Increasing the Tick: Examining the Impact of the Tick Size Change on Maker‐Taker and Taker‐Maker Market Models

• Author: Robert Ness,Justin Cox,Bonnie Ness
• DOI: http://doi.org/10.1111/fire.12187
• Published date: 01 August 2019
• Date: 01 August 2019

The Financial Review 54 (2019) 417–449

Increasing the Tick: Examining the Impact

of the Tick Size Change on Maker-Taker

and Taker-Maker Market Models

Justin Cox, Bonnie Van Ness, and Robert Van Ness∗

University of Mississippi

Abstract

We investigate the effects of an increase in tick size on order and trading flow across

market fee models. Using the pilot firms in the U.S. Securities and Exchange Commission’s

Tick Size Pilot Program, we document that trade and order volume declines on maker-takerfee

models after the tick size implementation. We find that the inverted fee models (taker-maker)

experience an increase in both trade and order volume. Additionally, we find that a tick size

adjustment has a substantial influence on market participation in maker-taker fee models. We

also find that measures of both hidden and algorithmic trading decline with an increasing tick

size, which is strongly moderated by the differences in the maker-taker and taker-maker fee

models.

Keywords: tick size, maker-taker, algorithmic trading, hidden liquidity

JEL Classifications: G10, G12, G14, G18, L1

1. Introduction

On May 6, 2015, the U.S. Securities and Exchange Commission (SEC) issued

an order approving the National Market System (NMS) Plan to implement a Tick

∗Corresponding author: 329 Holman Hall, Universityof Mississippi, University, MS 38677; Phone: (662)

915-6940; Fax (662) 915-7968; E-mail: rvanness@bus.olemiss.edu.

C2019 The Eastern Finance Association 417

418 J. Cox et al./The Financial Review 54 (2019) 417–449

Size Pilot Program under the direction of both the National Securities Exchange and

Financial Industry Regulatory Authority (FINRA). The major function of the Tick

Size Pilot is to increase the tick size for smaller capitalized securities with hopes of

increasing trading, liquidity, and overall market quality in thesesecurities. While not

central to the Tick Size Pilot’s focus, we use the tick size change to examine recent

theoretical predictions that suggest changing the tick size increment might influence

trading activity across markets with different fee models.1Dating back to the turn

of the century, market fee models incentivizing liquidity providers via rebates (i.e.,

maker-taker) have become commonplace for many U.S. stock markets.2Recently,

an inverted fee model, the taker-maker fee model, is being used by three U.S. stock

markets. This fee model allows for rebates to accrue to liquidity demanders. To the

extent that changes in the tick size influences the decision to supply or demand

liquidity, trading activity across market fee models may be influenced.

Extant literature suggests that the tick size increment plays a prominent role in

determining the level of undisplayed or hidden orders. Specifically, in cases where

the tick size acts as a binding constraint—when the bid-ask spread equals the tick

size—a change in the tick size can impact not only transaction costs and trading

volume (Harris, 1991, 1994) but also order exposure (Harris, 1996, 1997).3Studying

the Tick Size Pilot Program allows us to answer questions pertaining to the relation

between tick sizes and order exposure, not only in the aggregate market but also

across different market fee models, such as maker-taker and taker-maker,which cater

to different clienteles. The taker-maker inverted fee model allows traders to pay a

fee to provide liquidity while takers of liquidity (i.e., liquidity demanders) earn a

rebate. This fee model appeals to traders because it allows them to undercut prices

and bypass the queue via paying the venue fee.

The inverted fee model (i.e., taker-maker) provides incentives for brokers to

route orders to taker-maker models despite another exchange offering the same price.

As Angel, Harris and Spatt (2015) document, the taker-maker model effectively

attenuates the presence of a minimum tick size since it allows a limit order trader to

bypass an existing quote by simply paying an access fee rather than the full tick. Thus,

taker-maker pricing allows dealers and traders a path to bypass limit order queues.

