f

Tick Size and Market Quality

David C. Porter and Daniel G. Weaver

David C. Porter is an A.s.wciate
I'rofe.s.sor of Finance in the College
ofBusine.ts and Economics al
University of Wi.\con.sin'
Whitewater. Daniel G. Weaver is
an As.sociate Professor of Finance
al Bariich College, City University
of New York.
We examine the impacl of a reduction in minimum tick size on market
quality, inlernaiization, and member profits using a transaclional
database of stocks listed on the Toronto Stock Exchange (TSE) for
March and May. 1996. The database identifies trading classes and
purpose for each trade. We find that execution costs decline for low-
priced and high-volume stocks, and we document a reduction in
quoted market depth. By identifying trades that have been internalized
against a member's inventory, we find that reducing tick size has a
negligible impact on Internalization and member profits and might
result in higher commission profits.

• Corporations have been interested in spread width
since Amihud and Mendelson's (1986) determination
that spread width is directly related to the cost of
capital. Recently. Congressman Oxiey introduced the
Common Cents Stock Pricing Act with the intention of
reducing minimum spread increments (tick sizes) in US
markets to under US$0.125. On the same day (March
13. 1997), the American Stock Exchange (AMEX) and
Nasdaq announced plans to reduce their minimum tick
si/.c from US$0.125 to US$0.0625. Since that date, the
New York Stock Exchange (NYSE). AMEX, and Nasdaq
have all reduced their minimum tick size.
In choosing the optimal market on which to list their
stock, corporations must bear in mind that changes in
legislation can impact spreads differently across
markets if those markets have different order-priority
systems. In the US, the AMEX has a price-time priority
system but the NYSE gives equal priority to all orders
after the first order at a price, and Nasdaq is a dealer
market without a priority system. Existing theory
We are grateful to the Toronto Stock Exchange for providing
the data for this study. Pina DeSaniis and Chris Matihews of
the Toronlo Slock Exchange and Hugh Cleiand of the Ontario
Securilies Commission were very helpful in explaining the
rules and structure of the T.SE. George Benston. Charles Cao.
Bill Christie, Larry Harris, Mark Klein. John Notsinger, Jeff
Ricker, and Dave Whittonib. a,s well as participants at the
Chicago Stock Exchange Specialists Association Conference
on Decimalizalion, the NYSE Conference on Global Equity
Issuance and Trading, and the Western Finance Association
meetings provided helpful comments on an earlier version of
this piipcr.
predicts that spreads on some stocks will narrow in a
price-time priority system if the minimum tick size is
reduced, but it does not address other priority
schemes, By empirically examining the impact on
spreads in differing priority systems, this study
contributes to the literature on the exchange listing
choice faced by firms.^
The impact of tick-size reduction on US market
quality is the subject of academic and industry debate.
Market quality can be defined using spread width,
depth, preferencing and internalization, and member
profits. Recent theoretical papers argue that tick-
size reduction will eliminate preferencing and
internalization. Preferencing is defined as brokers
directing order flow to certain dealers in return for cash
or soft-dollar payments. Internalization is defined as a
broker assuming ibe other side of a cusiotner order by
filling the order from firtn inventory. In both cases,
customer orders are not exposed to the market.
Preferencing and internalization are generally believed
to prevent narrower spreads on Nasdaq. Huang and
Stoll(1996). for example, show that if a large portion of
order fiow is preferenced or internalized, dealers who
post better prices will not capture additional order
flow reducing their incentive to compete. The
reduction in competition leads to wider spreads and
the associated reduction in market quality. Also,
the securities industry has opposed tick-size
^ . Carter, Dark, and Singh (1992) provide an excellent
review of existing literature on exchange lisiing.

Financial Management, Vol. 26, No. 4, Winter 1997, pages 5 - 26


reduction by arguing that trading profits would be
reducecCwhich would lead to a reduction in market
qualitj(^t is therefore important to study the impact
of tick-size reduction on market quality.
Previous papers examine the impact of tick-size
reduction on several aspects of market quality. For
example. Harris (1994) predicts that given a strict price- are floor-based, tick-size reduction causes prices to
time priority system, a reduction in minimum tick size
will cause spreads to narrow and depths to decline.
Depth is defined as the total number of shares offered
or sought at a price. Ahn. Cao, and Choe (1996) examine
changes in liquidity around the time that the AMEX
lowered the minimum tick size from an eighth to a
sixteenth for low-priced stocks. They find that spreads
and depths did decline, consistent with the predictions
of Harris. However, in the Ahn, Cao, and Choe data set
only low-priced stocks experienced a reduction in
minimum tick size. Therefore, they were unable to
examine a broader range of stocks.
This study examines changes in market quality
following the reduction in spread width by the Toronto
Stock Exchange (TSE). using a new transactional
database that allows for the examination of a broader
range of stocks. On April 15, 1996. the TSE reduced
the minimum tick size from C$0.125 to C$0,05 for stocks
trading above C$5.00. Stocks trading between C$3 and
C$5 had the minimum tick size reduced from C$0.05 to
C$0.01. Stocks trading below C$3 already had a C$0.01
niinimum tick size and no further reduction was enacted.
Bacidore (1997) finds that the changes in liquidity
related to the tick-size reduction on the TSE are
qualitatively similar to those of Ahn, Cao, and Choe
(1996). Several other authors have examined changes
in liquidity following the TSE's reduction in tick size,
and Harris (1997) provides a comprehensive review of
many of these studies.
A limitation of previous studies is that they do not
separately examine the Computer-Assisted Trading
System (CATS) and the floor-based trading system.
Recall that the Harris (1994) model applies to stocks
with strict price-time priority. Only CATS stocks have
strict price-time priority. By examining stocks separately size reduction, since ex post there is an increase in the
according to trading system, we can determine if
changes in market quality differ across trading systems.
Consistent with Bacidore (1997), we find that
reducing the tick size from C$0.05 to C$0.01 has a
negligible effect on market quality for both CATS
and floor-based stocks. Harris (1994) predicts that
Ihe impact of tick-size reduction will be greatest on
low-priced and high-volume stocks. Consistent with
Harris (1994), we find that for low-priced and high-
volume stocks that experienced a decline in tick size
-Untitled article. Washington Post, September 26, 1996. p.
D12. Grossman and Miller (1988) provide a theoretical linkage
between market-maker profits and the amount of liquidity
provided.
FINANCIAL MANAGEMENT /WINTER 1997
from C$0,125 to C$0.05, execution costs generally
decline. This decline is also accompanied by a
reduction in market depth. Therefore, for small-order
traders there is a net gain, but for large-order traders
there is a reduction in liquidity. Also, some evidence
suggests that for low-priced, high-volume stocks that
be less "sticky," which in turn leads to a reduction
in price variance.
Harris (1994) also predicts that reducing minimum
tick sizes will have little, if any, impact on profits.
Harris's (1994) model assumes that market makers
will maintain the same percentage of increased
volume. That is. even though traders earn less on each
trade, there will be more trades from which to profit.
Ahn, Cao, and Choe (1996) find that volumes
increase, but not by as much as Harris predicted.
They conclude that "...the new tick-size rule implies
that there i ^ wealth transfer from market makers to
investors("2^acidore (1997) finds no significant
change in volume, which leads to conclusions similar
to those of Ahn, Cao. and Choe. This study extends
previous contributions by directly calculating
market-maker profits.
We find support for Harris's (1994) conjecture that
market-maker profits will be unchanged by tick-size
reduction. However, the data do not support Harris's
assumption that market makers and other traders will
maintain constant proportions of volume after tick-
size reduction. Harris assumes that market makers profit
only from the spread, therefore any reduction in volume
should lead to a reduction in profits. However, Manaster
and Mann (1995) find that "the majoi:kv of market-
making profit is due to market timing.^ The Manaster
and Mann finding suggests an alternative explanation,
namely, that trading profits are either passive (market
making) or active (market timing or fundamental
analysis). The data suggest that traders generally
engage in active-trading strategies and can earn the
same amount on less volume. Tn addition, we show
that commission revenues likely increase after tick-
number and size of public orders.
The impact of tick-size reduction on preferencing
and internalization also lacks consensus. Chordia and
Subrahmanyam (1995) develop a revenue-maximization
model that suggests that tick-size reduction will greatly
reduce preferencing. The intuition is that finite tick
sizes could cause quoted prices to be greater than
specialist and off-floor market maker reservation prices.
By paying a small amount for order How. off-tloor market
makers can still earn rents in excess of their reservation
prices. The same logic can be applied to internalization.
In contrast, Battalio and Holden (1996) develop a
n, Cao, and Cboe (1996). p. 21.
••Manaster and Mann (1995), p. 5.
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY
quote-driven model that predicts that tick-size
reduction will have little, if any, impact on preferencing
and internalization. They argue that if brokers can
identify informed and uninformed trades, they will
internalize the uninformed trades and send the informed
trades to the primary dealer. Their argument is
contingent on the primary dealer having zero expected
profit, on average, across all trade sizes.
Only internalization (not preferencing) is allowed in
Canada. The database we use lets us identify
internalized trades. Therefore, we can examine the
impact of tick-size reduction on the percentage of
volume that is internalized. We find only a small
reduction in internalized order flow, which supports
the Baltalioand Holden (1996) model. Our findings are
also consistent with those of Hansch, Naik, and
Viswanathan (1997) who find no relation between
spread width and internalization or preferencing on
ihe London Stock Exchange suggesting that the
adoption of tick-size reduction in the US will have little
impact on preferencing.
The paper is organized as follows. Section I details
the different trading systems and priority rules used
by the TSE. Section II describes the data, and Section
III describes the methodology. Section IV di.scusses
the results. Section V offers concluding remarks.
I. TSE Trading Systems
The TSE has two different trading systems, each
with its own set of order priority rules. Stocks
trading on CATS have strict price-time priority,
similar to the AMEX. All new orders at a price go to
the back of the queue.
However, there are some nuances worthy of note.
First, on large orders, members are allowed to disclose
only a portion of an order. For example, if a member
has a lO.OOO-sharc order but only wants to disclo.se
2.000 shares, the order is marked accordingly. (On ihe
NYSE. this is known as a Convert and Participate
order, or CAPD for short.) If the disclosed portion
is filled, then an additional 2,000-share order is
placed at the end of the queue, and the total order
is reduced by 2,000. This feature allows members to
participate in active markets without having to
constantly monitor the market.
A second feature of CATS priority rules is that
registered traders ("RT" is the Canadian equivalent of
a US specialist) can set switches that allow them to
participate in up to half of each CATS stock's minimum
guaranteed fill(MGF), which ranges from 199 to 5.099
shares, based on the liquidity of the stock. On the
TSE, RTs are required to fill odd-lot orders and
guarantee that orders less than a certain size (the MGF)
will be filled at the inside bid or ask. RTs are allowed to
"step in front" of orders on the book up to half of the
MGF. However, the switch must be .set in aSvance to
signal market participants that the RT is participating.
Floor-based priority rules differ greatly from CATS
rules. Similar to the NYSE, only the first order to set a
new price has time priority. If an order entering the
market exceeds the first order at a price, the remainder
of the order is allocated to members on a sharing basis.
Initially, sharing takes place on an equal basis, with
each member who has an order on the book getting up
to 500 shares (1,000 shares for stocks in the Toronto
35 Index) of the excess order size. Any remaining
portion of the order is then apportioned to members
pro rata, based on the size of the member's committed
order. (The TSE. like the NYSE. differentiates between
disclosed and undisclosed orders,) Committed refers
to the amount of the order disclosed on the book. If
the order is not completely filled after the pro rata
allocation, then any remaining shares are distributed
to members on a rotating time priority basis until the
order is filled. Just as with CATS stocks, the RTs have
the right to take for themselves part of an incoming
order up to one half of the MGF.
Harris (1994) argues that for systems that enforce
strict price-time priority (e.g.. CATS), there will be a
positive relation between market depth and the
minimum price variation, since "time precedence and a
large minimum price variation protect traders who
display size by forcing quote matchers to improy©-.
price significantly if they wish to acquire precedence!"^
Trading systems that do not enforce strict price-time
priority (e.g., TSE Floor stocks) might have a different
relation between market depth (or other measures of
market quality) and the minimum price variation. For
example, in a strict price-time priority system, if an order
is not the first to set a new price, the trader can either
improve on the price or go to the back of the queue. In
a sharing priority system, the same trader can either
improve on the price or essentially share second place
in line, thus being assured of at least a partial fill.
Therefore, traders in a price-time priority system have
a greater incentive to improve on price If tick size is
reduced which would lead to a reduction in spread.
Therefore, we would expect that following the
reduction in tick size, CATS stocks would exhibit
greater changes in market quality than floor stocks.
II. Data
Our data are drawn from the confidential marker
version of the TSE equity history tapes for the months
of March and May 1996. The data contain every trade
and inside-quote revision with their associated prices,
'Harris (1994) p. 151.
 FINANCIAL MANAGEMENT/WINTER 1997

