Size Matters...

Amongst the many questions posed in the CESR/ESMA MiFID II consultation is this one;
“Is it necessary that minimum tick sizes are prescribed?"

Almost everyone (apparently excluding NYSE Euronext) agreed (at least until two days ago) that a lack of tick-size harmonisation is an unnecessary inefficiency that depresses volumes, creates trading errors and results in significant maintenance costs for venue operators and participants. And consensus seems to be growing that the dangers of restricting order-to-trade ratios or imposing minimum resting times on orders would outweigh any potential (poorly articulated) benefits. So attention is refocusing on tick sizes. And yet getting and keeping a consensus on tick sizes has been difficult, so, perhaps it’s worth revisiting why tick sizes matter so much, and to whom.

What are the pros and cons of small tick sizes?

• Smaller ticks intensify competition amongst market-makers and liquidity providers, and thus attract more liquidity and tighten spreads.
  
  
  
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    Tighter spreads are the most obvious measure of market quality. They reduce transaction costs for marketable orders.
  
  
  • For larger orders, greater depth of liquidity is required to reduce effective and realised spreads – and there has been a strong correlation between tighter bid-ask spreads and increasing depth of liquidity.
  
  
  • More tick granularity improves the efficiency with which statistical arbitrageurs can “port” liquidity from one asset to a related one, resulting in more efficient and more liquid market.
  
  
  • So on the face of it, narrow ticks allow tighter spreads, and tighter spreads improve overall market efficiency.
  
  
• But, with many more price points to choose from, liquidity is naturally distributed across more price points, which has a number of possible implications:




• Liquidity at the touch (and every other individual price point) may be lower, which some have used to support a somewhat disingenuous argument that “liquidity has reduced since MiFID”. This argument is weak, since the “effective spread” or cost to trade any given size of order has declined due to an increase in visible liquidity when all price points are considered.


• This distribution of liquidity, and smaller volume at each tick, might reduce incentives to post larger orders, as they will be more easily discerned by other market participants. So smaller tick sizes can encourage the further slicing & dicing of orders.


• The participation by algorithms and market makers at a greater number of price points subsequently requires more order amendments and cancellations as markets move, driving higher volumes of market data and putting strain on the infrastructure of market operators, data vendors and consumers alike.

• Some argue that tick sizes can be too low (although exactly what constitutes “too low” is a subject of fierce debate):




• Where the tick size is too low, the cost of setting a new best bid/offer is small, and so large orders are more prone to being “stepped ahead of”. This reduces the incentives to display size in the public markets, continuing the trend towards smaller order and trade sizes and more frequent data updates.


• Lower liquidity (shorter queues) at each price point, combined with a number of competing order books for each security, might also dilutes the incentives to leave orders in the market for a period of time so as to reach the front of queue – and without such an incentive orders will tend to have a shorter duration – once again fuelling faster market data update rates.

What about larger tick sizes?

• Larger ticks force a consolidation of liquidity at fewer price points, leading to greater price stability and potentially strengthening the “time” component of “price-time” priority by requiring orders to remain in the book for a while in order to reach the front of the queue. This has the potential to drive greater stability and hence to reduce market data volumes.


• But, and it’s a very big ‘but’, larger ticks reduce the capacity for participants to price improve, and force wider spreads, and thus they:




• Materially increase transaction costs for marketable orders (particularly smaller orders from retail participants or algorithms).


• Exclude some liquidity from the market that cannot afford to cross the spread, and which is unable to gain time priority by setting a new best price.


• Increase incentives for investors to find price-improvement via non-display or OTC trading avenues.


• Increase the potential profits of market makers, creating stronger incentives for firms with a substantial distribution network to internalise client flow rather than route it to public markets.

Who wins with larger ticks?

• Many market makers and day-traders have seen their profits eroded by smaller spreads, and hence typically advocate larger ticks (or at least argue against further reduction). Whilst sustaining the profitability of such participants is unlikely to be regulators’ principal concern, a lack of profitability will lead to a further reduction in liquidity from such participants.


