Tick Size, Institutional Trading, and Market Making : A Study of the SEC Tick Size Pilot Program

Using the 2016 SEC Tick Size Pilot Program, we study the effects of an increase in tick size on institutional trading, market making costs, profitability, and activities. We find that increasing the tick size deters institutional trading participation, as it results in unfavorable stock characteristics, such as greater price impact and depressed share prices. In particular, we show that the implementation of the pilot program creates a substitution effect, which causes mutual funds to migrate from pilot (wider-tick) stocks to control (narrower-tick) peers. Furthermore, we document that widening the tick size increases adverse selection and inventory costs and thus reduces market making profitability, leading to lower market-making activities. Further analysis shows that these adverse effects can be attributed to the trade-at rule that prevents pricematching in non-displaying trading centers, while the quote rule that mandates a minimum quote increment of five cents enriches market makers and promotes liquidity provision. Finally, we show that our results are more pronounced for tick-constrained stocks than for unconstrained ones. Overall, the evidence contradicts the SEC’s intent to use a larger tick size to incentivize market making in small-cap stocks and attract more investors to trade these stocks, and dispraises the “one-size-fits-all” approach undertaken by regulators