Shall We Haggle in Pennies at the Speed of Light or in Nickels in the Dark? How Minimum Price Variation Regulates High Frequency Trading and Dark Liquidity

We demonstrate empirically how recent proposals to modify the penny-based system of stock trading may have simultaneous and opposite effects on the incidence of high frequency trading (HFT) and the trading of undisplayed (or “dark”) liquidity. We do so by exploiting the fact that the existing ban on sub-penny quotations (Rule 612 of Regulation NMS) only applies to equity orders (bids or asks) priced at or above $1.00 per share, thus creating a sharp distinction in tick size regulation between those orders that are just above $1.00 and those just below it. Using a regression discontinuity design, we find that permitting subpenny orders for stocks priced below $1.00 per share is associated with a sharp increase in the incidence of HFT and a sharp decrease in the trading of undisplayed liquidity (i.e., dark pools and broker internalization). Changes in market quality are mixed, with both quoted spreads and depths declining significantly for stocks priced just below the $1.00 cut-off. Our findings are robust to changes in stock exchange fee structures at the $1.00 cut-off, although maker/taker fee structures are shown to impair market quality both above and below this price point in certain contexts. These results are strongly suggestive that recent proposals by major U.S. stock exchanges to permit subpenny orders for stocks priced above $1.00 per share may result in greater HFT without necessarily changing the costs of trade execution. Conversely, Congress’ mandate in Section 106(b) of the JOBS Act for the SEC to investigate increasing tick sizes for emerging growth companies can be expected to erode further the amount of trading that occurs on conventional stock exchanges while potentially reducing the incidence of HFT. Lastly, our findings indicate that any reform to either increase or decrease tick sizes should be accompanied by limitations on exchanges’ maker/taker fees to minimize the incentive these fees can create for market manipulation.