volumes, and bid and ask sizes, as well as information C$3 and C$5 in each system.
for detertnining the stock's trading system (CATS or Table I contains descriptive statistics for tbe
floor). AU data are time stamped to the nearest second. CATS and floor-stock portfolios. Examining the
The data contain confidential markers for each stocks in each portfolio shows that CATS stocks
transaction tbat identifies each side of a trade. Included tend to bave lower volumes than floor stoeks. It is
for seller and buyer are the member firm numerical code, a common misconception tbat the CATS system is
the individual trader alpha code, and a marker that abandoned by stocks as they increase in price or
identifies the type of transaction. Transaction-type volume. In reality, TSE rules do not allow stocks to
markers identify wbetber tbe buyer or seller is an RT, switch trading systems.
other member, or a public client. In addition, if tbe
transaction involves another member, tben another
marker identifies whether tbe trade was for an
III. Methodology
inventory or a personal account. (We define an
One component of market quality is liquidity. O'Hara
inventory account as one in which the member's firm
(1995) states that "...liquidity, like pornography, is
has a financial interest. A personal account is one in
easily recognized but not so easily defined."* Harris
which the trader's personal funds are used.)
(1994) shows that a reduction in the minimum tick size
We include only common stocks tbat have at least causes changes in liquidity that are inversely related
50 quotes in each month. Tbere are eight stocks that to price and directly related to trading volume, because
trade in USS. To avoid biases due to fluctuations in for low-priced and higb-volume stocks, the minimum
exchange rates, we exclude tbese stocks. We also tick size can be viewed as a binding constraint.
exclude stocks that either split or changed in price by
Tbe market microstructure literature presents several
more than 50%.
liquidity measures, each with ils own merits. The list
We include only those stocks tbat trade completely of liquidity definitions includes dollar bid-ask spread,
within a price tier for both March and May. For percentage bid-ask spread, effective bid-ask spread,
example, we exclude a stock if its price range over the percentage effective bid-ask spread, and quote depth,
period is CS2.50 to C$3.25. Although this may seem as well as Hasbrouck and Schwartz's (1988) measure
extreme, it is necessary because of differing reductions of execution costs and market efficiency. We are also
in tick size for stocks trading in the CS3 to C$5 range concerned with the additional aspects of market quality
and greater tban tbe C$5 range. This separation allows whicb include price variance, the effect of tick-size
US to cleanly examine if any further benefits will occur reduction on inlernaiization and member profits.
from reducing tbe tick size from C$0.05 to C$O.Ol.
To examine tbe impact of tick-size reduction on market
Finally, we include only trades and quotes tbat quality, we compute each market-quality measure both
occurred between 9:30 a.m. and 4:00 p.m. before and after tbe TSE adopted decimalization on
Bacidore (1997) excludes stocks that are cross-listed April 15. 1996, To prevent bias of the analysis near the
between Toronto and a US exchange. Excluding cross- event date, we omit April 1996 and define the pre- and
listed stocks might ignore an important source of post-adoption periods as March 1996 and May 1996.
internalization or profit for members, therefore we do respectively. For eacb market-quality measure, we
not exclude cross-listed stocks from the sample. Note measure the change from March to May 1996, and test
that Mazzoli (1996) reports Canadian-based TSE for statistical significance.
interested market sbare increased only from 66.71 % to
68.13% pre- and post-tick-size reduction. Therefore, A. Liquidity Measures
any bias from including interested stocks can be
considered small. Consistent with previous researcb, we define tbe
Since floor and CATS stocks have different priority most widely used measure of liquidity, dollar bid-ask
rules, we first separate tbe sample according to the spread, as:
trading system. The resulting sample includes 165
Dollar Spread. ^ = Ask. ^ - Bid. ^ (1)
CATS and 315 floor stocks. Since we want to examine
differences between the two TSE priority systems, we where Ask^^ and Bid ^ represent tbe inside quotes for
first assign floor stocks that trade above C$5 to price company i revised at time t. Dollar Spread^ ^ is averaged
quartiles and separately to volume quartiles. We tben across all observed quote revisions for company i
assign stocks to one of 16 portfolios according to their during March or May of 1996.
joint-quartile membership. Using tbe same range of Christie and Huang (1994), among others, argue that
values found for floor price and volume quartiles, we a relative measure, such as percentage bid-ask spread,
separately assign CATS stocks to one of 16 portfolios.
We also separately examine stocks that traded between *Frorn O'Hara (1995), p. 215.
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY

Tabie 1. Descriptive Statistics of Portfoiios for TSE Stocks Trading Above C$5
This table shows average March 1996 price, average share volume (000s), and the number of stocks for each portfolio.
CATS stocks trade in the Computer-Assisted Trading Systetn. Floor stocks trade at assigned posts. The same minimum
and maxitnum amounts are used in assigning volume and price levels for CATS and tloor stocks. All dollars arc expressed
in Canadian currency.

