Market Microstructure in Emerging and Developed Markets

CHAPTER 11

Decimalization and Discreteness

BRITTANY COLE

PhD Student, University of Mississippi

BONNIE VAN NESS

Department Chair and Professor of Finance, University of Mississippi

INTRODUCTION

Most financial markets have rules that formally or informally state the minimum price variation for quoting and trading assets in that market. Minimum price variations, also known as tick sizes, require assets to be traded in discrete price sets. For example, an asset with a minimum price variation, or tick size, of $1.00 might be quoted at a $10.00 bid and $11.00 ask. If the minimum tick size is reduced to $0.25, then traders in the market have more price points they can quote: $10.25, $10.50, and $10.75. In other words, the set of discrete price possibilities expands. According to Anshuman and Kalay (1998), discrete prices drive a wedge between the asset's equilibrium price and its observed price. Larger pricing increments have both proponents and opponents. A coarser pricing grid (i.e., fewer possible prices) increases incentives for market makers and limit order traders and reduces both the time needed to negotiate (Harris 1991) and the information that traders need to track (Angel 1997). These benefits of larger minimum tick sizes are offset by the higher transactions costs in the form of larger bid-ask spreads incurred by investors.

A widely held belief is that the one-eighth tick size used by U.S. equity markets until 1997 evolved from the Spanish trading system, where prices were ...