liquidity?  

Smaller tick sizes attract high-frequency trading (HFT) firms that profit from arbitraging small price differences between venues, for example. Exchanges around the world have sought to increase their trading volumes by tapping HFT volumes in recent years. 

Yet some observers argue there is no more liquidity in Europe’s equity markets today than there was before MiFID helped bring about lower tick sizes by facilitating competition between trading venues. Instead, they argue, smaller tick sizes simply fragmented liquidity into smaller portions. As tick sizes reduced, so too did average order sizes.

This benefits high-frequency trading firms which do not take long-term positions. Long-only buy-side firms simply face increased complexity and cost when trying to complete their orders.

HFT firms have an added advantage, according to some, because they use co-location technology to minimise the latency between their trading systems and the exchange matching engine. This lets them jump the queue and beat long-only firms to the best offers. But for most asset management firms, the cost of co-location is too high – leaving them unable to compete.

Others claim HFT firms essentially create too much market noise, sending out  – and subsequently cancelling – such high volumes of orders, that it becomes difficult for long-term investors to discern genuine liquidity.

If the lit venues aren’t safe for long-term investors, where can they go?  

While lit venues have sought to invest in co-location and low-latency matching technologies to attract HFT participants, trading figures suggest other market participants are shifting towards trading in the dark. Data provided by Thomson Reuters reveals dark pool trading swelled in Europe during January, with turnover on non-displayed multilateral trading facilities (MTFs) reaching its second-highest total ever.

Dark MTFs – which include NYSE Euronext-owned SmartPool, UBS MTF, Goldman Sachs’ SIGMA X MTF and venues operated by BATS Chi-X Europe and Turquoise – traded €26.81 billion in January, just short of the €27.3 billion traded during the summer peak in August last year. That gave dark MTFs their highest-ever proportion of total equity market activity in Europe – 3.87% for the month of January – suggesting buy-siders may be turning more and more to dark liquidity as a means to avoid predation by HFTs in lit markets.

Noting the fact that many HFT firms avoid trading in the dark because of the absence of pre-trade transparency, one buy-side trader recently told “The last place I want to trade is in the lit market.”

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