Volume Level

1-Low 2 3 4-High
Volume < 184 1 8 4 ^ Volume < 538 538 ^ Volume < 2,207 Volume > 2,207

Average Price Average Price Average Ptice Average Price

Average Volume Average Volume Average Volume Average Volume
Price Level N N N N

Panel A. CATS

I-Low $7.55 $7.85 $7.54 $7.85

Price < $9.53 73 291 1.324 3,148
18 U 14 6
2 $11.79 $12.05 $11.55 $11.79
$9.53 < Price < $14.60 96 354 897 2,619
20 13 13 4

3 $19.06 $17.79 $19.19 $18.93

$14.60 < Price < $23.55 54 341 1.156 5.421
13 9 10 4

4-High $40.87 $28.78 $43.29 $39.45

Price 5 $23.55 84 278 1,103 2.701
20 2 1

Panel B. riotn

I-Low $7.67 $7.51 $7.98 $7.53

Price < $9.53 64 306 1,199 5.187
23 23 22 10

2 $11.98 $11,59 $12.42 $11.98

$9.53 < Price < $14.60 63 352 1,085 6.147
21 18 1 18 22

3 $18.52 $18.14 ... , $19.24 $18.31

$14.60 < Price < $23.55 49 314 i 1.189 4.609
16 23 1 20 20

4-High $42.08 $47.29 $34.27 $38.62

Price > $23.55 66 383 1.329 8.551
18 15 19 27

is a more appropriate measure ol" liquidity than the March or May of 1996.
absolute-dollar spread. They define percentage bid- Trades can occur at prices other than the best quoted
ask spread as: bid and offer (BBO). Hasbrouck {1991) finds that large
trades must frequently make price concessions, which
(Ask-,-Bid,,)
Percentage Spread = results in trades occurring outside the BBO. Lee and
(2)
f Ask. + Bid, Ready (1991) find that 30% of the transactions in their
study occurred inside the BBO. As a result, Christie
and Huang (1994) and Lee. Mucklow, and Ready (1994)
where Percentage Spread. ^ is also averaged across all suggest that effective dollar spread (EDS) width be
observed quote revisions for company i during either measured as two times the absolute difference between
10 FINANCIAL MANAGEMENT / WINTER 1997

transaction prices and the midpoint of the posted bid- The data do not allow us to measure actual depth
ask spread, or: directly.** However, we can test indirectly for
changes in actual depth.
Ask. -Bid
EDS =2 Price. - (3) B. Volatility and Efficiency Measures
In the absence of sufficient "hidden" liquidity, a
where Price. ^ is the price of company i stock at time t. reduction in quoted spread depth could result in an
As with the quoted spread measures, we average increase in price variability. Ceteris paribus, narrower
Effective Dollar Spread, ^ (EDS^ ^) over all transactions depths increase the probability that transactions will
for firm i in either March or May.^ Similarly, we define deplete the depth at quoted price levels. This, in turn,
relative effective bid-ask spread as: will cause greater deviations from the equilibrium price,
leading to an increase in the variance of price and
possibly exposing investors to an increase in risk.
(4) Accordingly, we examine two measures of volatility.
(Ask., + Bid,,)/2 The first measure, Varprice., is a price variance
which we define as the average trade-to-trade
where we again average the Effective Percentage squared deviation from the mean for stock i for either
Spread^, (EPS) over all transactions for firm i in either March or May.
March or May. The second measure uses a variance-ratio model
Measuring effective spread requires an estimate of suggested by Hasbrouck and Schwartz (1988).
the quote at the time Price., is observed. Lee and Ready Hasbrouck and Schwartz argue that in an informationally
(1991) observe that the NYSE uses two different input efficient market, long-interval variances should be
paths to record quote revisions and transactions. The proportional to short-interval variances. However,
result is that transactions can be time stamped about execution costs cause proportionally larger return
five seconds late. Therefore, studies that require the variances when measured using short intervals. They
proper sequencing of transactions and quotes on the propose a market efficiency coefficient (MEC), which
NYSE must adjust the time stamps. they define as the ratio of observed long- and short-
The TSE uses an electronic system that automatically horizon variances:
updates spreads and transmits transactions and
quote revisions simultaneously, thus avoiding
sequencing errors inherent in the NYSE data and MEC = : r - ^ (5)
the need to adjust the time stamps.
Lee, Mucklow, and Ready (1993) argue that any
discussion of liquidity must include both spreads where : R^^ ~ ^^^ '"S of the long period price relative
and depths. (Recall that depth is defined as the total (1 + return) for firm i;
number of sbares offered or sought at a price.) They R,^ = the tog of the short period price
show that volume shocks cause spreads to widen relative for firm i; and
and depths to decrease. Therefore, we also examine L/S = the number of time periods of length S
spread depth. Because changes in tick size may not in time period L.
equally affect the depth at each side of the spread, we
define the depth measures as Bid-Depth,, and Ask- Hasbrouck and Schwartz (1988) estimated long-
Depth,, where Bid-Depth., (Ask-Depth. J is the average interval variances using two days. Given data
depth at the inside bid (ask) for company i during either availability, we use one day as the long interval.
March or May. Consistent with Hasbrouck and Schwartz, we use 30-
minute intervals to measure short-interval variances.
Harris (1996) argues that in systems that allow
As suggested by Hasbrouck and Schwartz, estimates
"hidden" orders (e.g., the TSE), a reduction in tick size
of expected returns for short time periods are less
could cause traders to expose less of each order.
reliable than assuming a zero expected return; we also
Therefore, a reduction in tick size could cause quoted
adopt this convention. Note that in an informationally
depth to decline, while actual depth is unchanged.
efficient market, MEC = 1.
^Christie and Huang (t994) use equal weighting while Lee. To derive an additional measure of percentage
Mucklow. and Ready (1994) use a volume-weighted measure. execution costs Hasbrouck and Schwartz (1988) use
Lee. Mucklow. and Ready examine intraday changes in spread.
Christie and Huang examine changes in liquidity over a longer "An accurate measure of actual depth could be obtained by
period resulting from Ehe decision to list. The time frame we including the hidden portion of orders at the inside quote.
use is similar lo that used by Christie and Huang, Therefore, LInfortunately, the TSE did not begin constructing order files
we use equal weights. until one month after their reduction in tick size.
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY
the fact that execution costs cause the MEC to be
other than unity. They define execution costs, C, as:
if MEC < (6)
or
C=- ifMEC> (7)
C. Measures of Internalization and Market-
Making Profit
Determining the impact of tick-size reduction on
internalized order flow requires differentiating those
itades that are internalized from customer crosses. The
confidential markers of the database identify, for each
side of a transaction, the type of trade (i.e., public, RT,
or other member) and, in the case of other members,
whether the trade was for an inventory or a personal
account. Combining these markers with the numerical
firm identifiers for each side of a trade, we extract all
trades in which
I. the numerical firm identifier is the same for both
sides of a trade,
2 one side is a public order, and
3. tbe otber side is an inventory account.
Then, fur March and May, we separately sum up the
number of internalized shares and standardize by dividing
by the total number of shares traded for the month. The
result is the percentage of internalized share volume.
Harris (1994) suggests that market-maker profits will
remain unchanged for small stocks if the tick size is
reduced. He assumes that market-maker volume will
rise proportionally with market volume, hence the
decline in profits per trade will be offset by an increase
in the number of market-maker trades. Several
previous studies have assumed constant market-
makcr proportions.' The database used in this study
is unique, and it can be used to calculate trading profits
directly for RTs and also for other members trading for
their inventory accounts.
The model we use is similar in spirit to Sofianos
(1995) and Hansch, Naik, and Viswanathan (1997). The
data used in the Sofianos study includes inventory
positions, but only pertains to specialists. Our data
do not contain opening inventory positions, so we are
only able to measure profits derived from trading in a
particular month. However, where Sofianos only
examines specialist profits, we measure both RT and
other member profits. Both Sofianos and our study
'See Ahn. Cao. and Choe (1996) and Bacidore (1997).
11
ignore profits from other activities such as
commissions. However, we do examine the change
in the number and size of public trades. Therefore,
we can draw inferences concerning profits derived
from commissions.
We calculate RT profits per stock and per RT.
However, we aggregate other member profits by
firm. Note that while one RT is charged with
maintaining an inventory position in each stock, a
firm can route an order to any one of their traders
for execution, but the trading affects a comtiion firtn
inventory position in each stock.
We accumulate long, short, and net positions over
time. If a member purchases stock, the long position is
increased, and a cash outflow is realized. If a member
sells stock and the amount sold is less than the current
long position, the long position is reduced, and the
member realizes a cash inflow. However, if the sale
exceeds the member's current long position, then the
long position is reduced to zero, and the cash inflow
is equal to the long position times the sale price. This
result is consistent with only examining current-month
trading profits. If a member shorts the stock, then the
short position is increased, and the member realizes a
cash inflow. If there is a subsequent purchase, then
we assume that the member is covering a short
position. The short position is reduced, and the long
position is unaffected. If a purchase exceeds the short
position, then the short position is reduced to zero,
and the long position is increased by an amount equal
to the excess.
In botb cases, the member realizes a cash outflow
equal to the transaction amount. At the end of the
month, we assume that all inventory positions are
liquidated at the monthly closing price.
Table 2 contains a numerical example of the above
algorithm. The model can be mathematically defined
as:
,,,s,_, (-1.0)1
I=t
, p s - p . T|. (8)
and
I[ (9)
where: P^_^ = trading revenue for member m in
stock i;
Y| = 1 if the trade was a purchase, otherwise
0:
p., = price of stock i in transaction t:
s,, = number of shares in transaction t;
12 FINANCIAL MANAGEMENT / WINTER 1997

Table 2. Example Of How Profits are Calculated .£jdjsiA

This table illustrates how profits and positions are tallied. Profit is defined as net cash flow arising from trading activity
in a stock during a month. Sales in excess of the existing position are considered the previou.s month's trading activity and
are not cotipted. Members are assumed to unwind their position at the end ot the month. Net position is the sum of the
long and short positions. All dollars are expressed in Canadian currency.