• Smaller brokers (and often investors executing on a DMA basis) struggle to execute amongst the “blur” resulting from smaller tick sizes and hence higher data volumes. Only those with significant IT budgets can invest in Smart Order Routers capable of capturing the visible liquidity spread across many price points and venues. So perhaps many would welcome a re-consolidation of liquidity at fewer price points, even if it moderately increased their transaction costs. And exchanges to whom such members are more important might reach different conclusions about the optimal level for tick sizes.


• Both data vendors and data consumers have been stretched by the climb in the order-to-trade ratio. Might they breathe a sigh of relief if tick sizes were increased?

Who prefers smaller ticks and spreads?

• For retail brokers, tighter spreads translate directly into lower transaction costs.


• Firms with diversified investment portfolios (e.g. index and quant investors) who rely heavily on algorithmic trading should also realise lower transaction costs.


• Electronic market makers and some retail brokers, who prefer “egalitarian” markets in which they can interact with liquidity on a fair and equal basis with banks and brokers, like smaller ticks because they reduce brokers’ appetite and capacity to internalise flow. Reduced internalisation, they argue, results in more natural liquidity reaching the public markets, thereby reducing the potential for adverse selection and encouraging greater limit order liquidity (whether from market makers or investors) into the markets.


• Statistical arbitrageurs, upon whom market participants rely to transfer liquidity and risk across venues and correlated instruments, are negatively impacted by larger ticks and by internalisation, and so hence have a strong preference for smaller tick sizes.


• Any individual venue enjoys a relative advantage if it allows smaller ticks than its competitors, simply because it can publish a tighter BBO, and hence attract order flow from brokers seeking best execution. But, this is tragedy (of the commons) waiting to happen, and can lead to a “race to the bottom” which harms market quality.

Historically, tick sizes were set by exchanges. They sought to balance the needs of different types of market participant. In the UK, the buyside, led by the IMA, consistently lobbied for smaller ticks, with the banks (and market makers in particular) resisting, and the exchange was stuck in the middle. Only as the business migrated towards DMA did this impasse clear, with narrower ticks becoming more widely accepted.

Then the MTFs arrived, and by offering standardised pan-European ticks across their own markets and adopting smaller ticks, we succeeded in attracting new liquidity to our platforms and to the market as a whole. The success of MTFs in attracting this liquidity forced exchanges to follow suit or find that they no longer offered best execution.

After a while, market participants, struggling with inconsistent tick-size regimes across venues, then gave impetus to the discussions that have resulted in today’s “gentleman’s agreement” on harmonised dynamic tick tables for many markets. And somewhere along the way, some on the buyside seem to have switched to the other side of the debate, and now advocate larger ticks.

So what happens next?

• The harmonisation of tick sizes, attractive in principle, requires a compromise between firms with opposing interests. How robust is the consensus that harmonisation should trump individual venue’s ability to tailor their market to their customers needs? NYSE Euronext seem to be challenging the need for a consensus by announcing changes to their own ticks (deviating from the FESE tables) without consulting many market participants or other platforms.


• If we aim to retain harmonised ticks, how do we allow different types of market participant to have an appropriate level of influence in the debate, or should we be looking to put the decisions in the hands of academics or regulators rather than practitioners with vested interests?


• Can the current “gentleman’s agreement” approach involving venues and brokers working be relied upon to keep working, as new MTFs spring up, or in the face of a global exchange group announcing changes (whether considered good or bad) without consultation?


• If ESMA intends to prescribe tick sizes, then how should the terms of reference be set to ensure they reach an appropriate balance between Europe-wide harmonisation and the dynamics of different markets?

Regardless of who makes the decisions, a larger problem is determining whether proposed changes are likely to be beneficial for investors (who should matter more than intermediaries). There are two problems:

1. We have no universally accepted measure for market quality.


2. Because MiFID coincided with the credit crisis, we have no way of disaggregating MiFID’s effects on liquidity and market quality from the effects of the crisis.

