TICK SIZE AND MARKET QUALITY

All of the US stock markets have reduced their respective minimum tick sizes. Since the three major US markets, the American Stock Exchange (AMEX), New York Stock Exchange (NYSE), and Nasdaq, all have different order-priority systems, the impact of the tick-size reduction on spre ad width, as well as other aspects of market quality, can differ acros s the markets. Given that previous research has established a link bet ween spread width and a firm's cost of capital, this differing impact is important to firms in their exchange-listing decision. This study e xamines changes in market quality across two different priority system s, price-time and price-sharing, following a reduction in the minimum tick size by the Toronto Stock Exchange (TSE) on April 15, 1996. We fi nd that, following the reduction in minimum tick size on the TSE, spre ads generally narrow and quoted depths decline for both priority syste ms. (Depth is defined as the total number of shares offered or sought at a price.) The effect is greatest on low-priced, high-volume stocks. We predict that price-time system stocks will experience a greater de cline in spreads than similar price-sharing system stocks, but we find that the reverse is true. Spreads on price-sharing system stocks in t he lowest-price, highest-volume portfolio narrow by an amount that is twice as large as the corresponding price-sharing system portfolio. Qu oted depths also decline by a greater amount for price-sharing system portfolios compared to price-time system portfolios. Very little chang e is found in either system, regarding the percentage of volume that i s internalized following the reduction in tick size. We also conclude that exchange member's trading profits are unaffected by the tick-size reduction. The TSE has two trading systems. The Computer-Assisted Tra ding System (CATS) has a strict price-time priority system similar to the AMEX. TSE floor stocks have a price-sharing priority system that i s somewhat similar to the NYSE. Accordingly, we first partition our da ta into CATS and floor stocks. We then assign stocks into one of 16 po rtfolios based on price and volume quartile membership. Floor stocks a re assigned first. CATS stocks are then assigned to portfolios using t he same range of price and volume values. We then calculate various me asures of market quality, including dollar and percentage quoted, effe ctive spreads, and bid and ask depth. To examine the change following the reduction in minimum tick size, we determine monthly means for eac h firm-specific measure during March and May 1996. Although we find th at spreads narrow and depths decline, the results for quoted depth mus t be interpreted with caution, since on the TSE traders can choose to hide part of their order. Therefore, actual depth can differ from quot ed depth. Data limitations do not allow us to test directly for change s in actual depth. However, we are able to examine actual depth indire ctly, and we conclude that in all probability, actual depth does not d ecline by as large a margin as does quoted depth. The nature of the TS E database allows us to examine directly two other aspects of market q uality, namely, internalization, and trading profits. ''Internalizatio n'' is defined as a brokerage house taking the other side of a public order rather than exposing it to the market for execution. Proponents of a reduction in minimum tick size believe that it will eliminate int ernalization. We find no statistically significant impact on either in ternalization or profits following the reduction in tick size. Because we compare the impact of a tick-size reduction on market quality acro ss different order-priority systems with similarities to competing US exchanges, our findings are important to financial managers. For examp le, one aspect of market quality, spread width, has been shown to be d irectly related to a firm's cost of capital. Given the differing impac t on market quality across priority systems, an understanding of this study will aid financial managers in choosing the best stock market fo r trading their firm's shares.