Cash Long Short Net

Shares Price Cash Flow -' Position Position Position Position

Assumed $0 0 0 0
Starting
Positions

Buy 1,000 $10,000 ($10,000.00) ($10,000.00) 1.000 0 1 .()(K)

Buy 5,000 $10,125 ($50,625.00) ($60,625.00) 6,000 0 6,000

Sell (100) $10,250 $1,025.00 ($59,600.00) 5,900 0 5,900

Sell (8,000) $10,250 $60,475.00 $875.00 0 0 0

Buy 500 $10,125 ($5,062.50) ($4,187.50) 500 0 500

Sell Short (1.000) $10,250 $10,250,00 $6,062.50 500 (1.000) (.500)

Buy uoo $10,125 ($12,150.00) ($6,087.50) 700 0 700

Ending Inventory Value $7,087.50

Profit $I.(X)O.O()

1 if the trade was a sale, otherwise 0; variance. The result is the f o l l o # i ^

member m's long position in stock i
after transaction t - 1 ;
1 if the trade was a short sale,
otherwise 0;
end-of-month price of stock i;
member m's end-of-month net
inventory position in stock i; and
member m's short position in stock i
after transaction t - 1 .
Members also derive profits from commissions on
public orders. Therefore, we examine changes in
public-order flow. We calculate the percentage of total
volume, number, and average size of public buy and
sell orders. Since commissions are negotiable, we
cannot directly measure commission profits. However,
increases in public-order flow imply increases in
commission profits.
(10)
where: = the average market quality mea.sure
(e.g., dollar quoted spread) for firm i
in month t ( March or May);
= the log of share volume for firm i in
month t;
= the variance of daily return for firm i
during month t;
= the average closing price for firm i
during month l; and
= 1 if the market quality measure is for
D
May, and 0 otherwise.
If tick-size reduction affects changes in market
quality, we would expect p^to be significantly different
from zero.

D. Controlling for Other Factors

Any observed changes in market quality could be
due to factors other than the adoption of tick-size
reduction. Benslon and Hagerman (1974) and Stoll
(1985) show that spreads are a function of price,
volume, and variance of return. Therefore, consistent
with Christie and Huang (1994), we use a dummy
variable to test for the significance of tick-size reduction
on the reported changes in market quality. At the same
time, we control for changes in price, volume, and return
IV. Results
Results for the liquidity and efficiency measures will
be discussed first, followed by internalization and
market-maker profit estimates. We conclude the results
section with the spread-determinant regression.
A. Liquidity Measures
Harris (1994) bases his supposition—that market
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY
quality will change following a reduction in the
minimum tick size—on the premise that pre-change tick
sizes are binding constraints. To test whether a C$0.05
minimum tick size is a binding constraint, we first
examine the market quality measures lor stocks trading
between C$3 and C$5. (Recall that the tick size for
stocks trading between C$3 and C$5 reduced from
C$0.()5 to C$0.01.) Table 3 reports the mean market
quulily measures and associated standard deviations
for March and May 1996. Table 3 also contains the
difference between March and May along with a paired
t-test statistic. Neither CATS nor floor stocks exhibit
any statistically significant change in any of the market
quality measures listed. These results are consistent
with of Bacidore's (1997) findings. Based on Table I,
we can conclude that a C$0.05 minimum tick size is not
a binding constraint on market quality. This implies
ihat any benefits of tick-size reduction in the US could
be realized with only a partial move to complete tick-
size reduction (i.e., US$0.05 versus US$0.01).
Table 4 contains the mean differences in quoted
dollar spreads from March to May and a paired t-test.
We use these measures to examine differences in
quoted spreads, for stocks trading above C$5, across
priority systems and across price and volume quartiles.
Table 4 also lists row and column averages for each
trading system. Harris (1994) suggests that a C$0.125
minimum tick size is a relatively more binding constraint
for low-price and high-volume stocks. Consistent with
Harris's prediction, we find CATS stocks in the low-
price, high-volume quadrant (price portfolios 1 and 2,
and volume portfolios 3 and 4), and all show declines
in spread width. However, only two of the four
portfolios have stalisticiilly significant changes.
Contrary to Harris's prediction of an inverse relation,
we find the reduction in spread for CATS stocks in the
high-volume column is directly related to price.
The changes for floor stocks more closely resemble
Harris's (1994) predictions. The highest-volume column
has the predicted inverse relation between spread
reduction and price. In fact, for floor stocks in the
lowest-price, highest-volume portfolio, the reduction
is more than twice as large as it is for the corresponding
CATS portfolio. The remaining price-volume portfolios
show spread changes similar to the corresponding
CATS portfoiios. At the very least, we can conclude
Ihat Harris's predictions also apply to the sharing-
priorily systems.
Table 5 shows the results for effective dollar spreads,
which are qualitatively similar to those for quoted
dollar spreads. Again, the lowest-price, highest-
volume floor portfolio exhibits a reduction twice as
large as that of the corresponding CATS portfolio. We
find the same qualitative results for both percentage
quoted spreads and effective percentage spreads."*
"Tallies are available from the authors upon request.
13
As mentioned earlier, spreads must be examined in
conjunction with depths. Table 6 examines changes in
quoted ask depths. (The results for quoted bid depths
are similar to quoted ask depths, and hence are not
reported.) Only one of the CATS portfolios shows any
statistically significant change in depth. This change
is a reduction just as predicted by Harris (1994). The
size of the reduction for floor stocks is generally
significant. It is also linearly related to volume and
inversely related to price, as predicted by Harris.
The findings of Tables 4 through 6 suggest that
spread and depth reduction is a function of priority
rules. Therefore, a reduction in minimum tick size in
the US might affect the AMEX and NYSE differently.
Since the NYSE priority rules are the most similar to
the TSE floor rules, we can expect a larger reduction in
spread and depth on the NYSE compared to the AMEX.
An alternative explanation for the differences
between the two TSE priority systems could be the
result of differences in the makeup of the trading
populations in each system. We will show later that
public orders represent a larger portion of total volume
on CATS compared to the floor. Non-public traders
(as opposed to public traders) might exhibit a greater
propensity for withholding liquidity (or alternatively,
not revealing all of it) after a reduction in lick size.
B. Volatility and Efficiency
Harris (1996) documents an inverse relation between
quoted size and volatility. Therefore, a reduction in
depth might cause an increase in the variance of price.
Table 7 shows the mean variance of price for each
portfolio and a paired t-test. The results are mixed.
Only one CATS portfolio has any statistically
significant change in average variance, and it is an
increase, which is consistent with Harris's theory.
Since this CATS portfolio exhibits a reduction in
both ask and bid depth (although not statistically
significant), we can conclude that the reduction
increases the occurrence of trading through the book.
Two floor portfolios have a statistically significant
decline in price variance, indicating that prices are less
sticky. No clear pattern is evident in the other portfolios
lor either CATS or floor stocks.
It could be that traders in tloor stocks merely hide
more liquidity following tick-size reduction, which
reduces the probability of an order going through the
book. This allows the reduction in price stickiness to
dominate. (Recall that traders can choose to only
partially reveal their order size on the book. If traders
revealed less of their order size after tick-size reduction,
then true depth could have reduced by less than stated
depth.) Harris (1996) shows that as tick sizes reduce,
so does the disclosed portion of orders. Once again,
the different trading populations in CATS and floor
stocks could explain the result, since the public might
14 FiNANCiAL MANAGEMENT/WINTER 1997

Tabie 3. Changes in Market Quaiity Measures for Stocits Trading Between CS3 and C$5
This table shows changes in market quality measures from March to May 1996. the two months surrounding the reduction
in minimum tick size by the TSE in April 1996, N = 12 for CATS, and N = 24 for floor stocks. The t-statistic is from a
paired t-tesj. All dollars are expressed in Canadian currency.