Perhaps we can take a leaf out the SEC’s book in the US. When considering changes of this kind, the SEC has a longstanding practice of running short pilot programmes (of a few months), applying the proposed changes to a small but representative sample of securities. This allows the SEC, market participants and academics to gather solid empirical evidence and evaluate the impact of the changes on liquidity and transaction costs relative to a control group of stocks for which no changes were made. I don’t suppose this resolves the arguments or competing interests, but it must surely guarantee a more informed debate.

Or perhaps the dynamic tick tables we use in Europe (whereby the tick size changes intra-day based on the instrument’s price) already provide adequate data for academics to pour over?

This has been, and will continue to be, an imperfect process, and I worry that this week's announcement by NYSE Euronext will harm our ability to maintain a consensus in the future.

Lots of Cooks

IOSCO (the International Organization of Securities Commissions) recently published a Consultation Report titled “Issues Raised by Dark Liquidity”. And the ECON Committee of the European Parliament voted on 9 November to adopt a report intended to influence the MiFID review, with an emphasis on encouraging the use of pre-trade transparent venues. So how similar were the recommendations?

IOSCO’s headline recommendations from its press release were rather mundane, reflecting existing best practice rather than suggesting any radically new ideas. But reading between the lines…

“Principle 3: In those jurisdictions where dark trading is generally permitted, regulators should take steps to support the use of transparent orders rather than dark orders executed on transparent markets or orders submitted into dark pools. Transparent orders should have priority over dark orders at the same price within a trading venue.”

Not too exciting really, given that most exchanges, MTFs, and ECNs already apply price-visibility-time priority. So why state the obvious, and what didn’t they say?

First, the US practice of Flash Orders (which the SEC proposes to ban) probably contravene these guidelines, especially where marketable orders are reflected to preferred liquidity partners (whose liquidity is “dark”) prior to interacting with lit bids or offers in the venue’s book.

Second, the report goes on to emphasise that rather than restrict dark orders per se, regulators should instead “look at ways to incentivize market participants within the regulatory framework to use transparent orders… the key interest is in taking steps to ensure that there are adequate transparent orders in the marketplace.”

• In Europe, MiFID sought to promote transparency by banning most hidden and discretionary orders in lit books. However, rather than encourage the use of transparent order types as anticipated, this tougher stance spawned the creation of discrete dark books (both MTF and broker-operated) which are isolated from the lit orders books. The effect has been to demote transparent books in the order routing hierarchy for certain types of flow.


• If European regulators were to take IOSCO’s recommendations to heart, they might instead consider encouraging more flexible use of dark orders within transparent order books (e.g. relaxing the LIS constraint), so as to encourage participants who want to post dark orders to use these venues. After all, lit books offer far greater certainty of execution, and so would be very attractive for smaller hidden orders.


• Unfortunately, the political tide seems to be flowing in the other direction, with the ECON Committee contemplating whether further restrictions to dark order types and venues would “encourage” liquidity into lit venues. Personally, I doubt that “forcing” such orders to be displayed will produce the desired outcome. Lit markets have evolved, and put simply, they are just too transparent and too efficient for some investors/orders – with prices changing more quickly than ever to reflect slight imbalances between supply and demand. So I worry that further restrictions will drive liquidity out of the markets altogether.

Third, giving transparent orders priority over dark orders within each venue can only be expected to have a beneficial impact if much of the dark liquidity is in venues that also have transparent orders. With most of the dark liquidity residing in discrete dark MTFs or BCNs, this prescription lacks impact. Both the SEC and Canadian IIROC have considered going further, giving transparent orders priority vs. dark orders at the same price across markets, e.g. by requiring that dark pool executions always offer both participants material price improvement (e.g. at least one tick) vs. the best available lit price for equivalent size.

Turning to the ECON Committee report, it’s clear that it is a product of negotiation & compromise, and an attempt to square the many competing vested interests. The general thrust is that since MiFID introduced competition, the pace of innovation has outstripped the ability of regulators to keep up, and also that competition has produced some unexpected or unwelcome outcomes (including the emergence of non-display MTFs and broker crossing networks). The final report avoids some of the more over-protective prescriptions that had been in circulation previously, and which would have harmed market quality, for which the committee should be commended. But even in this compromise document, there were a few recitals/recommendations that caught my eye:

• “Whereas market fragmentation in equities trading has had an undesired impact upon liquidity and market efficiency…”
  I think a more positive view of MiFID is warranted, because although many participants are still adjusting to the new landscape, spreads and liquidity depth are demonstrably superior in stocks that are subject to competitive trading (thankfully Spain’s failure to implement MiFID properly creates a useful control group), and given that trading tariffs are some 90% lower than they were pre-MiFID.


