Tick Size: Theory and Evidence

We model a public limit order book where rational traders decide whether to demand or supply liquidity, and where liquidity builds endogenously. The model predicts that a reduction of the tick size will cause spreads and welfare to deteriorate for illiquid but improve for liquid books. We find empirical support for these predictions based on European and U.S. data. The model also generates predictions for volume, but we find less empirical support for these predictions which we attribute to opportunistic High-Frequency-Traders selectively entering the market.

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