March May Difference

r
Market
Quality Trading Standard Standard
Measure Location Mean Deviation Mean Deviation Mean t-Statistlcs

Dollar CATS 0.112 0.040 0.127 0.047 0.015 1.519

Spreads 0.079 -0.001 -0.099
Floor 0.132 0.078 0.132

Percentage CATS 0.028 0,010 0,032 0.012 0.003 1.392

Dollar
Floor 0.035 0.020 0.033 0.021 -0.002 -0.955
Spreads

Effective CATS 0.045 0.016 0.049 0.016 0.005 1.142

Spreads
Floor 0.050 0.022 0.053 0.033 0.004 0.879

Effective CATS 0.011 0.004 0.012 0.004 0,001 1.033

Percentage
Floor 0.013 0.006 0.013 0.009 0.000 0.427
Spreads
Quoted Ask CATS 42.051 18.085 39.995 19.992 -2.056 -0.379
Depth 8.382 1.166
Floor 50.102 30.722 58.484 35.093

Quoted Bid CATS 37.612 22.449 32.669 19.987 -4.943 -1.827

Depth 2.568 0.342
Floor 44.841 34.500 47.409 31.690

Market CATS 0.529 0,198 0.641 0.307 0.1 II 0.978

Efficiency
Floor 0.709 0.335 0.678 0.305 -0.032 -0.455
Coefficient
Percentage CATS 0.44 0.14 0.41 0.23 -0.02 -0.456
Execution
Floor 0.37 0.19 0.42 0,19 0.05 1.409
Costs

be less inclined to hide liquidity, and therefore quoted
liquidity may be close to true liquidity.
Table 8 shows the results for Hasbrouck and
Schwartz's (1988) market efficiency coefficient. Recall
that in an informationally efficient world with no
execution costs, the market efficiency coefficient
would equal one. If tick-size reduction results in an
increase in market eificiency, we would expect changes
in the measure to be positive. Both CATS and Floor
high-volume portfolios show increases in market
efficiency, although only one portfolio in each trading
system is statistically significant. Therefore, we
provide only weak evidence that tick-size reduction
causes increases in market efficiency. However, the
lack of a statistically significant decline in the
Hasbrouck and Schwartz variance ratio provides
additional indirect evidence that true depth does not
decline. Hasbrouck and Schwartz's percentage
execution costs show the same qualitative results as
the other spread measures previously examined."
C. Internalization and Profits
Chordia and Subrahmanyam (1995) argue that a
reduction in tick size will eliminate preferencing and
internaiization, since they will cease to be profitable.
In the context of Harris (1994), if minimum spread width
exceeds equilibrium spread width, then it becomes
profitable for market makers to pay lor order flow and
to ititernalize orders. As we have noted, only
internalization (not preferencing) is allowed in Canada.
If tick-size reduction eliminates internali/ation, then
we would expect the percentage of total internalized
order flow to approach zero after decimalization. Table
9 details the percentage of share volume Lhat represents
"Tables are available from the authors upon request.
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY 18

Table 4. Change in Quoted Spreads Following the Adoption of Decimalization

Thi.s table shows the average change in qLioted dollar spreads from March to May 1996, the two months surrounding the
reduction in minimum tick size by the TSE in April 1996, tor stocks trading above C$5 during theentire period. We define
quoted dollar spread^ ^ = ask^^ - bid.^ for firm I in time t. The same minimum and maximum amounts are used ig assigning
volume and price levels to CATS and floor stocks. The t-statlstic is from a paired t-test. All differences are expressed in
Canadian currency.

Volume Level

1-Low 2 3 4-High
Avg. Change Avg. Change Avg. Change Avg. Change
Price Level t-StatistIc t-StatistIc t-Statlstic t-StatJstic Row Average

Panel A. CATS

1-Low 0.108 -0.063 -0.046 -0.031 0.009

0.903 -3.380*** -7.035*** -1.329 0.196

2 -0.023 -0.016 -0.049 -0.058 -0.031

-0.865 -0.349 -1.671 -5.617** -1.772*

3 -0.019 0.024 -0.015 -0.068 -0.013

-0.494 0.444 -0.776 -15.997*** -0.642

4-High -0.087 0.046 0.414 0.038 0,044

-1.726 0.526 0.527 -1.112

Column Average 0.015 -0.017 -0.026 -0.043 -0.017

1J19 -0.739 -1.622 -3.713** -1.059

Panel B Floor

1-Low -0.032 -0.058 -0.044 -0.066 -0.048

-1.571 -3.511*** -5.373*** -19.341*** -5.901***

2 -0.026 -0.044 -0.045 -0.065 -0,045

-1.043 -3.987*** -2.004* -12.550*** -5.146***

3 0.033 -0.019 -0.052 -0.063 -0,028

0.606 -1.162 -2.468** -14.006*** -2.096**

4-High 0.039 0.005 -0.049 -0.045 -0,017

0.441 0.054 -1.871* -5.409*** -0.638

Column Average -O.OOO.S -0.032 -0.048 -0.058 -0.035

-0.0184 -1.731* -4.856*** -16.408*** -4.236***

***Significani at the 0,01 level.

••Significant at the 0.05 level.
•Significant at the O.IO level.

ititenialized order flow for each portfolio. We report
the March and May percentages and the change. We
find (hat tick-size reduction does not eliminate
internalization. In fact, for the majority of the portfolios,
internalization rose after decimalization.
If internalization is directly related to the difference
between equilibrium and minimum spread widths, then
only those stocks that show the largest decline in
spread widlh after tick-size reduction would eliminate
intcrnaiization. When we examine those portfolios in
both systems that He in the low-priced, high-volume
quadrant, we find that tick-size rcdocticm bas a very
small impact on internalization. CATS (floor) stocks in
the lowest-price, highest-volume portfolio decline in
internalization from 6.55% to5.54% (25.5% to 19.86%.)
Therefore, we conclude that tick-size reduction has
little effect on internalization, and by inference, on
prefereneing.'-
As noted earlier, many dealers fear that their profits
''Another explanation for the results in Table 9 is that six weeks
is an insufficient lime for firms to adjust to lick-.slze reduction.
Data limilalions prevent us from testing this hypothesis.
16 FINANCIAL MANAGEMENT/ WINTER 1997

Table 5. Change in Effective Doilar Spreads Foiiowing the Adoption of Decimaiization

This table shows the average change in effective dollar spreads from March to May 1996, the two months surrounding the
reduction in minimum tick size by the TSE in April 1996, for stocks trading above C$5 during the entire period. We define
Ask. - Bid
effective dollar spread = 2 Price for firm i in time period t. The same minimum and maximum

amounts are used in assigning volume and price levels to CATS and floor stocks. The t-statistic is from a paired t-test. All
differences are expressed in Canadian current y.
Volume Level

1-Low 2 3 4-Higb
Avg. Change Avg. Change Avg. Change Avg. Change
Price Level t-Statistic t-Statistic t-Statistic t-Statistic Row Average

Panel A CATS

1-Low 0.039 -0.049 -0.038 -0.033 -0.011

0.985 -3 99'^*** -7.206*** -1.545 -0.705

2 -0.008 -0.048 -0.028 -0.052 -0.027

-0.499 -1.898* -1.097 -5.006** -2.387**

3 -0.005 0.035 -0.005 -0.061 0.002

-0.148 0.721 -0.312 .7.199*** 0.095

4-High -0.066 0.034 -0.169 0.028 -0.080

-1.324 0.494 -1.202 -1.727*

Column Average -0.012 -0.022 -0.046 -0.041 -0.026

-0.619 -1.300 -1.909* -3.960*** -2.329*^^^

Panel B. Floor

I-Low -0.018 -0.040 -0.038 -0.061 -0.036

-1.068 -3.392*** -3.603*** -17.588*** -5.201***

2 -0.025 -0.032 -0.027 -0.055 -0.035

-1.161 -2.597*** -1.331 -16.028*** -4.508***

3 0.095 -0.005 -0.041 -0.052 -0.006

2.281** -0.278 -3.149*** -13.235*** -0.475

4-High 0.423 0.014 -0.035 -0.033 0.079

1.090 0.175 -1.580 -3.756*** -0.874

Column Average 0.105 -0.018 -0.036 -0.048 0.0007

1.160 -1.106 a,346'^'** -13.488*** ().{)3 10

***Significant at the 0.01 level.

**Significant at the 0.05 level.
"Significant at the 0.10 level.

would be reduced following a tick-size reduction. '^
Previous studies assume that market makers maintain
the same proportion of volume before and after tick-
size reduction. We are able to calculate RT trading
profits directly, using Equations (8) and (9). Note
that RTs do not trade actively in all stocks in both
months. Table 10 lists average March trading profit,
per stock, for each portfolio and also the increase
''See footnote 5.
or decrease in profits during May. N is the number
of stocks in which RTs have current-month trading
activity in both months.
Examining the changes and associated t-statistics,
we find that RTs experience no statistically significant
change in profits in CATS stocks following tick-size
reduction. Only those stocks in the lowest-price,
highest-volume floor portfolio have a statistically
significant reduction in RT profits. However, since RTs
represent a number of stocks, overall, we can conclude
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY 17

Table 6. Change in Quoted Ask Depth Following the Adoption of Decimalization

This table shows the average change in quoted ask depth from March to May 1996. the two months surrounding the
reduction in minimum tick size by the TSE in April 1996, for stocks trading above C$5 during the entire period. We define
depth as the average depth in shares at the inside ask for firm i during either March or May. The same minimum and
maximum amounts are used in assigning volume and price levels to CATS and floor stocks. The t-statistie is from a paired
t-tcst.
Volume Level
1-Low 2 3 4-High
Avg. Price Avg. Price Avg. Price Avg. Price
Price Level t-Statlstic t-Statistic t-Statlstic t-Statistic Row Average
Panel A. CATS