• “Asks for an investigation by the Commission into the effects of setting a minimum order size for all dark transactions, and if it could be rigorously enforced so as to maintain adequate flow of trade through the lit venues in the interests of price discovery;”
  The target here is both MTF/Exchange dark pools and broker crossing networks. But what’s missing is any discussion as to what is meant by “adequate”. Certainly, there is no sign that price formation has been in any way weakened thus far, and economic theory suggests that price formation is much more robust than regulators/politicians are giving credit for. Personally, I have more sympathy for the SEC’s emphasis on “avoiding a two tier market” as a rationale for ensuring the pre-eminence of venues with non-discriminatory access. Again, I believe it would be better for market efficiency and liquidity if regulators allowed small dark transactions to be handled by lit venues, rather than see them ban such order types altogether.


• “Suggests ESMA conduct a study of the maker/taker fee model to determine whether any recipient of the more favourable "maker" fee structure should also be subject to formal market maker obligations and supervision;”
  To me, this suggests a limited understanding of the topic and of market structure. Firstly, MTFs treat all members equally – and hence all MTF members (basically every major bank or brokerage house in Europe) are receiving the “maker” rebates for a proportion of their business. Secondly, and related to the point of equal treatment, most European markets no longer have a concept of market makers with particular privileges and obligations for liquid stocks. And thirdly, some MTFs pay rebates for passive liquidity, whilst others pay rebates for aggressive flow, making receipt of rebates a poor basis to define “market making”.


• “Requests that no unregulated market participant be able to gain direct or unfiltered sponsored access to formal trading venues and that significant market participants trading on their own account be required to register with the regulator…”
  Many proprietary trading firms have been told by their domestic competent authorities that their activities are not subject to regulation, so this would be a significant change.


• “Calls for an investigation into whether to regulate firms that pursue HFT strategies to ensure that they have robust systems and controls… and the ability to demonstrate that they have strong management procedures in place for abnormal events”
  Clearly, HFT firms are risk management specialists (people trading with their own money and seeking to capture low-alpha opportunities have a healthy appreciation for risk), and faced with failings of market infrastructure/regulation during the US flash crash, they behaved appropriately by stopping trading. Perhaps regulators would have preferred them to “stand in front of the train”, and keep buying the face of a tsunami of sell orders – but that would simply convert a brief liquidity shock (albeit with nasty implications for consumer confidence in the integrity of markets) into a more serious systematic-risk issue that could have bankrupt firms and/or their clearing brokers.


• “Asks for an investigation into OTC trading of equities and calls for improvements to the way in which OTC trading is regulated with a view to ensuring the use of RMs and MTFs in the execution of orders on a multilateral basis and of SIs in the execution of orders on a bilateral basis increases, and that the proportion of equities trading carried out OTC declines substantially”
  This is actually one of several recitals explicitly calling for a reduction OTC trading in favour of transparent exchanges and MTFs. Still, the suggestion that “improvements to the way in which OTC trading is regulated” should lead to less OTC trading seems somewhat odd.

Even though some of the Committee’s recommendations might benefit MTFs such as Turquoise at the expense of OTC, I’m troubled by assertions/conclusions that contradict the empirical evidence and by the emphasis on “protecting” lit markets by restricting innovation and investor/intermediary choice, rather than by allowing them the flexibility to compete.

Hopefully CESR/ESMA will find a way to address the Committee’s concerns whilst recognising that MiFID is actually working, and that much of the anxiety over fragmentation and “opacity” can be attributed to growing pains that will subside as participants become accustomed to the new market structure.

As for unintended consequences, I’m willing to bet that these efforts to drive trading towards transparent venues will lead to a further proliferation of non-display MTFs. Any takers?