Tick Size Constraints, High-Frequency Trading, and Liquidity

Yong Chao, University of Louisville - College of Business - Department of Economics, Chen Yao, University of Warwick, and Mao Ye, University of Illinois at Urbana-Champaign discuss Tick Size Constraints, High-Frequency Trading, and Liquidity.

ABSTRACT: U.S. exchange operators compete for order flow by setting “make” fees for limit orders and “take” fees for market orders. When traders can quote continuous prices, fee breakdown is neutral and exchanges compete on the total fee. The one-cent minimum tick size constraints prevent perfect neutralization and create a role for exchanges to differentiate otherwise-identical trading platforms through their fee breakdowns. This product differentiation creates an incentive for an operator to establish multiple platforms for second-degree price discrimination, and leads to mixed-strategy equilibria with positive profits for competing operators. Fees can improve social welfare in the presence of tick-size constraints.