I-Low -5.089 -17.245 -62.947 -39.693 -28.586

-1.929* -1.942** -2.193** -2.341 -3,115***

2 -11.498 -1.602 -41.993 -54.254 -20.275

-3.053*** -0.282 -1.511 -2.489** -2.561**

3 3,012 -0.392 7,164 -82.646 -6.203

0,653 -0,048 0.449 -1.972 -0.785

4-High 1.528 -6.184 15.342 -56.027 2.319

0,511 -3.354 0.701 0.407

Column Average -3.547 -6.469 -28.367 -56.119 -15.565

-1,937 -1,561 -2,060* -4.074*** -3,693***
Funei B Floor

1-Low -0,063 -6.053 -30.419 -188.819 -34.591

-0.033 -0.737 -5.288*** -4.002*** -3.662***

2 -2.194 -30.766 -10.217 -83.993 -33.312

-0.754 -2.065* -1.748* -3.845*** -4.193***

3 4.864 -6.699 -9.604 -71.008 -21,373

0.552 -2.063* -1.788* ^.346*** -3.712***

4-High 4.592 -0.311 -9.148 -65.452 -23.583

1.098 -0.132 -2.774** -5.475*** -4.313***

Column Average 1.448 -10.782 -15.431 -87.638 -28.194

0.648 -2.461** -5.571*** -7.976*** -7.706***
0,01 k'vcl,
**SignificaiU al the 0,03 level.
* Significant ai ihe 0,10 level.

that tick-size reduction produces no statistically
significant change in RT profits.
Table i 1 details average member trading profits
across linns trading in each price-volume portfolio. N
represents the average number of firms trading per
month. Examining the values of N across the table
shows that member firms have a propensity for trading
high-volume Hoor stocks. On average, over 30 firms
trade in each high-volume floor portfolio. This average
exceeds (he averages for all CATS portfolios.
Only three of the CATS portfolios exhibit any
statistically significant change in trading profits from
March to May. Two are decreases, and one is an
increase. Examining the low-priced, high-volume CATS
quadrant (in which spreads are hypothesized to decline
by the greatest amount), we find that three of the four
portfolios experietice an increase in protits. However,
in that quadrant, only the portfolio with declining
profits is statistically significant. The corresponding
floor quadrant contains an equal number of increased
and deereased portfolio profit levels, although none
is statistically significant. The variances are quite large
for each cell. The average firm earned about C$2,007
(a = C$170,733) over all stocks and systems, during
March and lostC$l8.9l8 (a = C$469.539) during May.
Taken together. Tables 10 and II generally support
18 FINANCIAL MANAGEMENT / WINTER 1997

Table 7. Change in Price Variability Following the Adoption of Decimalization

This table shows the average change in the average variance of price across all transactions for a stock, in March or May
1996, the two months surrounding the reduction in minimum tick size by the TSE in April 1996, tor stocks trading above
C$5 during the entire period. The same minimum and maximum amounts are used in assigning volume and price levels to
CATS and floor stocks. The t-statistic is from a paired t-test. All variances are computed using Canadian currency.
Volume Level

1-Low 2 3 4-High
Avg. Change Avg. Change Avg. Change Avg. Change
Price Level t-Statistic t-Statistic t-Statistic t-Statistic Row Average
Panel A CATS

l-Low 0.094 -0.113 -0.013 0.106 0.019

0.983 -1.909* -0.239 2.872** 0.441

2 0.128 1.049 -0.220 -0.147 0.255

1.658 1.259 -1.035 -2.307* 1.107

3 0.249 -0.012 0.337 -0.007 0.179

1.244 -0.039 2.010* -0.294 1.571

4-High -1.327 2.594 -0.191 1.206 -0.716

-0.104 1.031 -0.261 -0.085

Column Average -0.268 0.499 -0.023 0.082 -0.008

-0.076 1.417 -0.171 0.938 -0.005
Panel B. Floor

1-Low 0.063 -0.003 -0.111 -0.101 -0.026

1.429 -0.067 -2.381** -2.282** -1.062

2 0.133 0.012 0.507 0.926 0.411

1.221 0.189 0.669 0.671 0.986

3 0.665 0.157 0.315 -0.109 0.232

1.235 1.139 1.217 -1.478 1.720*

4-High 10.960 24.352 1.433 5.149 9.225

1.255 1.793* M60 1.097 2.511***

Column Average 2.720 4.671 0.509 1.977 2.467

1.333 1.711* 1.459 1.199 2.6(X)***

***Significant at the 0.01 level.

**Significant at the 0.05 level.
*Significant at the 0.10 level.

Harris's (1994) hypothesis that profits will not be
uniformly affected by a reduction in tick size.
Harris (1994) assumes that volumes would increase
and market makers would maintain the same relative
percentage of total volume. Table 12 details changes
in the volume and percentage of public-order flow. Total
share volume on CATS increases by 2 3 % from March
to May. Floor volume only increases by 5%. The
percentage of CATS share volume represented by
public orders decreases by just over 200 basis points,
so the percentage of CATS share volume representing
member trading increases, which is consistent with
Harris's hypothesis. However, the percentage of total
volume representing public orders increases on floor
stocks, indicating that member trading is reduced.
Applying the public percentages to the total volume
numbers for floor stocks shows that the increase in
public shares exceeds the increase in total shares. This
shows that members traded less in floor stocks after
tick-size reduction.
Recall that floor stocks e x p e r i e n c e the largest
declines in spreads following tick-size reduction. Also
note that market making is a relatively passive trading
strategy. These two facts, when viewed in light of the
generally insignificant change in member profits
reported in Tables 10 and 11, might indicate that
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY 19

Table 8. Change in Market Efficiency Following the Adoption of Decimalization

This table shows the average change in the Hasbrouck and Schwartz (1988) market efficiency coefficient from March to
Miiy 1996. the iwo months surrounding the reduction in minimum tick size by the TSE in April 1996, for stocks trading
above C$5 during the entire period, Hasbrouck and Schwartz define their market efficiencv measure as "

-MEC) ifMEC< I a n d C = . if MEC > I. where MEC = ; R.^is thelogof

the long-period price relative (I + return) for firm i; R_^ is the log of the short-period price relative for Tirm i; and L/S is the
number of time periods of length S in time period L, The same minimum and maximum amounts arc used in assigning
volume and price levels to CATS and floor stocks. The t-statlslic is from a paired t-iest.
Volume Level

1-Low 2 3 4-High
Avg. Change Avg. Change Avg. Change Avg. Change
Price Level t-Statistic t-Statistic t-Statistic t-Statistic Row Average

Panel A. CATS

I -Low -0.020 -0.023 0.144 0.337 0.069

-0.205 -0.175 1.436 1.849 -1.175

2 -0.104 0.164 -0.151 0.211 -0.021

-1.403 2.129* -1.469 1.239 -0,429

3 -0.089 0.212 0.076 0.403 0.086

-0.846 1.849** 0.629 4.269** 1.362

4-High 0.012 -0.207 0.122 0.559 0.041

0.155 -1.227 1.199 0.668

Column Average -0.047 0.096 0.038 0.336 0.041

-1.092 1.606 0.672 -3,871*** 1.392

Panel B Floor

1-Low 0.063 -0.005 0.012 0.090 0,032

0.613 -0.071 0.169 0.738 0.716

2 -0.088 0,059 O.IOI 0.093 0.039

-0.708 0.603 0.926 0.959 0.723

3 -0.047 0.017 0.069 0.035 0.022

-0.689 0.170 0.886 0,458 0.523

4-High -0.057 0.144 -0.033 0,240 -0.089

-0.411 1.513 -0.327 3.092*** 1,698*

Column Average -0.028 0.439 0.036 0,129 0.045

-0.498 0.968 0.825 2.828*** 1.882*
•**Significant at the O.OI level.
**Significant at the 0.05 level.
•Significant at the 0.10 level.

members profits were reduced by their passive trading
activities, but that members were able to cotnpensate
through active positioning strategies.
Another source of revenue for members is
commissions. We can asses the impact of commissions
on total member revenue by examining the number and
size of public orders. Table 12 .shows that for both
CATS and floor stocks ihc number of public orders
increased following tick-size reduction. To the extent
that Canadian commissions have a minimum fixed
portion, the increase in public orders indicates that
members earned more in commissions following tick-
size reduction.
Changes in member revenue.s derived from the
variable component of commissions can be
approximated by examining the size of public orders
pre- and post-lick-size reduction. The results arc tiiixed.
Table 12 shows that, while both CATS and floor stocks
20 FINANCIAL MANAGEMENT/WINTER 1997

^Tabie 9. Internalized Order Flow

This table reports the change.s and shows the percentage of share volu^me representing internalized order flow fck March
and May 1996. the two months surrounding the reduction in minimum tick size by the TSE in April 1996. for stocks
trading above C$5 during the entire period. Internalized orders are those transactions where a member firm bought or sold
from inventory. The same minimum and maximum amounts are used in assigning volume and price levels to CATS and floor
stocks. Percentages are based on the total share volume for each portfolio.

