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Low-priced shares are the greatest beneficiary.
On June 5, 1997, the New York Stock Exchange voted to adopt a system of decimal price trading, changing its longstanding practice of using eighths. While the decimal system does not go into place until the turn of the century, the NYSE began trading stocks in sixteenths, so-called teenies, as an intermediate step on June 24, 1997. The move to reduce the tick size was prompted by competition from Nasdaq, the American Stock Exchange, and the regional exchanges, and by a threat of congressional action to force the issue. The NYSE's move to a smaller tick size offers a rare opportunity to evaluate empirically competing arguments regarding an "optimal tick size." The arguments in favor of a larger, "significant," tick are threefold.
First, significant ticks may encourage market liquidity. The larger the tick size, the greater the minimum quoted bid/ask spread.l If the tick size is binding, then a larger tick size will generate more market maker revenue, thereby increasing the number of individuals willing to engage in market-making and providing the market with enhanced liquidity.
The strength of this argument depends on the extent to which the tick size is a binding constraint on the bid/ask spread. Just because spreads can be reduced to as little as the tick size does not mean they have to be. The London Stock Exchange, for example, has no minimum tick size, and quoted bid/ask spreads are typically five pence or greater.
Second, significant ticks reduce bargaining costs.
A larger tick size reduces the number of possible prices at which to trade, thereby reducing bargaining costs and increasing operational efficiency.2 Third, significant ticks provide stronger priority rules in the order book. If a tick is too low, some investors may offer marginally better prices, thereby gaining priority and discouraging other investors from placing limit orders.3
The primary argument in favor of a smaller tick size is that smaller ticks may encourage market liquidity. Presumably investors are interested in after-transaction cost returns. If the current tick size is binding, a lower tick size will mean lower trading costs, thereby encouraging existing investors to trade more frequently or encouraging new investors to begin trading.
The debate over whether there is an optimal tick...