Angel, Harris and Spatt (2015) suggest that the SEC prohibit both fee models or, to a

lesser extent, allow clients, not brokers, to have direct access to all fees and rebates.

They also suggest that due to the fragmented markets that exist today, increasing the

1Foucault, Kadan and Kandel (2013) posit that a change in the tick size impacts annualized revenue

between optimal and uniform pricing policy. They further conclude that a coarser price grid is preferred

by maker-taker fee model platforms.

2See page 4 of https://www.sec.gov/spotlight/emsac/memo-maker-taker-fees-on-equities-feevenues.pdf

3Harris (1994, 1996, 1997) argues that changes in the minimum price variation influence the level of

displayed orders. Aitken, Berkman and Mak (2001) show that traders are more likely to hide their orders

when the tick size is small. Cebiroglu, Hautsch and Horst (2014) provide a theoretical argument that tick

sizes that are too large on a relative basis can preventlatent traders from trading publicly.

J. Cox et al./The Financial Review 54 (2019) 417–449 419

tick size will incentivize dealers and proprietary traders to engage in quote-matching

practices that allow traders to undercut current limit orders. Likewise,Buti, Consonni,

Rindi, Wen and Werner (2015) argue a wider tick increases the presence of queue-

jumping activity to gain priority of resting limit orders. Thus, to the extent we findthat

increasing the tick size increases the presence of taker-maker activity,one unintended

consequence is that quote-matching could increase.

One argument in support of an increase in the tick size is to reduce fast (non-

human) traders, thereby favoring human traders (Weild, Kim and Newport, 2012).

Several studies suggest that the relative tick size influences the level of nonhuman

or algorithmic trading. For example, Ye and Yao (2014) argue that a larger tick size

hinders price competition and increases the role of time priority, in which traders

with speed benefit. Likewise, O’Hara, Saar and Zhong (2015) posit and find that a

larger relative tick size allowshigh-frequency market makers to become more aggres-

sive, undercutting resting limit orders. Further, Foucault, Kadan and Kandel (2013)

suggest that the trading frequency on market fee models may influence the level of

algorithmic trading, indicating a positive relation between overall trading activity

and algorithmic trading. We add to these recent studies by analyzing the effects of an

increase in the minimum tick size on the level of algorithmic trading. Specifically,

we identify if measures of algorithmic trading change across market fee models,

maker-taker and taker-maker, using algorithmic trading proxies outlined by Weller

(2017).4

We also analyze changes in hidden liquidity around the tick size change. One

component of the Tick Size Pilot is that it contains a “trade-at prohibition.” The

“trade-at prohibition” is aimed at curbing the level of price matching by trading

centers that are not already offering or displaying a quote at the best price—a practice

that is often associated with off-exchange trading centers or “dark” pools. Comerton-

Forde, Gregoire and Zhong (2017) provide corroborating evidence that dark trading

activity changes for the pilot firms subject to the “trade-at prohibition.” Weexamine

the relation between the larger tick size and hidden trading activity as hidden and dark

trading are not exact substitutes (see Degryse, Tombeur and Wuyts, 2015). Hidden

trading refers to the trading practice of using hidden limit orders in the lit venue limit

order book, while dark trading refers to off-exchange trading where private forums

offer market participants pre-trade transparency. For instance, a change in the tick

size may result in varying levels of hidden and dark trading activity as a wider tick

size on a lit venue (i.e., quoting exchange) may incentivize traders to transact in

the dark venue since dark venues offer more price improvement than the lit venue.

On the other hand, a wider tick size may reduce the level of hidden liquidity since

4Ye and Yao (2014) provide a full discussion as to the level of high-frequency trading across market

fee models. They argue that increasing the relative tick size favors high-frequency traders (HFTs) since

it eliminates the non-HFTs’ advantage to undercut HFTs because of their ability to quote better prices.

However, Ye and Yao suggest that non-HFTs will migrate toward taker-maker venuesto bypass tick size

constraints primarily to avoid undercutting HFTs.