Volume Level

1-Low 2 3 4-High
March March March March
May May May May
Price Level Change Change Change Change Row Average

Panel A. CATS

1-Low 2.90% 1.98% 7.92% 6.55% 6.63%

0.53% 4.30% 4.64% 5.54% 4.80%
-2.34 2.33 -3.28 -1.01 -1.83

2 1.90% 2.58% 1.98% 5.87% 3.44%

2.40% 5.73% 0.59% 10.04% 4.65%
0.49 3.15 -1.39 4.17 1.21

3 10.32% 4.64% 9.88% 10.09% 9.59%

1.61% 4.52% 3.80% 16.49% 10.48%
-8.70 -0.12 -6.07 6.39 0.89

4-High 0.96% 0.24% 2.94% 5.57% 3.08%

1.40% 3.20% 5.19% 2.89% 4.01%
0,44 2.97 2.25 -2,68 0.93

Column Average 2.66% 2.76% 6.29% 7.71% 6.29%

1.71% 4.84% 3.77% 11.68% 6.93%
-0.95 2.08 -2.52 3.97 0.64

Panel B . Floor

1-Low 1.24% 7.15% 7,06% 25.50% 18.12%

1.87% 8.86% 10.29% 19.86% 14.17%
0.63 1.71 3.24 -5.65 -3.95

2 2.02% 9.21% 13.04% 19.50% 18.11%

7.38% 8.69% 6.72% 16.09% 14.77%
5.37 -0.51 -6.32 -3.41 -3.34

3 4.12% 7.91% 15.39% 15.85% 15.22%

0.32% 5.36% 7.49% 19.26% 14.99%
-3.79 -2.55 -7.89 3.41 0.23

4-High 0.62% 5.25% 10.71% 19.61% 18.33%

19.81% 12.82% 12.47% 22.17% 20.63%
19.19 7.57 1.76 2.56 2.30

ColLimn Average 1.79% 7.45% 11.22% 19.57% 17.65%

5.70% 8.91% 9.60% 19.51% 16.96%
3.91 1.46 -1.62 -0.06 -0.69
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY 21

Table 10. TSE Registered Trader (RT) Profits Before and After the Adoption of
Decimalization i
This table shows average RT (specialist) profits per stock for each portfolio during March 1996. as well as the change in
profits from March and May. the two months surrounding the reduction in minimum tick size by the TSE in A'pril 1996.
for stocks trading above C$5 during the entire period. RT trading activity is required in both tnonths for inclusion in the
analysis. The same minimum and maximum amounts are used in as.signing volume and price levels to CATS and floor
stocks. The t-statistic is from a paired t-tcsi. All dollars are expressed in Canadian currency.
Volume Level

1-Low 2 3 4-Hlgh
March Profit (Loss) March Profit (Loss) March Profit (Loss) March Profit (Loss)
May Increase (Dec.) May Increase (Dec.) May increase (Dec.) May Increase (Dec.)
t-StatJstic t-Statistic t-Statistic t-Statistic
Price Level No. of Stocks No. of Stocks No. of Stocks No. of Stocks Row Average
Panel A. CATS
! -Low $252.83 $1,554.52 $181.76 $162.42 $488.28
($218.32) $437.03 $617.26 $9(W.58 $321.56
-0.468 0.229 0.272 1.066 0.374
10 6 10 3 29
2 $549.55 ($140.19) ($2,007.35) $1,578.41 ($213.41)
($1,461.33) ($215.62) $12,887.47 ($332.52) $3,026.80
-0.720 -0.142 1.009 -0.108 0.815
11 8 9 4 32
3 $1,968.45 $556.45 $2,422.33 ($536,63) $1,458.15
($515.64) $932.93 $1,962.58 $8,917.77 $1,748-16
-0.682 1,695 0.676 2.653* 1.619
U 7 . 9 4 31
4-High $159.96 ($16.88) $6,156.72 $887.88 $1,487.57
($5,856.10) $395.38 ($4,913.90) $2,407.77 ($5,020.17)
-0.986 -0.387 -1.040
16 I 5 1 23
Column Average $683.03 $549.27 $1,101.09 $461.85 $754.33
($2,450.57) $355.59 $3,492.53 $3,288.55 $390.54
-1.207 0.478 0.863 1.779 0.267
48 22 33 12 115

Panel B. f^loor
1 -Li)w $367.30 ($814.51) $1,061.43 $10,355.04 $1,966.76
$66.55 $1,591,72 ($643.15) ($9,163.58) ($1,312.13)
0.094 1-955 -0.503 -3.107*** -1.581
15 16 17 10 58
2 $595.83 $901.14 $1,541.15 $667.07 $896.26
$521.96 ($268.41) ($336.04) $2,447.65 $743.16
0.832 -0.335 -0.281 0.554 0.535
13 13 12 17 55
3 ($23.77) .$747.01 $1,593.14 $2,886.90 $1,490,05
$84.04 ($830.36) ($729.61) $5,733.94 $1,204.57
0.357 -0.794 -0.389 1.406 0.898
9 18 18 18 63
4-High $14,047.19 ($10,583.46) $7,538.61 $8,803.92 $5,207.10
($5,601.73) $3,662.55 ($2,669.07) ($6,656.73) ($3,408.07)
-1.593 0-205 -0.623 -0.965 -0.705
11 14 13 26 64
Column Average $3,490.84 ($2,230.16) $2,720.28 $5,574.04 $2,460.39
(.$1,105.81) $955.86 ($1,046,62) ($1,688-59) ($739.41)
-1.231 0.239 -0.917 -0.564 -0.534
48 61 60

***Significant at the 0.01 level.

*Significant at the 0.10 level.
22 FINANCIAL MANAGEMENT/WINTER 1997

Table 11. Toronto Stock Exchange Member Firm Inventory Trading Profits Before and After
the Adoption of Decimalization
This table shows average member firm inventory trading profits for each portfolio during March 1996. as well as the
change in-average firm portfolio profits from March to May, the two months surrounding the reduction in minimum tick
size by the TSE in April 1996, for stocks trading above C$5 during the entire period. Stocks are included that have member
trading activity in either month. The same minimum and maximum amounts are used in assigning volume and price levels
to CATS and floor stocks. The t-statistic is from a difference of means t-test. N is the average number of firms trading in
March and May. All dollars are expressed in Canadian currency.

Volume Level
1-Low 2 3 4-Hlgh
March Profit (Loss) March Profit (Loss) March Profit (Loss) March Profit (Loss)
May Increase (Dec.) May increase (Dec.) May increase (Dec.) May increase (Dec.)
t-Statistic t'Statlstic t-Statistic t'Statistic
Price Level Avg. No. of Firms Avg. No. of Firms Avg. No. of Firms Avg. No. of Firms Row Average
Panel A. CATS
l-Lx»w $1311.52 $937.01 $326.85 ($738.03) $386.23
($1,831,73) ($205.48) $5,062.73 $5,034.96 $2,700.34
-2.171** -0.253 1.069 1.658 1.545
13.5 19 26 23 81.5
2 ($20,17) $714,93 ($511.25) $3,727.28 $853.05
$7,119.80 ($571i2) $2,861.61 ($4,038.61) $1,288,03
1.302 -0.925 1.690 -2.524»* 0.852
17.5 21 24 17.5 80
3 ($333,88) $1,338,00 $14,823.43 ($726.92) $4,687.20
$573,44 $22,591,66 ($18,999.69) $8,104.18 $922.14
1.575 0,954 -1.345 2.803*** 0.139
13 14 22.5 24 73.5
4-High $1,813.15 $1,305.69 $54.i71.95 $57,838.46 $27,806.62
(Sl.887.81) $5,484,89 ($31,601.77) ($56,989,87) ($19384,47)
-1.766* 1.153 -1.03] -0,985 -1.259
17 10,5 15.5 11.5 54,5
Cohimn Average $795.81 $1,009,01 $13,014.67 $15,23O..56 $7,033.43
$919.76 $5,924,76 ($7,898.34) ($13,055.51) ($2^49,98)
0.540 1,043 -1.074 -0.959 -0.710
61 64,5 88 52 289.5

Panel B. Floor
1-Low ($49.15) ($3,210.78) $2,112.24 $9,008.97 $2,729.96
$3,863.69 ($2,757.12) ($3,884.36) ($10,657.26) ($4,346.00)
1.574 -0.324 -1.536 -0.346 -0.455
18.5 23 24 31 101.5
2 ($333.35) ($2,601.71) ($21,053.41) ($42354.09) $21,395.86
$3,616.26 ($27,707.31) $35,413.65 $44,847,05 $19,500,15
1,767* -0.788 i.957* 1.238 1.160
17,5 24 25 37 103.5
3 ($1045.85) ($76,43334) $11,937.05 ($23,104.75) $22,404.62
$1,271,26 ($76,161.95) ($16,605.10) $25,628,50 ($15,500,16)
2,014* -0.450 -2.092** i,469 -0,367
14 24 23,5 34 100.5
4-High $1,021.21 $232,343.20 $10,650,35 $202,98 $43,154.93
($1,413,70) ($852,457.45) $11,393.21 $19,179.67 ($151315.41)
-0.340 -1.262 0.966 1.706* -1.199
23,5 18 29.5 37 98
Column Averse ($226.42) $21,781.63 $1,601.37 ($12,227.17) ($31.15)
$2,305.61 ($203,630.37) $5,699.35 $19,435.76 ($36,594.94)
1.862* -1.409 0.973 2.001*** -1.113
63.5 89 112 105 403.5

***Significant at the 0.01 level.

**Significant at the 0.05 level.
•Significant at the 0.10 level.
PORTER & WEAVER /TICK SIZE AND MARKET QUALITY

Table 12. Effect of the Adoption of Tick-Size Reduction on Order Flov^ Size and Composition
This table shows the effect of tick-size reduction on various measures of order flow size and cotnposition and demonstrates
values and changes for each measure for March and May 1996. the two months surrounding the reduction in minimum tick
size by the TSE in April 1996, for stocks trading above C$5 during the entire period.

