There is an optimal tick size, and regulators should enforce it. That is the conclusion of a report by broker CA Cheuvreux, 'Navigating Liquidity 6 – a global menu for optimal trading'.
Tick size is the minimal increment between the prices of two limit price orders. In the US, the tick size applies to all stocks. In the UK, it depends on the price range and the quotation group that the stock belongs to – a system called tick size regime on the basis that it is intended to group stocks according to their liquidity.
The optimal tick size depends on the liquidity of a stock, with higher tick sizes for less liquid stocks – its price, with higher tick sizes at higher prices, and its volatility, which is matched by higher tick sizes as it increases.
The report criticises the US model, on the basis that it is in effect a “one size fits none” policy that puts a strong constraint on stocks priced below US$10 and leaves stocks priced above US$200 with “nearly empty order books that have less meaningful quotes”. CA Cheuvreux suggests that US firms aware of the impact of tick size on trading are essentially forced to use splits or reverse splits to reach a satisfactory tick size, but that other complications such as trading fees based on the number of shares exchanged, often make the choice more difficult.
Europe fares little better, according to the research, which castigates the ‘gentlemen’s agreement’ that fixed Europe’s tick sizes in 2009 for preventing markets making any changes in tick size in search of greater efficiency. That agreement followed a tick size war between Europe’s exchanges, which, barring a brief but unsuccessful attempt by NYSE Euronext, has resulted in an uneasy return to the status quo ever since.
“Our hope is that the regulator decides to enforce rules on the subject and does not leave it to market forces,” states the CA Cheuvreux research. It also insists that the tick size should not be set as low as possible, since a larger gap between tick sizes helps concentrate liquidity and creates market depth.