Europe’s tick sizes are haphazard and inconsistently applied, according to some observers, leading to inefficient markets and irrational distribution of liquidity. Is regulatory intervention the answer?
The ancient Chinese concept of yin and yang – two polar opposites, each connected to and unable to exist without the other – stands as an enduring symbol of the importance of balance in life. Too much of either alone would be ruinous for all concerned – instead, the ideal situation is a healthy equilibrium.
Some would argue that this is the situation that has been reached by exchanges and trading venues in Europe. As competition between national exchanges and multilateral trading facilities ramped up post-MiFID, focused in part on attracting trading volumes from new high-frequency trading (HFT) firms, a tick size war looked like it would prompt a headlong flight to the bottom. But in 2009 a gentlemen’s agreement between trading venues stabilised the region’s tick sizes on a standard set by the Federation of European Securities Exchanges (FESE).
Does the current system really represent a healthy equilibrium? Or has the gentlemen’s agreement fossilised Europe’s tick sizes?
Supporters of the status quo argue that the FESE agreement represents collaboration and consensus across Europe's market operators and participants. This, they say, is preferable to a free-for-all in which each venue is able to set its own tick size independently.
For example, in February 2011, NYSE Euronext decided to unilaterally reduce tick sizes by using only the first two bands of FESE’s table four for blue-chip stocks traded on its Paris and Amsterdam exchanges – a move that immediately caused uproar among Europe’s other trading platforms. The exchange agreed to back down shortly afterwards, returning to the status quo.
Some observers suggest that absolute freedom of choice would allow exchanges and trading venues to seek out the optimum tick size, increasing efficiency. But others counter that individual market operators should not be permitted to set tick sizes, because the prospect of gaining advantage over rivals will always spur them to compete using every means at their disposal – regardless of the best interests of the market as a whole.
Even the existing choice of four tick sizes set out by FESE is too flexible for some, too rigid for others. From one perspective, the current regime is applied inconsistently across venues, does not cover all stocks, and is not applied at all to exchange-traded funds.
NYSE Euronext, for example, opted to apply FESE tick size table four across the majority of its stocks. By contrast, the SIX Swiss Exchange uses tick size table two, which is several times wider.
This can result in inconsistencies such as large-cap Swiss stocks like Nestlé rising and falling in price increments larger than a typical mid-cap French stock.
Other detractors of the current FESE-brokered tick size regime suggest that Europe's relatively low tick sizes attract a high proportion of HFT activity, which can create market noise that makes it harder for institutional investors to discern real liquidity. It is sometimes argued that narrower tick sizes make it harder for buy-side firms to find large blocks of shares. The extra cost of trading technology and market required to overcome the resulting liquidity fragmentation erodes the potential to realise cost savings for all market participants by narrowing spreads, the argument runs.
So what’s the solution?
Some observers suggest that the solution is regulatory intervention. Europe’s regulators should simply set a fixed tick size regime that covers all stocks consistently, in consultation with market participants, and update it twice a year. Such a solution might help moderate the participation of HFT firms in the European market, according to CA Cheuvreux, by raising the tick size significantly. This would benefit long-term investors, while reducing the technology costs associated with finer tick sizes, they argue.
However, there is no consensus that regulatory intervention is needed. Other market participants insist that there is no need for regulators to get involved in tick sizes at all. Some fear that a fixed regime would reduce the potential for end-investors to benefit from the competition between trading venues brought in by MiFID. Collectively, market participants and operators are better placed than regulators how best to manage Europe's tick sizes, they suggest.
So where does that leave us? In ancient Chinese philosophy, yang represents logic, while yin represents intuition. Advocates of regulation such as CA Cheuvreux and advocates of unilateral action such as NYSE Euronext sit at the opposite ends of a spectrum. If the balance between a prescriptive regulatory approach and total freedom of action is a gentlemen’s agreement of exchanges and trading venues, then perhaps we are not so very far from equilibrium after all.
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