Measure Trading Location March May Change

Share Volume CATS 137,539,904 168,788,012 22.72%

Floor 707,160.261 738,011,384 4.81%

Percentage of Share CATS 67.75% 65.39% -2.35%

Volume Represented
by Public Sell Orders Floor 57.10% 59.34% 2.23%

Percentage of Share CATS 67.26% 65.22% -2.04%

Viilunie Represented
by Public Buy Orders Floor 55.79% 61.86% 6.08%

Number of Public Sell CATS 44,272 53,482 20.80%

Orders
Floor 174,340 195,011 11.86%
Number of Public Buy CATS 47,634 55,453 16.41%
Orders
Floor 183,136 189,277 3.35%

Average Size of CATS 2.105 2,064 -1.95%

Public Sell Orders
(Shares) Floor 2,306 2,246 -2.60%

Average Size of CATS 1,942 1,985 2.21%

Public Buy Orders
(Shares) Floor 2.145 2,412 12.45%

experience an increase in the average size of public
buy orders following tick-size reduction, they also
experience a decline in average size of public sell
orders. However, since the increase in average size of
public buy orders exceeded the decline in sell orders,
we can conclude that, following tick-size reduction,
Ihe total variable portion of commission revenue
increased tor member firms. Since trading profits do
not significantly change, but cotnmission revenues
appear to increase, we can assume that the total effect
on member profits is positive.
D. Regressions
The observed changes in market quality measures
following tick-size reduction could be due to changes
in other influential variables. Table 13 shows the results
of regressing cbanges in market quality measures
against volume, variance of return, price, and a dummy
variable that captures any remaining effects due to
tick-size reduction. We report the regression
parameters and iheir associated t-statistics. the F-
statistic, and adjusted R- for each model.
The dummy variable parameter has a negative sign
for all of the spread tiieasures and the Hasbrouck and
Schwartz (1988) market-efficiency measure, which is
consistent with a reduction in execution costs. AH but
one of the dummy variable parameters for floor stocks
are statistically significant. However, only two of
the five CATS dummy variable parameters are
statistically significant.
To measure reductions in liquidity that could result
from tick-size reduction, we run the regression
including a dummy variable for bid or ask depth. (The
results from both regressions are qualitatively similar
so we report only the bid depth results.) The dutnmy
variable parameter tor bid size is statistically significant
and carries the predicted sign for both CATS and floor
stocks. The dummy variable parameter for the market-
efficiency coefficient and RT profits shows no
statistically significant relation with tick-size
reduction. We do not include other member profits,
since members are not constrained to trade in a set
of stocks, as are RTs,
V. Conclusions
This paper examines changes in market quality,
including internalizatioti and member profits, following
the adoption of decimal pricing by the TSE on April
15, 1996. We find that reducing the minimum tick size
24 FINANCIAL MANAGEMENT/WINTER 1997

Table 13. TSE Market Quality Regressions

To determine if observed changes in market quality measures are a function of conversion to decimalization, we regress:

where M is the average market quality measure (dollar spread, percentage spread, bid size, ask size, effective dollar
spread, effective percentage spread, market efficiency coefficient, execution cost, and RT profit) for firm i in month t
(March or May), V.^ is the log of share volume for firm i in month t; o-^^is the variance of daily return for firm i during
month t; P ^ is the average closing price for firm i during month t; and D^ ^ is a dummy variable which is assigned a value of
1 if t equals May and 0 otherwise. We use 165 (stocks) times 2 (months) or 330 (630) observations for the CATS (floor)
regression except for RT profit. Since RTs only trade in 123 (243) of the CATS (floor) stocks, the RT profit regression is
based on 246 (486) observations. R- is the adjusted coefficient of determination.

Market
Quality P. Volume Variance Price Dummy F-Statistic
Measure Location t-Statistic t-Statistic t-Statistic t-Statistic t-Statistic
Dollar Spread CATS 0.862 -0.065 29.214 0.016 -0.029 173.400
8.954*** -8.886*** 4.823*** 23.382*** -1.236 0.677
Floor 1.282 -0.088 1 8.799 0.009 -0.039 156.300
19.636*** -18.523*** 3.739*** 16.556*** -2.116** 0.497
Percentage CATS 0.085 -0.005 Z728 -0.000 -0.004 39.990
Spread 12.588*** -9.213*** 6.411*** -5.065*** -1.106 0.322
Flow 0.081 -0.004 0.848 -0.000 -0.004 241.200
-35.156*** -15.489*** 4.757*** -11.900*** -5.597*** 0.576
Bid Size CATS -165.026 17.163 48.412 -0.133 -14.707 34.300
^8.136*** 11.133*** -0.038 -0.935 -2 945*** 0.288
Floor -199.816 21.499 -4.055.800 -0.587 -27-816 88.747
-11.760*** 17.3M*** -3-098*** -3.858*** -5.831*** 0.358
Effective Dollar CATS 0.273 -0.020 11.651 0.006 -0.018 208.700
Spread 7.832*** -7.673*** 5.306*** 26.534*** -2.108** 0.716
Floor 0.538 -0.037 6.627 0.004 -0.001 56.200
12.262*** -11.688*** 1.959*** 9.368*** -0.068 0.259
Effective CATS 0.032 -0.002 I.1I5 -0.000 -0.001 37.706
Percentage 11.959*** -8.449*** 6.721*** -4.936*** -1.452 0.309
Spread Floor 0.032 -0.002 0.301 -0.000 -0.001 107-600
25.161*** -18-540*** 3.036*** -8.097*** -2.666*** 0.404
Market CATS 1.189 -0.047 40.898 0.001 O.0t2 14.812
Efificiency 9.609*** 4.960*** 5.253*** 0.606 1.363 0.144
CoefiFicient Floor 1.072 -0.038 40-511 0.004 0.039 22.300
11.748*** -5.833*** 5.765*** 4.524*** 1.528 0-119
Execution Cost CATS 0.001 0.000 0.388 -0.000 -0.001 24.058
a769 3.583*** 7.841*** -3.322*** -2.7%*** 0.219
Floor 0.004 -0.000 0.582 -0.000 -0.001 37.600
5.595*** -0.371 10.580*** -5.667*** -2.971*** 0-189

RT Profit CATS -1.144.514 591.404 -1,701,963 6.181 552.938 12,700

-1.271 1.799* -6.734*** 0.192 0.490 0.161
Floor -7,531.364 745.401 -2,764.885 63.803 -63.606 15.200
-1.413 1.945* -7.444*** 1.439 -0.043 0.105

'**Significant at the 0.01 level,

**Significanl at the 0.05 level.
*Significant at the 0.10 level.
 PORTER & WEAVER /TICK SIZE AND MARKET QUALITY 26

from C$0.125 to C$0.05 is generally accompanied by a experience a larger reduction in spread than the AMEX.
reduction in execution costs, especially for low-priced, To the extent that spread width is related to a firm's
high-volume stocks. We also find thai reducing the cost of capital, firms listing on the NYSE might
minimum tick size to C$.01 does not generate any experience a larger decline in cost of capital than firms
statistically significant change in execution costs. The that list on the AMEX,
tick-size reduction primarily benefits small traders, Many academics and government officials believe
since it is accompanied by a reduction in depth, which preferencing and internalization hurt investors by not
is of concern to large traders. providing optimal execution, and have called for tick-
Reducing the tick size does not eliminate size reduction to eliminate them. Our findings suggest
internalization and. by inference, preferencing. This tick-size reduction will have little impact on
finding contradicts recent papers which argue that preferencing or internalization. US regulators may want
tick-size reduction eliminates preferencing and to consider banning internalization in a manner similar
intcrnaiization by reducing excess rents caused when to a special committee of the TSE. which has
minimum tick sizes are larger than reservation prices. recommended banning internalization for trades of less
The evidence from the TSE data suggests that than 1,200 shares.'••
member trading profits are not adversely affected. If the results for the TSE can be generalized to the US,
Additionally, revenue derived from commissions then the US securities industry will not suffer economic
appears to increase. These findings contradict the loss from tick-size reduction, although the costs for
fears of the securities industry that profits would converting systems to decimal pricing could be large.
decline as a result of tick-size reduction. The TSE has recently announced that it is closing
The implications for US markets are that conversion its trading floor and will be using CATS for all stocks.
to complete tick-size reduction (US$0.01) pricing will However, ail stocks will trade using the sharing priority
bring about a reduction in execution costs for small system currently used to trade floor stocks. The
traders, but a move to nickel pricing will yield the same differences between the systems that we have detailed
result. The greater reductions in spread and depth for in this paper show that further academic study of
TSE floor stocks suggest that the NYSE might priority system rules is warranted. •

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