Streetwise Professor

May 4, 2007

Ticked Off

Filed under: Derivatives,Exchanges — The Professor @ 10:06 am

In FI magazine, Galen Burghardt makes a good point:

This may be a good time to reflect on the influence that the electronic revolution has had on the costs of trading, and consider asking the exchanges to make drastic reductions in their minimum tick sizes. Now that the locals have been taken out of the equation of exchange decision-making, all major stakeholders— traders, hedgers, exchange shareholders, and brokers—would stand to gain enormously from such reductions. It would be a win/win/win situation.

It is indeed something of a puzzle that demutalized exchanges have not reduced tick size. As I have noted before, the demand for exchange services is a derived demand. The higher the price/cost of complementary services, such as liquidity supply, the lower the demand curve for exchange services–and hence the lower the fee that the exchange can charge. By reducing tick size, an exchange will reduce the price that liquidity suppliers charge; if the tick size is currently binding, the marginal cost of liquidity provision equals the tick size, and competition between potential liquidity suppliers dissipates any profit they could earn by resulting in queuing of orders and a commensurately lower probability of execution of a limit order. By reducing the tick size, the exchange reduces the marginal cost of liquidity, and raises the derived demand for its services. It can profit from this by raising its fee.

Thus, it is not quite the win-win-win Burghardt suggests; any decline in liquidity costs that results from a reduction in tick size will be offset in part by an increase in exchange fees. There is also a cost issue–lower tick size is likely to lead to more message traffic as more orders are entered and canceled. So exchanges will have to bulk up capacity to deal with a lowered tick.

Given the pressure on exchanges to generate earnings, it is surprising that they have not been more aggressive in exploiting this strategy. Perhaps the penny tick experiment in equity options will convince futures exchanges to take the plunge and reduce tick size. Message traffic has not overwhelmed the options exchanges, and the penny experiment seems to be generating a big uptick (no pun intended) in volume.

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