Agency broker CA Cheuvreux has called on European regulators to mandate rules on tick sizes, claiming that the current regime is too favourable towards high-frequency trading and reduces certainty of execution for more long-term investors.
The broker's latest bi-annual European equity liquidity report, ”Navigating Liquidity 5', analyses the impact of the current tick size system on price formation and high-frequency trading (HFT) and proposes an alternative series of tick size tables. Tick size are the increments by which a stock price can move up or down on a trading venue. The European Commission launched a consultation for reviewing MiFID in December 2010, but it has not proposed a unified tick size regime for European stocks. The consultation phase is due to end on 2 February 2011.
Currently, exchanges and multilateral trading facilities (MTF) can use tick sizes as they see fit, although most have agreed to use one of four tables suggested by trade body the Federation of European Securities Exchange (FESE). Borsa Italiana has recently proposed its own individual tick size table.
But Charles-Albert Lehalle, head of quantitative research, CA Cheuvreux and co-author of the report, believes the tick sizes tables suggested by FESE to favour the trading strategies employed by HFT.
“When you have thin tick sizes, traders can move ahead of other orders very easily by cancelling their order and re-entering it one tick away from the last traded price. You will basically be paying a premium to jump the queue,” Lehalle told theTRADEnews.com. “If the tick size is too thin, this premium is negligible and will encourage a change to price-led execution tactics, from traditional queue-orientated trading.”
If markets are too price-led, traditional buy-side traders, who do not constantly amend or cancel their orders, can find they struggle to get executed against because they are always stuck behind high-frequency traders.
According to the study, the optimal tick size is dependent on the individual characteristics of each stock including volatility profile and market depth.
ESMA's role
In Lehalle's view, the European Securities and Markets Authority (ESMA), the pan-European regulatory body that superseded the Committee of European Securities Regulators at the start of this year, should be given control to dynamically adjust tick sizes, in part to monitor and manage HFT flow.
“We found that smaller tick sizes allow high-frequency traders to move their liquidity around cheaply and create a blurring of the order book. High-frequency strategies are necessary for building ”liquidity bridges' in a fragmented trading environment, but we are concerned that this advantage is negated for long-term investors by the costs of doing business with HFTs,” said Lehalle.
As well as upfront trading costs, he also argues that increased trading activity generated by HFT firms requires all market participants to spend money on new technology to store and process large amounts of data that are not necessarily informative.
In its MiFID consultation paper, the EC proposes options for controlling HFT, including a separate category for firms that conduct HFT as part of an effort to better define automated trading, liquidity provision obligations for electronic market makers – such as a minimum quoting period – and fair access to co-location.
But Lehalle suggests that regulators should look to a solution that can be tuned to suit market evolution.
“Tick size is a perfect tool for this,” he explains. “Regulators can use trial and error to experiment with tick sizes and control the frequency of order book changes.”
For instance, if the level of HFT were to diminish in the future, ESMA could increase the tick size to favour long-only institutions. Conversely, if a stock would benefit from the liquidity provided by some HFT strategies, its tick size could be narrowed.
A smoother ride
In the report, Cheuvreux also suggests a series of tick size tables that are designed to smooth the transition for stocks that may move between tick sizes intraday. For example, under the current FESE table two –used by most MTFs – a stock movement from €10 to €10.01 will automatically result in a tick size change from €0.005 to €0.01. Cheuvreux's proposals are designed to limit such steep changes, partly by narrowing the tick size bands.
The issue of tick size has already caused some tension between trading venues. In June 2009, MTFs BATS Europe and Turquoise implemented finer tick sizes for a selection of UK and Italian stocks than were offered on their domestic markets. While the MTFs claimed that finer tick sizes would result in reduced price volatility and less chance of price slippage when trading against a VWAP benchmark, others argued that the change would thin out liquidity across more price points. Furthermore, some viewed the MTFs' move as a way of building up market share by attracting flow from smart order routers that would automatically choose the slightly better price offered by the smaller price increments on MTFs. Shortly after the dispute exchanges and MTFs agreed to harmonise tick sizes based on the FESE tables.